Can you wholesale a home with renter occupants?

Question

I see wholesaling done frequently with empty homes for flippers or other investors. But what about wholesaling a home that is currently occupied with tenants? Does this ever occur? Are there any downsides with a contract assignment on a home/duplex with renter occupants? I am just wondering if this situation happens and if any wholesaler has had experience in this occupied rental realm.

Edward Peugh · Answer

@Julie Marquez there isn't really a mechanical difference caused by having tenants.

You will have to mange showings a little differently (an open house style will be better than individual showings, so you don't disturb the tenants much)

Your target market will be investors verse home buyers.

And as a result you will lead your marketing efforts with Cap Rate and less of a focus on Delta between Purchase and ARV.

We use a term "Turnkey Rental" when marketing something like this.  I am happy to help with the analysis if you like.

Ed

Edward Peugh · Answer

@Bob Bowling When evaluating and comparing rental properties you really want to understand two things.

First, how much cash flow will I generate? This is measure is called Net Operating Income.This is all Income minus All Expenses.

So in my analysis it looks something like this:

Annual Rent (Monthly rent * 12) – (Taxes, Insurance, Maintenance, Management, and Vacancy Loss)

Taxes and Insurance are often firm annual figures.

Maintenance, Management are often stated as a percent of Annual rent (In most cases I use 10% and 8% respectively).

Vacancy Loss is how to take vacancy into account in NOI.I often will use 5% of annual rent for Vacancy Loss.

However NOI is only half the story.

Second, one wants to understand how efficiently we are generating this cash flow compared to other investments. This measurement is Capitalization Rate (commonly called Cap Rate). The Cap Rate is calculated by dividing the NOI by the purchase price (including expected repairs).

Take any given investor who says I want to generate an NOI of $10,000.This is a good goal, but it is a little empty.As it doesn’t take into account what is being invested to reach that $10,000.Intuitively, we understand that if I am making $10,000 on an investment of $100,000 (Cap Rate 10%) this is better than the same return on an investment of $200,000 (Cap Rate 5%).

Dividing the number 1 by Cap Rate will offer the time period in number of years to pay of the property.

In my market we see 8-10% Cap Rates as attractive investments, which imply a payoff period of 10-12.5 years.

(For sure there are other approaches, but this one has served me pretty well.It should be noted that I generally don’t take any appreciation into account for my modeling, as I don’t have much interest in selling over the next two decades.Of course there will be some, but I don’t make these types of decisions with any thought of that.)

Happy to hear other points of view.

Ed

Edward Peugh · Answer

Thanks for the explanation @Wes Brand

Wes Brand · Answer

You need to learn the market you're investing in. When there's a down year or 5, how long does it take prices to recover? When they recover how long until they double the previous high? Previous low? How much data do you have about the specific neighborhood / property? (say your property has a unique view that the others in the area don't, so your property goes up by 7%/year while others are only 5%/year) Ideally you want this data going back 30 or 40 years. When prices go up, what happens to rents? Do they track home prices, do they stay flat?

For example, in the Lake Tahoe market prices can double or triple and rents stay relatively flat at 700/800 per bed for 2+ beds. Why? Well, most people buying in the area are buying for a 2nd home/vacation home. Most renters are short term renters for the winter season, so you don't have the typical fight between "I could rent for 1500/mo or buy for 300k" -- the people buying are interested in 800k+ properties, the people renting are interested in 800/bd or less because they're making minimum wage at a ski resort and can't afford more, and don't plan to stay in the area long term. There are specific exceptions to this, but the ratio there is pretty skewed because of the particular market dynamics (vacation destination with relatively few long term residents).

Edward Peugh · Answer

@Wes Brand Great point about appreciation!  (Which of course is not a myth..)

I guess my approach has always been to buy the worst house in the best neighborhood..  (We will close in a couple of weeks with cashing out 85k from a short sale we purchased in 2010)

My challenge is that I am a formula based guy (see above), and I am not sure how to write this appreciation into my model.  This is additionally compounded by the fact that it's only a guess..

What reference would you use to watch this type of inflation?

Edward Peugh · Answer

@Bob Bowling Could you direct me to a reference that more clearly outlines which expenses are removed for NOI?  I.E. What is meant by only "Operating" expenses  (I have been writing the formula that way for years now..  Doesn't mean I have been right for years.... Just means I have reviewed this with a lot of folks and have never discussed this distinction...    :/    )

Bob, Continuing on your point about Cap Rate, I do understand that Cap rates vary by market, and are reflective of expected risk in a given market, but could you clarify how a Cap Rate is different from a "Return"?

Wes Brand · Answer

@Edward Peugh Not factoring in appreciation is a huge mistake. I made the same mistake. If you ignore appreciation you're giving up the biggest boost to your profits you can get, anywhere. Cashflow is pretty minimal compared to what you get from appreciation...if you take your 100k for 10k purchase, you'll end up spending 100k of your own money (ignoring financing for a moment), just to get it back over 10 years. And that's best-case; no unexpected vacancies, no unexpected damages, etc. After 10 years you'll start making a profit, but it's still pretty minimal, and, importantly, linear. You'll still be getting the same 10k/year in 30 years (remember, no appreciation). You'll actually be losing money due to inflation. When you sell, you get back your 100k.

Ok, so let's take the safe appreciation of "inflation" at 2%/year into account. Now at least you'll have inflation adjusted dollars coming in (but you're anticipating appreciation, there are markets where you can't even assume you'll continue getting inflation adjusted rent increases). So you've spent 100k to get 10k+2%/year (so in 10 years you're looking at 12k/year), but that's still pretty minor.

Now, let's look at appreciation. The "worst house in the best neighborhood" or "market where everything is going up" or "the fixer":

You paid in 100k, to make 10k/year. But if you look at market data for your neighborhood and saw that it's gaining 5% / yr instead of inflation adjusted 2% / year, and further you see that the house you're looking at is undervalued by 20% because it has a dated kitchen...well, now you're looking at 10k on a kitchen remodel (so you spent 110k, for a value of 120k, yes I'm rounding), but in 10 years your investment is worth:

10k + 2%/yr rent (110k)

120k + 5%/yr appreciation (66k)

for a total of 185k over those 10 years, or an extra 18.5k / year...you're making 28.5k every year instead of 10k. Could you get lucky and buy into this situation from the start? Definitely. Should you be aware of it and design your investments to take advantage of it? I'd say so. Why do you think people say to buy the worst house in the best neighborhood? Let me give you a hint: It's not because they think appreciation is a myth.

Account Closed · Answer

Ed, NOI only subtracts OPERATING expenses, not all expenses from POTENTIAL GROSS income, not all income.  It is important to know that.

Also a smart investor will invest for profit and ONLY be concerned with cash flow to the extent that it is needed to hold the investment until it turns a profit.  Cash flow is NOT NOI and NOI is not profit.

Account Closed · Answer

Ed, you need to understand that cap rates are created ONLY when a market player decides to pay a certain amount and the seller agrees to sell a NOI for that amount.  It speaks to the demand for the NOI in that market not the "return".  While true if you are in a market that market participants pay $100,000 for a chance to collect a $10,000 NOI then it would be foolish to pay double BUT what you are missing is that in some markets the market participants ARE willing to pay double for the chance to collect the exact same $10,000 NOI.  Do you really think these investors are willing to accept half the profits?  No.  It is about risk and anticipation.

Ed, I hope this clears this up for you that cap rates only measure what the market is paying for NOI and all similar properties in the same market will have similar cap rates so there is no way to compare or make any meaningful analysis.

Account Closed · Answer

Edward, can you explain how focusing on the cap rate provides any meaningful analysis?

Can you wholesale a home with renter occupants?

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