rental on 10 year note doesn't cashflow, is it ok?

Question

I signed the purchase agreement before finding this site, so the deal is done, but please help me analyze anyway.  The property doesn't cashflow but that's because it is a 10 year note at 8% (seller carry).

I am buying a mobile home on land with garage.  It needs  renovations with me doing the work.

purchase price: $80k
down payment: $16k
renovation materials: $3k
P&I payment: $800
expected rent: $900/month

tax is 600/yr so only $50 month.

Negative cash flow but this is for a long-term investment and the fact it will be paid off in 10 years has to add something to the deal.  Is it normal to include only the interest portion of the mortgage payment in the cash flow calculation?

I want better return than the stock market over 20 years.

Spencer B · Answer

Alex,

Leverage is great when it is used properly.  Risk/Reward needs to be appropriate.  In your example, going from 9.6% to 12% by putting yourself into $900k in debt @ 90% LTV is not something I'd call a good risk/reward curve and any institutional money money manager would agree.

Also, in your example, if you had 1 vacant house, your monthly income would be $900 minus the mortgage payment on that vacant home, which would probably be around $900, netting you around break even.  2 vacant homes, negative, 3 vacant, more negative.  Leverage is a very sharp double edged sword.

Alex Aronson · Answer

I do not like the deal.

When I buy real estate, I buy assets that make me money.  By defination, an asset is something that puts money in your pocket regardless if it appreciates or depreciates.  If does not, then it is a liability.  Rich people buy assets not liabilities.

Three things to consider:
1) With negative cash flow, what happens when you get in a cash crunch and cannot make a payment on the property?  That property is a liability not an asset.  Things might be fine now, but if your wife or girlfriend gets pregant or you have to get a new car note, will you be ok?

2) If you are ok with the negative cash flow you are assuming is sutainable now, have you imagined what the negative cash flow could be if the rent range is less than what you expected or if the property is vacant?  Can you continue to stay negative.

3) Your speculating that the land will appreciate and therefore you will make up your negative cashflow.  What happens if several crack dealers move in next door or that some government agency finds toxic waste next door?  What is the property worth then?
The difference between a real estate speculator and a real estate investor is that a speculator only makes money when they can sell the property and if the property is worth more than it is worth.  A real estate investor makes money when they buy the property and money when they sell it.

If you really want to do the deal, I would recoomend getting the seller financing first, then immediately get a new mortgage asap (since refi's are easier and cheaper than purchase loans to get in todays market place) and put that property on a 30 year note so that it at least makes money for you each and every month.

I would also like to add that you make more money buy using other peoples money and knot your own, so I am not sure why the big hurry to pay of the property in 10 years is for?  For example, if you have $100K to spend on real estate.  you could go and buy $100K property that rents for $1000 a month.  After taxes, property management, and insurance, lets say you are clearing $800 a month for arguement sake.  That is $9,600 a year or 9.6% return on your $100K which is better than most people can do in the stock market.  However, lets use other people's money and buy 10 $100K putting $10K down.  Each home also rents for $1,000 a month.  After expenses and mortgage, lets say you are clearing $100 for each home.  That gives you $1000 a month profit for $12K a year or 12% return.  If your cash flow is $200 per property then you have 24% return.  Also, if your 1 property is vacant, then your return for the month is 0.  However, with the 10 homes example, if 1 home is vacant, my return is $900 for the month.

Just food for thought.  Hope you can walk away from the deal, beacuse you can do better.  There are deal of the century that come up every day.

Jon Holdman · Answer

That 8.1% return is in nominal dollars.  While I think is a reasonable assumption that over time inflation will drive up both rents and expenses, that's not a given at all.  Different factors drive those two items, so its possible for them to diverge.  Five years ago here in Denver, vacancies were 12+%, thanks to everyone being able to buy.  Now they're more like 3%.  When vacancies go up, your rent tends to be flat, or even decline as you have to offer deals to get tenants.  Expenses on the other hand, may continue to rise.

Rentals are a source of income right now.  Best to buy rentals at a price and with terms that will allow them to produce income.  If you choose to plow the income back into paying them off, great.  But, if you're stuck with a deal that requires you to put money into it each month, you're limited in your other alternatives.  If properties are positive even a little, you can buy them all day.  If they're negative, you'll eventually run up against the limit of your other income.

If you want another evaluation, look at this property with more conventional terms.  $900 rent less 40% for expenses give $540 NOI.  Less $100/month in desired profit gives you $440 for debt service.  At 7% for 30 years that's a max price of $66K.  I'm not sure exactly how expenses would go for a trailer (I know they use some of the same hardware as RVs, and everything you buy for an RV is overpriced), so I might use a 50% ratio even with self-management.  That puts max price at $53K.

Betting on appreciation is dangerous.  Nice if you get it.  Better to be OK along the way in case you don't.  I think we have quite a ways to go down before we start seeing any appreciation, and then it will just be inflation.  Which promises to be high, so owning real assets, at the right price, isn't a bad idea.

Alex K. · Answer

OK thanks for the advice Wheatie.

I would like to add that the property (land) would be appreciating, and even if it's just keeping up with inflation, the return would be 8.1% after inflation, which no money manager would claim to match, especially with inflation at current levels.

The landlord hassle aspect is a very good point.  Money managers don't call when the toilet breaks.

Jon Holdman · Answer

One more think.  Have you actually closed?  If not, and you only have a grand or two on the line as earnest money, and the contract states that the sellers only remedy if you don't perform (i.e., no "specific performance" clause), you might really think about letting that go and walking away.  Unless the land really is worth something.  There's no trailer in existence that's worth anything near $80K.

Lonnie deal refers to Lonnie Scruggins, and his book "Deals on Wheels".  Its available in the store here.  Might want to give it a read.

Jon Holdman · Answer

Have a look at this recent thread on rental property expenses.  Expenses are much higher than you would think just walking in the door.  A one month note would be equivalent to paying cash.  One of the ways to evaluate an income property is the "cap rate" (capitalization rate).  This is NOI/purchase price.  NOI is gross rent less all expenses.  The rule of thumb from that other thread is that expenses run between 40 and 50% of rent.  I use 40 because I'm willing (for now) to manage them myself for free.  I used 50% in the rough calculation, but lets use 40% here. 40% of $900 is $360.  That leaves you an NOI of $540/month.  With a P&I payment of $800, you're in the hole $260/month.  If you paid cash, your annual cash flow would be $6480.  Divide by the $80K you paid, that's an 8.1% return.  Certainly better than CD's.    comparable for what I've managed long term in stocks, though below what money managers will tell you stocks should make.  For a risky, hassle investment like real estate, I'd like better returns.  I certainly want rentals that pay their way.

Maybe you'll be lucky, and your expenses will be less than the 40%.   But with rent of $900 and P&I or $800, there's no way this will make you money on a monthly basis.

But, if you can turn around and sell this after you fix it up and net $110-120K, then you've got a nice flip.

Michael Rossi · Answer

The bottom line is that you paid WAY TOO MUCH for this rental.  The good thing is that you have learned that early in your career and can do it right in the future.

Good Luck,

Mike

Alex K. · Answer

Wheatie,

If it was a 30 year note, the P&I would be $470/month and it would cash flow.  So it seems your rejection is based solely on the loan term length.  If I'm planning to own it for the long term, what's wrong with paying it off early?

Alex K. · Answer

Thanks for the info Wheatie.

There is an empty lot in the same neighborhood listed at $97k.  The property 2 houses away has a much smaller mobile and no garage, listed at $119k.  I called the agent and she said lots in that neighborhood with similar mobiles are selling for $105k to $110k with no garage.  The comps on zillow back that up.

Your formula for cash flow seems flawed, what if it was a 1 month note and didn't cash flow for one month, then cash flowed big time after that.  Your formula would say no way.

I have paid nothing so far but it still seems like a good deal, even if just to flip.

Jon Holdman · Answer

Ouch!  On a house, rent of $900/month and P&I of $800/month would amount to a $260-350/month loss.  This looks like the wrong end of a "Lonnie Deal".

You include whatever you have to pay out each month in the cash flow calculation.

Unlike houses, trailers are depreciating assets.  Good to buy, fix, and sell with owner financing.  Not so good to actually own.  Sorry.

What's the land worth?  How much land is there?  Hopefully, something like $70-75K.  Even a brand new trailer that's sells for $20K will only be worth a fraction of that in a few years.