Should I Accept the Counter Offer for a SFH in SoCal?

[Annie Li]

I'm a new investor and would love to hear your opinion on my 1st rental property purchase attempt in Southern California.

The good:

1. 4/2/2 1600 sf SFH with big yard;

2. flipped house so everything is new;

3. comps with smaller square footage or not so good condition are all over $100k (ARV is around $120k-130k), and seller countered for $75k;

4. it can rent for $1000/month;

5. it's a relatively safe and quiet area.

The bad: 

1. vacancy rate is like 20%-30% in average for that area because it's rural and has lots of rental properties;

2. roof is in very bad shape and will need to be replaced in a year or 2, which will cost about $5000-$8000;

3. no dishwasher, will cost about $1000-$1500 to alter kitchen cabinets and add dishwasher;

4. only has vinyl siding, not a good choice for high heat area and will stretch and sag, cost $5000+ to replace with stucco;

5. no separate garage door connecting main house, will cost about $1000 to add it;

6. house is about 2.5 hours away from where I live;

7. almost no appreciation.

Expenses: 

property tax: $1541

insurance: $570

property management: 10%

maintenance: 5%

tenant replacement: one month rent

I understand how hard it is to find cash flow properties in SoCal, so I'm struggling on whether to proceed with this deal even though cash flow is only about $100/month, not to mention cash on cash ROI is less than 5% considering all the capital expenses in the near future.

I welcome any input.  Thanks in advance.

[Kyle J.]

Originally posted by @Annie Li:

@John D. Yes, I was using BP rental calc for my analysis.  I mentioned 1.33% because it's so unusual in SoCal which is one of the main reasons I placed an offer.  I also noticed those SFHs with non-permitted alternations, but the ones I looked are all in horrible conditions that I'm not too excited to deal with being far away.

@Matt R.

Hey Annie,

1.33% rent/value might sound good (especially in SoCal), but that's just a super quick "rule of thumb" to help quickly rule out properties that don't fit your criteria or warrant further investment of your time. But as correctly pointed out by John, when you have abnormally high numbers in other categories (like vacancy), you have to take that into account too.

For instance, if you had the choice of purchasing House "A" for $75k that rented for $1,000/month (which is 1.33% and your exact example), or House "B" for $75K that rented for only $675/month (less than 1%), which would you choose? Probably House "A", right? But what if I told you that House "A" was in an area with 30% vacancy and House "B" was in an area with only 5% vacancy? Would you still go with House "A"?

Let's see which would likely bring you more money after 5 years of ownership:

- House "A" = $1000/mo for 5 years is $60,000. But you're only going to collect 70% of that because of your 30% vacancy rate, so that brings you down to $42,000. Now subtract 10% from that for your Property Mgmt fee and that'll bring you down to $37,800. But wait, every time you had a vacancy, you also had to pay your Property Manager one month's rent for new tenant placement. With a 30% vacancy rate you probably had to place about 7 tenants in the 5 years, so that's another $7,000 to pay to the PM. Now you're at $30,800 (before any other expenses).

- House "B" = $675/mo for 5 years is only $40,500. But your vacancy rate on this house is only 5% so you'll still be at $38,475 after factoring that in. Now subtract 10% from that for your Property Mgmt fee and that'll bring you down to about $34,627. With a 5% vacancy rate, let's say you had to place 3 tenants in the 5 years, which would be another $2,025 to pay to the PM. Now you're at $32,602 (before any other expenses), which is more than House "A" even though the rent on House "A" was actually quite a bit higher. 

(The numbers above obviously leave out other less variable expenses for simplicity sake, but keep in mind some expenses - like utilities - could also cost you more on House "A" because you'll have to pay them while your house sits vacant for more months.)

Anyway, I tried not to make this too confusing but I just wanted to point out how a "rule of thumb" like the 1% rule (or in your case, the 1.33% rule) can be misleading when you take other factors into consideration.

Good luck with your investing whatever you decide. :)