Should I flip it or rent it?

Question

I have purchased a single family home: 1550 sq feet, 3 bedroom, 2 bath that I initially bought for a rental. However, due to home prices in my area I'm wondering if this should be a flip instead.

Here are the numbers:

purchase price $142,000

Closing costs: $7500

Repairs/updating: $9500.00

Carrying cost: $1800

Rental rates are $1400 for a 3 bed/2bath in this area.

Home sales are $110/sq foot (no remodeling, as is) up to $120 sq foot with updates.

Any thoughts or feedback?

David Faulkner · Answer

Forget about the % of rent for CapEx ... that is garbage IMO. The roof costs what it costs to be replaced and when it does, the roof does not know nor does it care how much rent is on the house. You need a more detailed grass roots analysis ... take all the things that will need to be replaced in time ... flooring, HVAC, plumbing, electric, roof, etc. ... ALL of it. Estimate how much for that particular property how much it will cost to replace each of those items. Estimate the usable lifespan for each of those items. Combine the replacement cost and the usable lifespan to calculate $/mo for each of those items. Add them all up ... that is a reasonable estimate for CapEx expense. Guaranteed your answer will be >$100/mo. Here is an example, ripped of from one of Ben Leybovich's articles:

https://www.biggerpockets.com/renewsblog/wp-content/uploads/2015/03/CapEx_Aricle_TABLE_1.png

Also, another false statement I see on BP all the time is that because it is newly remodeled, an investor should be able to eliminate or reduce the CapEx expenses... this one is actively sold by the turnkey companies as is the % of rent CapEx falsehood, if they even talk about CapEx at all. It is all FALSE. If a property is newly remodeled, then you can get away with lower initial CapEx funds in your reserve account, but the $/mo figure calculated above does not change nor should the CapEx monthly expense. In other words, even if a property is freshly remodeled does NOT make you immune to all those expenses ... if you hold onto the property long enough (as you well should as a buy and hold investor), then sooner or later those items are going to need to be replaced and are going to cost money to replace ... if that money does not come from CapEx reserves taken out over time as a CapEx expense in the budget, then where else would the money come from?

CapEx is one of the major things I see newbies get wrong and as a result get in trouble over the long term, so great question and I hope this explanation helps ...

David Faulkner · Answer

No way, no how is your CapEx going to average $100/mo for a 1,550 sf SFR, not going to happen ... putting in a realistic number there and I'm guessing you'd be cash flow neutral (break even, plus or minus a few bucks). Problem is that CapEx being what it is, you may not discover this fact until a few years in ...

I like the mindset and practice of buying a property that would work as either a flip or a rental since it gives you multiple exit strategies, but I have to agree with others on this one ... unless there is an established historical track record for excellent appreciation in this neighborhood over the long term or some other catalyst where you are VERY sure the property will appreciate long term very well, then this property does not work out well as either a flip or a rental. If you already own it, I'd flip it and move on with a few lessons and more experience under your belt.

David Faulkner · Answer

I respectfully disagree ... gross rental income and CapEx expenses are two variables that are not really directly correlated, so I never understood why some try to calculate one as some percentage of the other. Yes, you can look at thousands of properties in a particular market and calculate average CapEx expenses as a percentage of gross rents, but that doesn't mean they are correlated or that % is useful, especially when trying to apply that same % to a different market (as is often done). To me it is just mental laziness to do that rather than do any real grass roots analysis. To further emphasize my point, here is an illustration ... say there is a 1550 SF house in Los Angeles, composite shingle roof, stucco exterior, etc. It rents for $3000/mo, which is market rent for that neighborhood. Let's say there is the identical property in Phoenix AZ, same 1550 SF, same composite roof, same stucco exterior, except that rent is $1000/mo because it is in Phoenix. The roof in LA goes out and at the same time the roof in Phoenix goes out. Does it take 3x as much to replace the same roof in LA because the rent is 3x more? No it does not! Perhaps a little higher in LA because the labor cost will be a bit higher, but material cost is roughly equivalent and total cost is not 3x. Yet that is what the calculations of CapEx based on % of rent would imply. It is therefore a bogus calculation to me as it is applied by most and can get people in trouble ... it will tend to over estimate CapEx expenses in a high rent area and under estimate in a low rent area ...

I do agree with you that CapEx is computed as the average over 30 or so years and will be "lumpy" in that it may be zero for several years in a row, then whamo, you get hit with a big bill for a major replacement, but what is computed is intended to be the average over the usable life span of those items ... agree with that, just disagree it seems on the best and most sensible way to calculate that average.

Thomas S. · Answer

Actually the use of percentages on the expenses related to income rental properties are usually very accurate measurements based on hundreds of thousands of rental property statistics. However what nay Sayers seem to misunderstand is that those percentages are based on the life of a property, 20 maybe 30 years. All costs are added up during it's 30 years life span and averaged out to be represented by a statistically accurate percentage estimate. A rental home built in 2016 will not have 5% - 10% cap expenses in year one but when added up over the life span (30 yrs) of the property and divided by 30 years it will fall into that estimated percentage.

In your case you have neglected to include many expenses and you will be lucky to break even if you hold the property long term.

John Leavelle · Answer

Howdy @Jennifer MacDonald

What @Jd Martin is referring to is your rent rate ($1400) is low for the purchase price ($142,000).  It does not quite make the 1% rule.  We will need to see your expense data along with your current mortgage payment to provide any comments on rental property option.  What is your estimated Cash Flow?

JD Martin · Answer

You paid too much for that property to be a rental. SFHs work in a lot of places but in this case you really don't have any room to do anything. 1550x$120/sf = $186k. You're $160k into this already, so unless you sell without a realtor for your top price you're going to break even at best.

Either you hope for appreciation here, or you consider it a learning opportunity and move on.

John Leavelle · Answer

I agree with both Thomas S. to an extent.  I believe it is prudent to use a percentage of income in the initial analysis of a property.  Since I want to be conservative I like using 10%.  Once the property is under contract I can have the property inspected and I then use the more accurate method of individual CapEx item evaluation.  i estimate the useful life and replacement cost of each along with current age and condition of the property.  This gives me a total reserve amount to save for and what the monthly withholding should be.  Example:  Life expectancy of some CapEx items to be 5 years with an estimated cost of $15,000.  Monthly CapEx withholding's = $15,000 / 60 months (5 yrs.) = $250 per month.  Obviously this would have no bearing on what the income is.  However, it will effect Cash Flow.  So far in my limited experience most of the properties have been within the 5 - 10% of income range.

Jennifer MacDonald · Answer

The $100/month cap ex is based on 7%.  Most of what I have read says 5 to 10% for cap ex so I just went with a middle of the road value.  What % do you recommend for a 1500 sq foot SFR?

Jennifer MacDonald · Answer

Here is the breakdown:

Rental rate: $1400

Mortgage/insurance/taxes: $850

Vacancy-$98

CapEx-$100

Repairs-$70

Property management-$125

Estimated cash flow-$150/month

Jennifer MacDonald · Answer

JD, did you mean I paid too much for the property to be a flip?  You said rental but I think I am reading that you meant flip based on the number quotes.

I should say I did buy with the intention of renting and possibly even making this my home in a few years.  Very desirable area just not ready to move that way yet due to my job, however, in the future for sure.

Should I flip it or rent it?

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