Help evaluating a deal! What am I missing?

Question

Hello everyone! We have a deal that we are evaluating and need some thoughts/feedback on what we could be missing or looking at incorrectly. The numbers are great, but there are a few risks involved too.

Looking for thoughts, guidance, insight that could help us make the right decision.

Details:

- Large SFH (6 bedrooms / 5 baths) in a good community with a mix of newer large homes and older ranch style homes

- Comes with a tenant that just signed a 5 year lease for $8,000/month with $300 increases built in every year

- Basically NNN as the owner is only responsible for taxes (~$16,000/year) and insurance (~$300-400/month), the tenant pays for everything else

- The tenant doesn't live there, but lists the property on short term rental sites like AirBnB/VRBO. They do this with a few other properties in the area. Some they own, and some they rent. AirBnB is fully legal in our state/county/city.

- Purchase price would be around $700k, which is equal to the highest selling property in the area over the last 2 years. No appreciation expected so selling in the future would be a last resort exit strategy. We would also lose money renting it long term.

- Weird house layout as it has had several additions over the years. So it is great for STR, but bad for a primary residence. It has been on/off the market for several years and would be difficult to resell due to the layout. Listed by a commercial brokerage possibly because of previous challenges selling on the MLS.

- We had a bad experience with this broker in the past which makes us wary of anything he represents

- Optional HOA in this neighborhood for the community amenities, but supposedly any deed restrictions on this property have expired. If during due diligence we find that isn't the case this deal would be an immediate no go.

Financial breakdown:

Monthly Expenses = $4,775 (P&I = $3,092 ; Insurance = $350 ; Taxes = $1,333)

Monthly Income = $8,000

Monthly cash flow = $3,225 (27% cash on cash, 10.83% cap rate, 2.04 debt coverage)

The return seems to outweigh any potential risks, but we can't help but think we are missing something.

Thanks in advance for your help!

Justin Ellis · Answer

@Lucas LeBlanc unlike @Ned Carey I'm a big fan of STR however I agree with him that I don't like this situation.

If I understand correctly, if the current tenant bails and you needed to rent it to a standard tenant you would lose money monthly? If so, that's a bad contingency plan.

On a side note, this leads me to believe they're paying more than market rent in exchange for the sublease privilege?  Moving on...

STR may be legal where you're at however it's a real touchy subject within communities now, especially those with an HOA. Legal or not, the HOA can rule it out and it's done. They don't usually grandfather like municipalities do, it's "effective this date in the near future, all activity must cease". And I assume your tenant has a clause in the lease that lets them out if regulatory changes prohibit them from using the property as intended? (I know I would)!

So there you sit with a big ass property that can't  be used for STR and is a loser when rented to a standard tenant. Way to risky in my opinion....

"And for that reason, I'm out" :)

Joe Scaparra · Answer

I have 18 long term tenants but I just ventured into 1 STR.  I don't like this deal for several reasons.  In order for you to be satisfied, everything has to work out perfectly and we know that most of the time that is not the case.

What I mean, is that you have to rely on someone else's success for you to be successful.  If for whatever reason his STR business falters then your in deep Kimchee! You will be left with a very unique home that is hard to sell.  You have no shot at renting it out yourself and break-even much less think about making a profit.

I am learning that there are a lot more moving parts that have to be dealt with using an STR strategy.  One strategy STR investors use is renting other homes and turning them into STR.  However, if the business plan fails there is little incentive for the STR investor to hang in there to make it work.  Just walk away and leave the property owner holding the bag.

Look, if everything works as it supposed to you might be fine.  But you have failure if the actions of another don't go as plan.  If we were talking about a small 200k home with less risk and a backup option of getting a long term tenant should this STR strategy fail then OK.  But that is not what you are looking at.  You have no backup option, you're on a boat in rough seas and you really don't know enough about the captain to have confidence that you can get to your destination.

Good luck, cheers.

Ned Carey · Answer

That is great, I would want even more assurance. What are the financials of the company itself? Will the owners personally guarantee the rent. Remember if they are renting all their STRs then the company has no assets to go after.

It is worth considering the legal climate. Is there potential for the law to change regarding STRs in your area?  What happens when the economy changes and how will that affect STRs?

I am not saying don't do this. Just be aware of the potential risks you may have overlooked. Good luck.

Ola Dantis · Answer

@Lucas LeBlanc

What I don't like about this deal is that if it is so great ($3,225 MONTHLY CASHFLOW), then why in the world would the current owner want to sell this cash cow?!!

I would be cautious...

Lucas LeBlanc · Answer

UPDATE: This is a hard no go. Just spoke with someone from the HOA and it very much operates like a traditional HOA despite what the agent/tenant were saying. They are currently working with legal council to get amendments put in so they can limit STR.

Thank you everyone for your thoughts/feedback! On to the next!

Parechay M. · Answer

It's good to have an option like being profitable with long term tenant. STR's are great but for some of the communities it is still a taboo.Things can change anytime .So it's a no go for me. As @Erik Whiting, yes rich communities will take quick actions and have the power to change policies at HOA anytime.

Erik W. · Answer

6 bedroom houses are going to attract BIG group with MULTIPLE families/friends.  Wear and tear will be much higher than usual.  Will your STR master tenant have the expertise and diligence to keep up?

1 year experience STR?  Anyone can run a business for a year in a booming economy.  How's his track record during a slow down?

Also, what about the neighbors?  Will they be getting upset with all the extra traffic and calling the cops over?  Sounds like this house is in a rich neighborhood.  Rich neighbors pay premium prices to live in neighborhoods that aren't frequented by transients (i.e. people moving in and out every 2-7 days).  Will they be happy seeing strangers in THEIR pool or on THEIR clubhouse (or whatever HOA amenities are provided)?  They also have connections and funds to make legal trouble for people who aren't "fitting in", and I don't think the usage of this house will "fit it" well in the type of hood I imagine it's in.

Sounds like what you've got is a home only usable as a one-off timeshare for large groups, but you're not even getting the higher rent and maintenance fees that make typical timeshares profitable.  Too many potential problems to interest me.

Lucas LeBlanc · Answer

@Ned Carey @Justin Ellis @Joe Scaparra

Thank you for your thoughts! If what I'm hearing is correct these are the reasons you would walk away from this deal and some more detail around them:

1. Risk of the underlying viability of the tenant's STR business with this property and their ability to pay the monthly rent

- They have been running this specific STR for almost a year now and average ~$14k/month in rental income, and future months are already filling up. We would do a full audit of their finances during due diligence to have them prove this $14k number. @Ned Carey you are correct that they are paying well above market long term rent at $8k/month.

- If the current tenant leaves for some reason, my wife and I would take over running the STR business as we have experience with that and it is part of our overall strategy.

2. HOA risk

- This isn't your typical HOA as it is optional and doesn't hold the typical HOA powers. We are currently digging into the specifics, but if the HOA has ANY restrictions or covenants over this specific property then we walk. The agent and tenant are adamant that they don't, but we need to find this out for ourselves.

So overall, the only way we would end up being upside down on this is if the ability to use it as a STR goes away. And if that happens 4+ years down the road we will still come out ahead even if we take a bit of a loss on the resale due to the accrued cash flow.

Ned Carey · Answer

@Lucas LeBlanc I am not a fan of short term rentals, in part because I don't know enough about them.

How much can this tenant expect to sublease this for? How credit worthy is the tenant? This isn't a deal I would consider as it seems to have to much risk for me. If I understand you correctly, if the long term tenant fails, you are way upside down.

Help evaluating a deal! What am I missing?

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