My First Post and First Deal!

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My First Post and First Deal!

Issac P.
Minneapolis, MN · Member since 2015 · 4 posts · 0 votes

Hi all!

This is my first post on Bigger Pockets but I've been following the forums for a while and have listened to almost all the podcasts!

I'm looking at a non-MLS duplex deal I found in the Minneapolis area in a neighborhood that is probably a "B" neighborhood but is very quickly gentrifying with the city pouring lots of money and attention into this area. Lots of new businesses are popping up and the demographic is changing very quickly.

I've included the numbers below over a 10 year period and I would love people's thoughts.

Asking Price: $235,000 ($240,000 including closing costs)

Annual Rent: $22200 could be raised to a market rate of $ 26,400 (this is what I'm basing the IRR below on).

Vacancy & Credit $1400

Annual Insurance: $2500

Licenses: $100

Property Management (10% of gross rent): $ 2640

Annual Repairs and Maintenance (including turnover costs): $3000

Property Taxes: $4000

Trash, Water, Sewer: $400

Total Expenses: $12640

Net Income: $12360

Cap Rate: 5.15%

Cap Rate on Purchase Price/Closing Cost of $220,000 (1% rule): 5.61%

The IRR below has been based on a yearly rent increase of 5% and a yearly increase in expenses of 2%.

IRR on Purchase Price of $240,000:

Initial Investment (as negative amount) (20% down) (48,000)
Cash Flow, End of Year 1 1600.32
Cash Flow, End of Year 2 2602.32
Cash Flow, End of Year 3 3661.86
Cash Flow, End of Year 4 4781.9658
Cash Flow, End of Year 5 5965.817466
Cash Flow, End of Year 6 7216.75710282
Cash Flow, End of Year 7 8538.2970167514
Cash Flow, End of Year 8 9934.12828755518
Cash Flow, End of Year 9 11408.1297702985
Cash Flow, End of Year 10 12964.3775485462


Internal Rate of Return 5.37%

IRR on Purchase Price of $220,000:

Initial Investment (as negative amount) (20% down) (44,000)
Cash Flow, End of Year 1 2517
Cash Flow, End of Year 2 3519
Cash Flow, End of Year 3 4578.54
Cash Flow, End of Year 4 5698.6458
Cash Flow, End of Year 5 6882.497466
Cash Flow, End of Year 6 8133.43710282
Cash Flow, End of Year 7 9454.9770167514
Cash Flow, End of Year 8 10850.8082875552
Cash Flow, End of Year 9 12324.8097702985
Cash Flow, End of Year 10 13881.0575485462


Internal Rate of Return 9.13%

A couple questions:

1. Do my expenses look reasonable? I'm having a hard time estimating out the annual Maintenance/Repair costs. I decided to go slightly higher as I haven't included the cost of hiring a lawn/snow service.

2. If I'm benchmarking this investment against the S&P 500 which returns about 9% annually with dividends reinvested over the past 30-40 years, would IRR be the correct tool to use?

3. If IRR would be the correct tool to use, even purchasing a property at the 1% rule gives me a return over 10 years that is worse than passively investing in the S&P 500. What am I missing here? I was hoping to do an IRR over 5 years but this gave me a negative return. I don't want to include appreciation in value because I don't know how to estimate that, and any attempt to would be speculation. I guess I could include equity buildup but I wanted to look at cash flow only. Thoughts?

4. Does a cap rate in the 5% range for a duplex that is meeting the 1% rule in an up and coming Minneapolis neighborhood seem reasonable? That seems really really low to me.

5. Does a yearly increase in rent of 5% and an increase in expenses of 2% seem reasonable for IRR calculations?

I really appreciate the input that people provide!

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  • Ben Rutkevitz
    Lender · New York City, NY · Member since 2015 · 104 posts · 26 votes
    11y

    Hi @Isaac,

    Disclaimer: I do not own any real estate. I have been lending in this space for 8 years though. 

    I just got a deal in Manhattan at a 5% cap rate. I dont know your area at all, but I am assuming that the cap rate is way too low for your area in a "B" neighborhood. I would see what other properties have sold for your in area and calculate their cap rates. My gut says that you should come in with a much lower offer.

    0Reply
  • Issac P.
    OP
    Minneapolis, MN · Member since 2015 · 4 posts · 0 votes
    11y

    Hello,

    I appreciate the response! The only other conclusion I have come to is that my expenses are out of line, but they are 50% of the gross income so they do satisfy the "50% rule"...

    0Reply
  • Logan Hassinger
    Specialist · Fort Worth, TX · Member since 2014 · 528 posts · 226 votes
    11y

    @Issac P.

    Based on the annual income and expenses you have provided I have calculated an NOI of $8,160. Your insurance expense seems high as well. Call a local agent and get a landlord quote, it's free. Your cap rate seems to be way to low given a "B" rating in an up and coming neighborhood. I would use closer to a 7 or 8 Cap.

    I personally underwrite to IRR and I have a minimum acceptable rate of 12%. My analysis values this property around 105,000. So for me, I wouldn't touch it.

    0Reply
  • Issac P.
    OP
    Minneapolis, MN · Member since 2015 · 4 posts · 0 votes
    11y
    Originally posted by @Logan Hassinger:

    @Issac P.

    Based on the annual income and expenses you have provided I have calculated an NOI of $8,160. Your insurance expense seems high as well. Call a local agent and get a landlord quote, it's free. Your cap rate seems to be way to low given a "B" rating in an up and coming neighborhood. I would use closer to a 7 or 8 Cap.

    I personally underwrite to IRR and I have a minimum acceptable rate of 12%. My analysis values this property around 105,000. So for me, I wouldn't touch it.

     Thanks for the response!

    I believe you used the current rental price to come up with the NOI and not the market rate? Can I get your NOI if market rental rate of $26,400 was charged?

    Thanks!

    0Reply
  • Issac P.
    OP
    Minneapolis, MN · Member since 2015 · 4 posts · 0 votes
    11y
    Originally posted by @Logan Hassinger:

    @Issac P.

    Based on the annual income and expenses you have provided I have calculated an NOI of $8,160. Your insurance expense seems high as well. Call a local agent and get a landlord quote, it's free. Your cap rate seems to be way to low given a "B" rating in an up and coming neighborhood. I would use closer to a 7 or 8 Cap.

    I personally underwrite to IRR and I have a minimum acceptable rate of 12%. My analysis values this property around 105,000. So for me, I wouldn't touch it.

    In addition, when you calculate IRR, do you just include cash flow or do you include depreciation savings and equity buildup?

    Thanks!

    0Reply
  • Dr. Scott Benjamin
    Involved In Real Estate · Melbourne, FL · Member since 2015 · 25 posts · 10 votes
    11y

    It looks like you've received solid advice so far.  A 5% cap rate in a B neighborhood does indeed seem really low.  I've worked many B class neighborhoods in Baltimore (probably similar to Minneapolis) and our cap rate targets for "challenging" properties was closer to 10%.  

    You should also consider the cash flow perspective. At 80% financing of $235,000 using 5.5% interest, your payment will run around $1,070. Annualized that is $12,840....gobbles up your NOI.

    0Reply
  • Logan Hassinger
    Specialist · Fort Worth, TX · Member since 2014 · 528 posts · 226 votes
    11y

    @Issac P.

    My IRR calculation assumes an increase in rents and expenses, loan pay down, and a future value of the property based on expected cap rate at the time of sell (educated guess).

    With increased rents of $26,400 and minimum IRR of 12% (not obtained until year 9), then purchase price around $135,000 assuming conventional loan.

    0Reply
  • Jon Loca
    Rental Property Investor · Saint Paul · Member since 2014 · 62 posts · 14 votes
    11y

    @Issac P.

    @Issac P.Hey Issac, I also think your insurance is a bit high, I'm in NE Minneapolis and mine is about 1200 a year... I do homestead though. Are you planning on paying for the water, sewer, trash expenses for your tenants? I think you have $400 being way too low, for my duplex I'm close to $1300 for everything. To say if this is a good deal or not would really depend on where this property is at. Feel free to reach out to me if you have questions. 

    0Reply
  • Marc Jolicoeur
    Investor · Minneapolis, MN · Member since 2012 · 187 posts · 117 votes
    11y

    Isaac,

    I do not own duplexes yet in Minneapolis but I know they get expensive in desirable areas.  Look at Uptown, Lyndale, Lynnhurst, Kingfield, Fulton, and around 48th & Chicago for examples.  They are all $150K to $200K more than what you are paying.  Are you actually in the city limits?

    With that in mind your deal might be a great deal IF you are correct that your neighborhood will turn the corner from "B" to "A-" in the next 10 years.   

    When you buy stocks you are betting on appreciation.  The dividend yield is under 2%.  The 8%+ expected returns from stocks include 2% dividends, 3% inflation, and another 3%+ appreciation.      

    When comparing the investment to cash flowing real estate, I think it is ok to look for some amount of conservatively estimated appreciation.  Of course, betting on appreciation could be a disaster, but so could index fund investing during a major recession.

    If I were to calculate an IRR I would add 2% for annual price appreciation due to inflation over the next 10 years. This depends on the building somewhat because an older rough looking building will start depreciating at some point in it's lifetime. However, land value in Minneapolis is probably appreciating at a faster pace than inflation.

    If you feel like your B neighborhood will become another Kingfield or Lyndale in the next few years, then you could add another appreciation factor. Proximity to light rail, trails, or lakes would be almost a guarantee of the 'hood to become gentrified. So if you wanted to bet on another 2% appreciation due to gentrification you would have an IRR of closer to 10% which is about as good as parking your money in the S&P and hoping for the best.

    PS. I think you should get price estimates for lawn and snow care.  That is a huge burden in most winters.

    0Reply
  • Kirtley Whittington
    Nashville, TN · Member since 2012 · 11 posts · 2 votes
    11y
    Not sure how long you have been looking but I would keep looking for a better deal. The numbers aren't impressive and buying on hopeful appreciation doesn't always work in your favor. It's better to buy on what you know than on what you hope for.. Best of luck going forward!
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