Does this strategy make sense?

12 Replies

My partner and I looked at a property on a fairly major street in Woodland Hills, CA over the weekend.  It's a small house in really bad shape that we see as a tear down.  It's on a 7700 square foot that we believe is zoned R2.  

So, our thought was... We demo it and build a new duplex there.  They're asking $480K, but we're assuming we could get it for around $430K.  A 2400 square foot duplex (1200 square feet per unit) at roughly $150 per sq ft to build = $360K  So, roughly $790K all in.

We estimate we can rent these brand new units for about $2500/month, grossing $5000/month.

We're not sure what the property will appraise for when done, but if we refi once it's done (BRRR) and pull $700K out, it looks like the mortgage payment + taxes & insurance would be about $4000/mo. So, we'd net $1000/month.

I know these are rather vague numbers, but does it make sense at all??

Have you accounted for the holding costs for the time that you will not be collecting rent while pulling permits and obtaining all other requirements to build the duplex, and during construction.  I think you might also want to talk to a couple of contractors to get a firmer number on construction costs.  Also in a quick look on Redfin I believe that I found the property you are considering (I don't want to reveal the address on here) and it is listed as a hot home likely to sell soon, so I think it may be unlikely you will get that steep of a discount.

Im new here so forgive me if I am missing something. So, your going to spend $800,000 in the sort term and pull $700,000 back leaving $100,000 tied up with a return of $1000 a month? This is another reason I would never live in that state. 

Im clearing $500 a month with a $70,000 loan and 0 out of pocket.  With $80,000 I could cash flow $1400 a month. 

That sound like a terrible investment but as I said I am very new here. First day on this site.  

@Trevor Baker I would definitely double check your build costs. Most developers I know are building closer to $400/square foot. 

Rent: You're going to get $2500/month off of 1200 square feet? Don't get me wrong, I'm not familiar with that market so maybe it's doable. I can definitely get those numbers on the coast here, but it would definitely be a push to get that in a non-coastal city.

Cash out financing: I would talk to a lender about how easy it is to do a cash out refinance. It's my experience that those still aren't that easy. 

All of this being said, I agree with @Gordon French that if your end is $1000/month off of your $90k investment with an appraisal total of $790,000, that doesn't seem terribly great. Based on the kind of math I do, I would calculate that at a 1.11% ROI. Don't get me wrong, it gets you in the game, but this would be a lot of money tied up until you refinance and even so, it's not a very good ROI.

Be patient and keep evaluating deals. It's the way to get to the punch first when you can recognize the deal before others.

@Trevor Baker - as @Aaron K. , @Kristina Heimstaedt have mentioned, I believe you're missing some #s. I like the idea. I've pondered it myself as I own an empty lot (subdivided from another duplex I own) but I cannot make the math work to achieve my desired cash flow. Your estimate of $1k/net a month will quickly be chewed away by other expenses. I talk about those expenses in this article: https://www.biggerpockets.com/blogs/8160/52398-rea...

But the real question is...are you potentially building this property for cash flow OR another reason?  It will only make sense if this opportunity fits your investing criteria which support your goals, which funnels up to your purpose. All discussed in my 10 Step Guide. 

For a cash out refi, typically your LTV will be 70% on a multifamily, so you would need it to appraise for $1M in order to pull out $700,000. You'd also need to make sure you're able to qualify for a $700,000 loan of course.

If that worked and you only ended up with $90,000 in the deal, and you were actually cashflowing $1,000/month, that would give you about a 13% ROI ($12,000 income per year on a $90,000 investment). However, once you factor in utilities, repairs, capex, and management, your cashflow would be little if anything at all.

That's a crapton of money to be putting to work in order to get no cash flow.

I think something that might be missing from your equation is what the values are doing and what they have done historically in that area. Are they going up, down, staying flat? My guess since it’s CA is that they are going up. Of course you don’t want to count on appreciation but it’s probably safe to say that in another 10-20 years the values will be up from today.

The things I think you really need figure out and get very accurate are the ARV, construction costs, holding costs, taxes, insurance, and rents. If you can build and have an ARV that would allow you to take ALL your money out and still be cash flowing even a little bit then that might be a different story all together. Then you’d have a brand new building that is cash flow positive (even if it’s a small amount), 20-30% equity (that’s a lot of equity on a million!), a property that is extremely likely to go up over the long term, and none of your own money in it. As long as you have enough reserves to weather a storm.

@Trevor Baker I don't know much about your area but I do know those prices are insane man.

I really like your creativity but I think it could be used in a much better situation that makes better sense financially. People in my area would think you are smoking crack for wanting to put that much into a property to even cashflow 3k a month. There are way too many what ifs and assumptions in that scenario. Maybe those are typical numbers in Cali but here in Texas that is just absurd. The only way I could see that specific situation being a win is if you get it at a steep discount, finish the tear down and rebuild it swiftly and as cheaply as possible, and the property appreciates like crazy. This seems like an appreciation play and I'm not a big fan of that. I believe cash flow is king and in this situation it just doesn't work out IMO. I'm sure in a 1-2 hour drive from your area you can find a similar situation that will work out much better numerically and that would be my advice. Good luck!

I would for sure check your number 350 to 400 per sq foot on more realistic

@Trevor Baker I've been converting SFR properties into small MFRs for the past 7 years a little south of you in SD. The strategy has been very good to me, and I'm a fan.

Separate your construction costs into soft, horizontal and vertical components - soft for city fees, professional services , and holding/financing costs ... horizontal for any site prep, public improvements, and underground work ... vertical for foundation and everything on top of it.  The vertical part can run around $150/sqft if you have strong relationships.

To give you some other data points, I have three projects going at the moment.  One is 3 units.  The other two are 4 units - I can't make the numbers work for just two units unless I'm able to keep the existing unit and add on or construct on the lot.  Problem is those properties are prime flipping candidates too and if they're in a price range that makes sense for B&H, they generally make *more* sense to flip.  In short, it's really really hard to justify Buy-Develop-Hold at this point in the market cycle because buyers are willing to pay so much - it generally makes more sense to Buy-Develop-Sell instead.

@Trevor Baker Just one thing to think about, scraping a building takes time. Permits, approvals, etc. all take longer than a “standard” rehab project.

I didn’t look at the Fed minutes today but the “tone” for the past couple of months is “rated will increase”. So when you do get the property completely, rented out, etc. you might find that “5% today” turns into “6% at completion.” Which takes you from $3.7K on a mortgage to $4.2K. Basically it’s a $500 per month swing.

I’m not sure what rate you used to calculate your future payment but I’d stress test your deal by looking at some scenarios involving higher debt service costs.

As others have stated, that $1,000/mo net will be drained very quickly after factoring prop management, repairs, vacancy, tax’s, etc. maybe not repairs for the first year or two since it’d be a new building but they would be inevitable in the future.

No, your strategy does not make sense. I suggest you learn to do a more detailed financial analysis and set criteria for minimum returns before you make a bad investment and learn the hard way. As a friend who is a former golf pro and bookie told me, “lessons aren’t cheap”.

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