Please look at this proposal and tell me why it won't work

[Glenn Mayo]

First, thank you all for helping. Helping with what? Well, helping me to decide whether or not to put in this offer. I'm looking at it, and I THINK it'd work, but I can't help but feel that I'm missing something, or that there's something fundamentally flawed in my thought process that makes this unworkable. So, I'd really appreciate this august community looking at this idea and picking it apart to help me see the flaws.

Ok, I have located a 2 BR, 1.5 BR duplex near my home. It was built in 1970, and it doesn't look like it's been updated much since. It DEFINITELY needs a new roof, and although it doesn't quite need a gut rehab, it definitely needs completely new kitchens, bathrooms, floors, windows, doors, and various other updates and repairs. I know a new roof can cost anywhere from $4000 to $15,000 (I'm not going for the super fancy, high end roof that can cost MANY times more), so I just figured the high end to be conservative, and budgeted $15000 for the roof. I figured another $25,000 for the rest of the work, using decent, but not fancy, apartment grade stuff. So, $40,000

The seller owns the property free and clear, and is willing to do seller financing. He has it listed for $125,000, but my agent says that's overpriced, and that, in our area, the ARV is actually $110,000 - $115,000. Again, being conservative, I figured $110,000. If it appraises for more, great, but I'd rather count on it not.

Alright, here's the proposal I want to submit:

$87,000 purchase price: I know this is closer to 75% ARV, but I figure that the seller is going to want some consideration for carrying the note. More on that in a second. I think the seller may try to wring more than that out of me, but my reply to that is that I have to put a whole new roof on the place and then do a complete rehab on top of it, so...

$20,000 cash down: I figure cash talks, and $20,000 isn't anything to sneeze at.

Seller would carry a $67,000 note for 20 years, making my payments to him 279.17/month for 20 years.

To make this work, I'd have to:

- Secure a hard money loan for 70% ARV, or $77,000.

- From that, pay the seller $20,000

- Use the remaining $57,000 to rehab the property

"Now wait!", I hear you saying, "You said your rehab budget was $40,000!" Yes. Yes, I did. However, things tend to go wrong, and sometimes unexpected things come up. Here in Texas, those unexpected things sometimes take the form of foundation issues. I don't think there's anything wrong with the foundation, but you never know, and in any case, there are certainly some 1970's oddities about this place that it may take more than I suspect to fix. So, being conservative again, I left a $17,000 cushion, just in case. Whatever doesn't get spent on the rehab, I'll pay to the seller to pay down the note. But I'm not counting that pay-down in the rest of my figures.

I'm figuring that the HML will charge me 14% interest and 4 points on the loan. That makes my payments to the HML $1155/month. Add in the payment to the seller, and that makes my monthly payment to debt service $1434.17. To that, I have to add another couple hundred for insurance, taxes, electricity, water, etc., etc. I figure I'll be putting out $2000/month all told, which means I'll be hemorrhaging money for a month or two, until I can get a the rehab finished and get tenants into the place and shift the burden of the payments to their rents. It'll hurt, but I can do it. Each side of the place will easily rent for $725 in this area (and maybe more, but again, playing it safe), and the tenants will pay all of their own utilities. Their rents will cover my debt service plus trash removal and a little bit of my insurance. I'll have to spend the year paying a little bit for insurance, but it's not a tremendous amount.

In a year, I refinance at 80% of ARV. I use the $88,000 to pay off the HML (Which, with points and interest, is actually $90,860, minus a year of payments - $13,860 - leaving $77,000), leaving me $11,000. I pay that $11,000 to the original seller, reducing my balance with him to $52,649.96 ($67,000 - 3350.04 (sum of 12 monthly payments of $279.19) - $11,000).

I am now left with a new 30 year mortgage of $92,840 ($88,000 + 5.5% interest). My monthly debt service will be $537.06 ($257.89 on the new mortgage + $279.17 on the seller's mortgage). Even figuring in my other costs, one unit will cover almost all, if not all, of my monthly expenses on the house. At this point, I stop bleeding and start cash flowing.

In 5 years, I sell the property for $130,000. ($110,000 ARV + ~3.4% appreciation/year: I like to peg appreciation roughly to inflation, that way, if it appreciates more, it's a nice surprise). I pay off the remaining mortgage of $77,366.60, and the remaining seller's mortgage of $35,899.76, leaving me a profit of $16,733.64. Looked at another way, my profit would actually be $52,733.64 ($16,733.64 profit from sale + $36,000 profit from rent of one side of the building over 4 years). Or, I could hold onto it, and keep collecting rent on it forever. The big trick seems to be getting through the first year, which is just going to be painful, no matter how I slice it.

So, that's what I'm thinking. Where are the holes? Will this work?

[Glenn Mayo]

Originally posted by @Ben Leybovich:

Glenn,

HML don't typically like to sit in deals for as long as 12 months. Also, the ARV being this low, I am not sure any of them would be interested. Thus, I am not sure that any of this is real...

Having said this, If your debt service is $1,400/month, all the rest of your OpEx are certainly going to be higher that $600 more. In other words, you'll be bleeding much more than you think - and HML guys know this. Therefore, if one of them actually agrees, it is because they want to get in, foreclose on you, and do it right. But, with the owner in 2nd - let me just say I'd never be that owner in 2nd with these kind of margin...:)

But, more importantly - I am not sure why you even want this thing? What is your stabilized CF projection? What are the stabilized rents?

I think that you might be making a classic newbie mistake - you are focused on HOW to buy something, instead of being focused on WHY buy it in the first place...?!

 Ben, your response is EXACTLY why I posted this, and why I asked you to look at it. I knew there was something wrong with how I was thinking, but being new, I couldn't pinpoint what it was. It's that shift from HOW to WHY that I was overlooking.

Now, that being said, this IS a real place, the listed price is $125,000, and the ARV is $110,000 - $115,000. If you were looking at it, knowing that you like to buy with as little out of pocket as possible, how would you do it?