One of my wholesaler bird dogs sent me two “deals” that I wanted to put on the blog as yet another example of what NOT to do. I figure people learn just as much if not more from the stories of the deals that don’t work as from the deals that do. You will see by looking at the deal that it is a “buy and hold” not a “rehab and flip” or a “pretty house deal”, but I wanted to say up front that I am treating it as buy and hold for easier understanding. Both the deals are pretty much identical, so I am just going to use one of them:
35 Preston Drive, Jacksonville, Arkansas 72076: 3 Bedroom, 1 bath house with 1200 s.f. of living area. Asking $78,000 and currently rented at $700/mo.
This wholesaler, we will call him “Joe” wants me to buy an investment that will make me $700 bucks month, but I have to give up 78,000. I think any of you who have had even a little bit of training in real estate, not to mention basic math can see that this is NOT a deal; however, let’s take a look at it anyways, because I think we can all learn something here.
A quick look at the county data tells me the house was bought in 2007 by an investor from a bank; in other words it was an REO. The county has a value of 58 k on it and the home has central heat and air and was built in 1974. His square footage is a bit of an exaggeration at 1200; it’s actually 1168. The taxes are $630 per year.
Most of you know that I do not recommend zillow.com, realtor.com or any of the other sites out there as a replacement for a good realtor’s CMA, but for getting a rough idea of whether or not I would want to spend any time on a deal, or enroll one of my realtors to do the same, I often will check zillow for some basic numbers. Just as I suspected zillow believes the house is worth 82K, so this guy is asking pretty close to retail. I also checked realtor .com who said the median LIST price(not SALES price) for the neighborhood was 85K.
So, do we buy houses at retail boys and girls? And they all answered a resounding NO! But then, we already knew that; we are just looking at all the reasons why it won’t work for purposes of education.
I already know from experience that the insurance on this sucker will be around $350 per year if you have an umbrella policy like I do. If you don’t own many houses then you will not have one of those blanket style vehicles and the insurance will be higher, say $450 per year; but let’s just use $350 since this is just for example anyways.
A 100% loan at 20 years and 6% will cost me $640.48 per month if I escrow the taxes and insurance. Personally I try to never escrow taxes and insurance because I want to have use of my money during the year, not let it sit at some bank with no interest and then allow them to pay my bills with it; but if you are a new investor it might be easier on you. So I will make a $60 profit per month. Well, I’ll make a $60 profit per month as long as the renter pays me on time, nothing breaks and I don’t have to run an ad in the paper for a new renter.
What’s that you say? Interest rates are down and I can finance for 30 years? Okay, let’s look at that. First off, interest rates are down only for low risk loans. As an investor you are NOT going to get the owner occupant rate. Most of the banks I have ever dealt with will only go a maximum of 20-25 years on a single family investor loan. Of course I know a guy in Texas that used to tell the banks he was moving in, and then at the last minute “something changed” in his life and he decided to rent it instead. That might work for a while but eventually the banks will figure out what you are doing.
Okay, so you want to look at 30 years anyways…fine. Thirty year fixed with the same information as before will be a $549.22 per month payment. You will make $150 per month. Carpet and vinyl in Arkansas is about $2.25 per square foot installed. That’s $2700 bucks or 18 months of your profit. Paint will cost you 8 months profit. A water heater 5 months profit. You might want to look at what your future maintenance is going to be before you buy this sucker. How do you think I know that?
There is another problem with financing for thirty years as well. Interest! Yeah, I know, the tenant will be paying that interest, but let’s look at the numbers for just a minute, shall we? If we figure an average of 2% growth in terms of equity, your 78,000 home will be worth about 103K in ten years. The problem is, with a 30 year note, you will only have paid the note down to 65K; and based on the economy at this particular point do you really want to count on making your money with some future equity?
There are four main ways to make money in real estate. Depreciation, Appreciation, Equity and Cash flow. There are actually another six, but they are way too complex for this conversation, so let’s just look at the first four. Of the four only one is guaranteed to put money in your pocket now and that’s cash flow. As many of you know I am a student of Robert Kiosaki, and truly believe that an investment should pay you TODAY. Anything that does not put money in your pocket the day you acquire it is a liability. Ask all the folks with negative amortization loans in California, how they feel about equity and appreciation right now. One they aren’t getting and the other they never got!
Personally, I do not touch a rental unless I can make $300 per month minimum. Also, I base that on a 10 month year, because the average length of tenancy in Arkansas is 14 months and nationwide I read somewhere that it is around two years. That means that once a year I will be running an ad at $150 for the month and at minimum doing a cleanup and “make ready” at a cost of about $250.
The other way I look at any potential rental is that the numbers must still meet the MAO formula that I use if I was going to do a wholesale or retail flip on an ugly house.
MAO = (70%)*(ARV) – repairs
Your Maximum Allowable offer can be no more than 70% of the After Repaired Value based on a strong CMA and other evidence minus any repairs that are needed.
Given no repairs, this deal would still never make the grade based on the fact that the wholesaler is asking close to if not more than retail for the home.
Concentrate on making your money on the front end every time, all the time and you will not lose nearly as often. Remember that you will lose at some point. Investing in Real Estate is like riding my Harley. It is not a question of “if” I will lay the bike down it’s a question of “when”. You ride as long as I have and you know that you are going to lay it down eventually. My goal is to have you lay it down less, and to do less damage when you do lay it down.