The California Kid

The true story of a real estate investor who didn’t perform due diligence

There has been a push in recent years for real estate investors to buy homes in regions they believe will provide the greatest cash flow from monthly rents. Investors from all over the world are buying homes in areas hardest hit by the foreclosure crisis to try and maximize cash flow. Places like Cleveland, Detroit and Indianapolis offer homes for as little as $500.00. Many of these homes need little work, increasing the temptation to buy. Investors who are buying homes in areas they’ve never been to do so mainly because they cannot find homes cheap enough to produce a monthly cash flow where they live. They also believe that no matter where they buy a house, property management will be easy and they can just sell the house for profit if they run into problems. This unfortunately, is not always the case.

The “California Kid” is a nickname I gave to an investor who randomly called me out of the blue in 2008. I was a hard money lender operating in a suburb of Detroit, Michigan at the time. In case you are unaware, a “hard money” loan is designed to allow a home buyer to purchase and renovate a home using just one loan. Most hard money lenders will loan up to 65% of the final after repaired value (ARV) of most homes. During our initial consultation, the California Kid explained to me that he had just bought 18 homes in Detroit for the price of $10,000 each and wanted to get started rehabbing them. It has always been a macho thing for investors to purchase homes right from banks in “bulk” fashion because investing like this is usually reserved for big investors with a lot of cash; banks usually don’t sell bulk portfolios to puny investors. The California Kid was in the “big leagues” – or so he thought, despite having no experience investing. He was very excited to start these rehabs and he confessed to me that this portfolio of homes represented his life savings of $180,000. Once rehabbed, his intention was to hold these homes and rent them for a monthly cash flow.

Failure to check area home values and available financing options

Some real estate investors buy homes using their own cash and then refinance their purchase price plus anticipated rehab costs out of the home with a hard money lender. This strategy is practiced most by experienced investors who want to close a purchase quickly; doing so fends off other buyers, thus securing their deal. Investors will only make purchases like this if they know with absolute certainty, the values of the homes to be purchased and what financing options are available to them for purchase price reimbursement, closing costs, rehab expenses and carrying costs.

The California Kid confessed that he bought the 18 home portfolio sight unseen. He never actually checked the home values, nor did he research what his financing options were before he bought. Shortly after we spoke, I called one of the best real estate appraisers in the area and gave him the addresses of each home. Within an hour, the appraiser informed me that the most valuable house after all repairs was worth $15,000. The rest were each worth less than $10,000 after repairs. Homes with extremely low values are a sad reality in Midwestern cities like Detroit and Cleveland that many investors who live elsewhere simply don’t understand. People have been migrating out of these industrial cities for decades due to overseas labor competition. Each home the California Kid bought was located in drug infested areas with neighboring homes falling down. There was no way any lender in the world would have put up the funds for these rehabs. The “Kid’s” funds were literally stuck in these homes with no available financing options to bail him out.

Failure to analyze rehab estimates and property security

Because The California Kid never actually looked at the homes he bought, he had no clue what each home needed in the form of renovations. Someone must have given him quite a sales pitch before taking his money. I could tell just based on exterior photos, and having done over 50 of my own rehabs in the past, that each home would need a minimum of $20,000 in work. Most investors are unaware of the massive theft and vandalism problems in Detroit and cities like it. Many homes get stripped down by neighbors as soon as a home is vacated in various neighborhoods within Detroit. There is a huge underground market within the city for stolen doors, windows, furnaces, hot water tanks, copper pipes, copper wires, kitchen sinks, cabinetry, toilets, light fixtures, vanities and flooring. Even aluminum siding gets swiped off houses in certain Detroit neighborhoods. As soon as an investor sends a rehab crew in to upgrade a house, the new items are often gone by the next working day. Talented investors who rehab homes in Detroit have three solutions for vandals. One solution is to have the property renovation crew live in the house while the home is being worked on. The other solutions involve a hungry pit bull, or boarding up a rehab project from the inside to deter thieves. Detroit is a desperate city that robs new investors blind; especially out of town investors that don’t perform due diligence. There was no way the California Kid would have known this down side of urban investing. He should have talked to contractors and other investors before shelling out nearly $200K of his own money.

Failure to estimate carrying costs and cash flow

Carrying costs refer to the expenses associated with owning vacant real estate. Mortgage payments, property tax, and insurance are the most common carrying costs during a renovation project, which continue to accrue until the project is finalized and a paying tenant moves in or the house sells. The California Kid never checked the feasibility of getting the finished homes rented (hypothetically speaking, of course). Investors like the California Kid always assume they can get a government welfare recipient (Section 8, Family Independence Agency, Social Security recipient etc.) tenant to occupy their homes, then just kick back and collect monthly rents with ease. This is not the case anymore because housing inventories are so high in areas like Detroit. This means tenants have a choice now as to where they can live, so government rent voucher recipients are migrating to the suburbs for lower crime and better schools. Just based on location, nobody would have occupied any of the homes the California Kid bought except for squatters and drug dealers. There is no cash flow when a tenant leaves and the house gets stripped by thieves.

These issues are common with out of state investors

Unfortunately, this story is all too common in areas like Detroit. Out of state investors are driven by temptation into deals like this because they cannot find cheap homes capable of producing a monthly cash flow in their own geographic region. This however is an oxymoron. Where is an investor’s cash flow going to come from if they can’t find a paying tenant or their homes are continually stripped down during periods of vacancy in drug infested neighborhoods? There is a reason why investors can get homes for $500 in Detroit. It’s because nobody wants them; not even tenants. Investors who can make deals work far from where they live understand that they need to build an experienced support staff to stop problems before they start. They also need to analyze deals, in their entirety, before making a purchase. The California Kid, like many other aspiring real estate investors,  learned this lesson the hard, expensive way.