Help me determine my "walk away" point

[Paul Witte]

I’m evaluating a deal for a buy-and-hold duplex in a stable, desirable area in a midwestern college town. The neighborhood is outside of the typical student rental perimeter around the University. The sale is being listed by an asset management company since the private seller is apparently incapacitated.

Though I know I need to get exact numbers for expenses as much as possible to be able to do a good analysis, I’m looking for how you would think through “How much is too much for rehab expenses?” on this deal.

Property details

Built in 1923 as a duplex with two side by side 3 bed 1.5 bath units. Hardwood floors and original woodwork. Detached 2 car garage in 2 divided bays (with doors missing for some reason). Corner lot. Property is in a stable area often inhabited by university-affiliated professionals.

Price

Initial asking price: $175,000, reduced 20 days after listed to $159k.

My offer of $155k was accepted today. Hoping to negotiate this down some after a complete property inspection.  If the seller won't budge, I'm trying to figure out my "walk away" point after calculating rehab costs.  

Property Condition & Rehab Needs

Seller-provided pre-inspection shows a property that looks like generally it has been neglected for 20 years. No major defects, but everything looks like it needs at least reconditioning. Mechanicals are past the end of their lifespan (furnaces are 38 years old, water heaters are leaking). Roof is ~12 years old.

Formal inspection hasn’t been done yet.

Expenses

Taxes are ~$4000/year

Haven't gotten PM estimates yet but assuming it's typical 8-10%ish

Expecting low vacancy rates since the area is desirable.

Financing would be a conventional 30 year loan at ~3.5% with 25% down ($38,750). Monthly payment for principal plus interest = $522.

Income

Units are currently rented with leases until March and July of 2021 at $895 and $925/mo, total $1820/mo.

Analysis

Rent to value: $1820 per month / $155k = ~1.2%

50% rule (expectation that 50% of rental income will on average go to non-mortgage expenses) = $910. Based on this gross rule, I’d expect cash flow of $1820 (monthly rents) - $910 (expense estimate) - payment ($522) to give an estimated cash flow of $388/month. I recognize this is a very rough estimate.  Based on this, cash-on-cash would be 8% if I put 20k into the rehab.  Is that fair?  Should I be estimating costs differently somehow?  

My question as stated above is “How do I decide how much is too much to pay for rehab costs?”

Thank you!

[Andrew B.]

Hey Paul hopefully some experienced investors will weigh in, but I'll give you my two cents in the mean time.  On BP Podcast 311 from 1/3/19 @J Scott indicated he was looking for at least 15% below market value to close his deals in order to hedge against a possible downturn in the Real Estate market many are still bracing for.  With that in terms of the initial offer you would want a clear idea of what the area comps are valued at to determine whether or not you're initial offer is providing you up front equity and is a good deal.  

Since you're looking to buy-and-hold assuming it cash flows well and you're planning to hang onto it for awhile that works in your favor.  The advice I have seen is not to rely too heavily on the 50% rule.  It is a metric that is more for determining whether or not you should put time into analyzing a deal.  Given that you're already to the point of having an offer accepted you're going to want to develop a very clear picture of the actual expenses measured against the income to be more accurate in terms of what you could actually expect for cash flow.

I think it comes down to what the house is currently worth versus comps regardless of what it was listed for since the offer was accepted only $4,000 below their asking price at that time.  Then you'll want to run a few scenarios on what kind of repairs you think it needs and what the after repair value would be once they're done again measured against comps.  You mentioned it may need a new roof, furnace, and water heater along with cosmetic work and that is before the inspection so from an equity/appreciation stand point it seems like the deal is thin.  Since it may need some work right away and/or in the first few years due to its age and neglect that could negatively impact cash flow during that time.

Most people have a tendency to underestimate expenses and overestimate income so having the numbers as solid as possible before due diligence is over and your locked in will be critical.  It's tough to fully analyze the deal not knowing all of the details on the condition of the home and what kind of rehab plan you're considering with the 20k.  Not knowing the actual current value based on comps as well as the after repair value based on comps makes it difficult also.  I'm not veteran though so hopefully someone else can give you another perspective.