Mark's theory on the relationship between rehab leverage and neighborhoods

4 Replies

So here's Mark’s theory of neighborhoods and leverage through rehab

I’m sure this topic has been discussed before but I didn’t know what key words to look for.

So, I sell turnkey rentals and what I’m finding is that many of my clients are looking for properties priced 10-30% below After Repair Value and cash flow well above 12%. What I’m noticing with my inventory is that you generally need to choose one or the other and the relationship seems to be as follows:

"C" neighborhoods: Low price to rent so High ROI (at least on paper)-

>12% is not a problem unless you want to rehab to a high standard and have a high quality tenant. Lower quality tenants who want to live in these neighborhoods will affect your ROI down the road in unpredictable ways with higher vacancy costs and more damage. In Milwaukee, these neighborhoods have houses in the 15-30k range and the issue is this:- you put in 40k to bring everything up to code and updated looks and now you have a 70k in a house no one will buy for 70k. It's too expensive given the rents and tenant risk for investors and too rough of a neighborhood for the retail investors who can find good rehabbed homes in B neighborhoods in Milwaukee for that price. So in C neighborhoods your complete rehab has negative leverage- you get less than you put in. This leads to just putting in the bare minimum to make it habitable but being accused of being a slumlord.

“A” neighborhoods have few rentals and high price to rent ratios so they are difficult to achieve double digit ROIs in these neighborhoods but they are great for flipping because your rehab leverages the value of the house- you get more value than you put in because you can bring that house out of the investor pool and into the retail market where people pay extra because you put in the granite counters and higher end appliances. On the low end of A you pay 70k and put in 50k for rehab and have a home valued in the mid 100s.

“B” neighborhoods are of course between C and A in that ROIs are 10-12% in Milwaukee and the leverage you get for a rehab is roughly 1:1. 30k house + 40k rehab equals 70k house value.

Is this relationship pretty consistent in most cities? I’m sure the numbers would vary but does the relationship stay consistent? I would imagine it would be very similar in places like Indianapolis or Memphis.

@Mark Shaffar The numbers might vary by market but this pretty much applies universally anywhere. I hear people say that they expect equity in a turn key property also. What they don't understand is that you buy turn key for cash flow and not for equity. If you want equity, you have to improve the property. The pie generally isn't big enough for a turn key company to acquire the property, renovate it, make some profit and leave equity. The turn key company would have to be all in for 50% in order to leave 30% equity in it. Those days are over.

@Mike D'Arrigo

Thanks for corroborating that. It's hard to imagine buying and rehabbing a place for 35k in a decent neighborhood that would support a 70k ARV so you can leave money for profit, management, and commissions to the agents.

In a C neighborhood if you're putting in $40k you're spending too much.  $10k - $20k will do a very nice rehab.  If you need structural items like a roof and furnace then you're probably near the top end versus the bottom end range.  Case in point -- C class house purchased for $36,000, put $12,000 in and you're at $48,000.  Then rent that out for $950 - $1000 per month.

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