Am I crazy to make an offer?

[David Whartnaby]

Hi all, I live in Fargo, ND and the market has been hot here but has slowed down during the last quarter. Really tough to find deals still though. I visited a FSBO property and spoke with the owner... The home is a 2BR 1BA ranch built on a crawl space. It is in excellent condition with an updated bath, brand new furnace, newer windows, roof shows no wear or tear. Nice neighborhood... I do not see any major CAP Ex expenses coming in the near future other than possibly replacing the washer/dryer which are old. Owner paid $122,500 13 months ago and just paid for a new furnace on top of that. House is listed for $127,500 at the moment. She told me that she has little wiggle room since she has very little equity in the home. She accepted a new job about 1.5 hours away, already has housing lined up and plans to move. She told me that she will stay though if she doesn’t receive a decent offer. Her terms: 30yr, 3.5%, and she put about 5% down. Rent comps run in the $900-950 range. I am aware that this property long term may not cash flow well. However, starter homes have appreciated 8% over the last 4-5 years in this market. My dad is an appraiser and I am currently training under him. Our research indicates this type of property will not depreciate but only continue to appreciate at the moment (albeit more like 3-4% per year). Even during the great crash, these homes did not depreciate in this market but more flatlined for a little while. Since it is also December, historically speaking homes sell for about 10% less in the 4th quarter and 1st quarter in this market than during the spring time when more home buyers are out shopping. Vacancy rates are around 10%. If I can negotiate a CFD and pay her the equity she has in the property, am I crazy to take over the property? It would cost round about $10,000 all told up front by paying her equity piece and closing costs. I calculate that PITI would be around $700 per month for us. It won’t necessarily cash flow long term but i could sell the home in about 5 years and pocket the appreciation and debt that would be paid down by the tenant in addition to the short term tax breaks. The idea would be to sell before having to pay any major CAP Ex expenses and before the home “depreciates significantly” in the eyes of an owner occupant. How much would you allocate to CAP Ex on a property like this usually? Is this a crazy idea? How much risk would I really be assuming in this scenario? Thoughts?

[Steve S.]

Please forgive me if I have my facts messed up.

1) You believe this property will rent for around $900-950

2) If you purchase this property you believe it will cost you around $700 in mortgage fees.

3) there's 10% vacancy rate in this area.

I would run from this deal! There's only $200 difference between your mortgage and the rent, and you still will have to pay for insurance, land taxes and wear and tear on the property between tenants.

You won't make ANY money! This won't be a positive cash flow it's a negative cash flow.  And what if the property doesn't rent for 3-6  months? Will you be breaking a sweat paying off that mortgage without a tenant? Or will you settle for a tenant that you may not typically want. (This is the start to every bad tenant eviction story BTW!!)

From the sounds of it you're trying to justify this decision by saying the property will appreciate over time. I live just a little north of you across the border and I would say our housing markets are relatively the same. Sure the markets won't "slump" but they don't surge either. Think of property appreciation as the cherry on top. The "long term holiday bonus" you get for the years you put in managing the property or finding and working such a good deal.

Even with 3-4% appreciation you will be putting money into this property hand and foot I assure you, and at the end of 5 years you will realize that the total net gain, you probably will be far better off putting the money you did have into either (a) a better deal or (b) some sort of ETF that averages between 6&7% a year.

This first place you make your money in real estate is on the BUY! The numbers have to be right. Now if I told you, that you could buy this property for 80K it would be a no brainer for you and you'd pick up this property in a heartbeat b/c you KNOW you could make money right off the hop.

Seems like in this deal you're trying to "justify" poor cashflow by "utilizing" appreciate values. That's very VERY VERY VERY bad business practices. You can only count on the money that's in your hand, not on what MIGHT happen in a 5-10 year window.

Run don't walk from this deal... go home and start crunching the numbers to figure out how after ALL expenses and you should always include cap ex! (even if the house is brand new!!!) that you can generate positive cash flow.

hint: I look for a cash flow between $150 and $300 as acceptable, with an ROI of around 11%. All "appreciation" is just a bonus and should NEVER be considered as a reason to invest into a deal.