First Rental - 4% Rule Quick Opinions Needed!!

Real Estate Deal Analysis & Advice
11yFollow

First Rental - 4% Rule Quick Opinions Needed!!

Zach Mitchell
Investor · Orlando, FL · Member since 2012 · 183 posts · 155 votes

I am looking for some quick opinions on the deal below. Can I really go wrong with this?? I have submitted the contract and just waiting on the seller to sign but we have already agreed verbally. 

I have been looking to buy my first rental property for a long time and came across a listing for two duplexes for $35,000. You are reading that correctly, 4 units, $8,750 each. Rental rates are at $350/unit ($1,400 gross or 4%), with taxes around $1,100 annually and insurance around $1,000 (quoted by seller, not sure if accurate). There is one tenant who has been there for about 3 years who takes care of the yards for $50/mo, so taking out fixed expenses the net is about $1,175. After another 10% for management and a vacancy factor of 10%, even though the property has not had a vacant unit for over 5 years, and net rents are around $895. 

To me this looks like an NOI of around $10,740 indicating a cap rate of about 31%. I'm sure you're wanting to know how this is possible.... well, they are in the hood. Low income area, probably crime-ridden. Not stereotyping here either, I pulled the street on crimereports.com and there are literally break-ins on the same street within the last week. Should this stop me though? I'll never go to the properties unless a tenant moves out since they are about an hour away but I really don't see any need to. Most are long-term tenants and the seller said he has only had a few turnovers over the six years he has owned it.

In addition, both duplexes were re-plumbed (new supply lines), rewired, and had new windows put in, all in 2008. All separately metered and tenant pays own utilities. They both have metal roofs (not sure of age, seller guessed 20 years old) and there is no central a/c, just window units, and they are owned by the tenants, meaning no responsibility on my end for those. 

Lastly, I negotiated 70% seller financing on the deal so I am only going to be out of pocket $10,000! 5 year term, fixed at 8% so payments are about $500/mo. With net rents of $895 I would be cash flowing $400/mo. ($100/unit) with only $10,000 out of pocket.  

Can someone please snap me back into reality here. Where are the negatives to a deal like this?

0Reply
57 views

Most Popular Reply

Blair Poelman
Real Estate Broker · Provo, UT · Member since 2013 · 689 posts · 511 votes
11y

Who has been managing the units? I bet the answer is THE SELLER.

Does the manager have an actual property management system that logs service calls, rents, delinquencies?  I bet the answer is NO.

Does the rent roll look perfect?  I bet the answer is YES  (pretty easy to BS this one)

Did the leases start as 1 year, but now they're all on month to month because the tenants are "solid", and there's no need for new 1 year leases?  I bet the answer is YES.

All pretty big red flags.

Good heavens, @Zach Mitchell you've really brought out the pessimist in me tonight!

If it were me (and I've been in this situation before), I would go walk through each unit - and just ask the tenants how things are, what they like and don't like about their apartment, who they pay, how much, how often, and then ask if they think the landlord takes care of the place.  They'll either give you a laundry list of problems, or they'll tell you everything you want to hear (because their landlord told them to keep their mouth shut during the inspection).

I think I may have looked at this exact same deal about 3 years ago in Memphis.  That deal sounded awesome until I spoke with one of the tenants who quietly told me "I can't tell you anything, I've been told to keep my mouth shut".

I've done these deals before.  hood houses come with their own special challenges, but do have great cashflow when it comes in.  Just don't have an expectation that you're going to be able to actually profit that 31%, since a bunch of that is going to go back into the properties when they turnover. 

I'm not saying it's a bad deal - just do some more research before you really get into it, and take some measures to protect yourself.  

I can see you and the seller a year from now:
You:  "This deal blows.  You freak'n lied to me, and I'm not paying you anymore."
Seller:  "Cool.  I'll keep your down payment and go record the Deed in Lieu because you're defaulting on the financing, so you can hit the bricks now"
You:  (Zach walks away irate but can't do anything to get his 10k downpayment back)

Also, don't fool yourself into thinking you'll manage them from home and only go there when there's a vacancy.  You'll probably be there fairly regularly.

9Reply
See this reply in the discussion

51 Replies

Jump to latestLatest
  • Blair Poelman
    Real Estate Broker · Provo, UT · Member since 2013 · 689 posts · 511 votes
    11y

    Who has been managing the units? I bet the answer is THE SELLER.

    Does the manager have an actual property management system that logs service calls, rents, delinquencies?  I bet the answer is NO.

    Does the rent roll look perfect?  I bet the answer is YES  (pretty easy to BS this one)

    Did the leases start as 1 year, but now they're all on month to month because the tenants are "solid", and there's no need for new 1 year leases?  I bet the answer is YES.

    All pretty big red flags.

    Good heavens, @Zach Mitchell you've really brought out the pessimist in me tonight!

    If it were me (and I've been in this situation before), I would go walk through each unit - and just ask the tenants how things are, what they like and don't like about their apartment, who they pay, how much, how often, and then ask if they think the landlord takes care of the place.  They'll either give you a laundry list of problems, or they'll tell you everything you want to hear (because their landlord told them to keep their mouth shut during the inspection).

    I think I may have looked at this exact same deal about 3 years ago in Memphis.  That deal sounded awesome until I spoke with one of the tenants who quietly told me "I can't tell you anything, I've been told to keep my mouth shut".

    I've done these deals before.  hood houses come with their own special challenges, but do have great cashflow when it comes in.  Just don't have an expectation that you're going to be able to actually profit that 31%, since a bunch of that is going to go back into the properties when they turnover. 

    I'm not saying it's a bad deal - just do some more research before you really get into it, and take some measures to protect yourself.  

    I can see you and the seller a year from now:
    You:  "This deal blows.  You freak'n lied to me, and I'm not paying you anymore."
    Seller:  "Cool.  I'll keep your down payment and go record the Deed in Lieu because you're defaulting on the financing, so you can hit the bricks now"
    You:  (Zach walks away irate but can't do anything to get his 10k downpayment back)

    Also, don't fool yourself into thinking you'll manage them from home and only go there when there's a vacancy.  You'll probably be there fairly regularly.

    9Reply
  • Jan H.
    Investor · Saint Johns, FL · Member since 2015 · 141 posts · 100 votes
    11y
    My number one rule is not to buy in 'war zone'. The deal might look very good on paper but there are too many variables (gang, criminal activity, drugs etc.) and your property management cost will be much higher, as well as repairs and such. Not to mention that if you want out, it will be a harder sale. Good luck!
    1Reply
  • Logan Hassinger
    Specialist · Fort Worth, TX · Member since 2014 · 528 posts · 226 votes
    11y

    @Zach Mitchell

    The likely hood of you making any money due to the fact you probably won't be collecting the full rent even when you have tenants and the cost to get the units rent ready is slim to none.

     All I can say is good luck. 

    0Reply
  • Michele FischerPro Member
    Rental Property Investor · Seattle, WA · Member since 2013 · 2k+ posts · 1k+ votes
    11y

    Good question about who is managing these properties.  You may have a hard time finding a property manager to handle this - it is too little money for too much headache.  Collecting rent alone is a hassle, much less the increased maintenance by low income not knowing how to take care of things, and then how time intensive turnovers are, like almost always needing to repaint and recarpet.

    The street I live on often has crimes reported, that alone doesn't give a complete picture of the neighborhood.  What type of crime?  Have you driven the street in the daytime and at night?  Talked to the local police?  Is the area likely to improve or decline?

    The low turnover seems very fishy.  We had 12 turnovers in our 8 units last year.  Low income people tend to fall into two categories - stay in one place forever or are very transient.  I doubt this landlord has the magic formula to get only the first type, they are hard to find.

    Has the owner shared his costs on the things has has to capitalize for the IRS - the appliances, carpet, upgrades?  These may not be in his P&L, and can easily be very significant.

    If you were planning to self manage and knew the neighborhood I might say keep exploring, but this seems like it could very easily go south in a hurry.

    Podcast Guest on Show #79
    3Reply
  • Zach Mitchell
    OP
    Investor · Orlando, FL · Member since 2012 · 183 posts · 155 votes
    11y

    @Blair Poelman, you are pretty spot on with your assumptions and I know I should proceed with caution but have you had good experiences with something like this?

    Everything that has been mentioned, other than the crime, are typical concerns when purchasing any rental property. Obviously, the bad side of things tend to happen a little more often in low income housing but still... I'm really just trying to weigh the risk vs. reward here. I'm not buying a $200,000 property here, I'm buying two properties for $35,000 with only $10,000 out of pocket. Is that not worth some risk? I've never come across a deal like this (maybe there's a reason for that) and don't want to let it go just because of some risk. 

    At this point I can only go by what the seller is telling me and according to him, rent is deposited into his account directly each month. He said they are late every now and again but he stays pretty strict and doesn't let them go more than a few days. I will be requesting copies of bank statements during due diligence to see if everything is really what he says.

    You mentioned to take some measures to protect myself, can you give me some specifics on what you meant by that?

    Any suggestions on what I should be requesting from the seller? Any must haves other than copies of the leases?

    Appreciate the help. 

    0Reply
  • Zach Mitchell
    OP
    Investor · Orlando, FL · Member since 2012 · 183 posts · 155 votes
    11y

    @Michele Fischer, I agree on the turnover, sounds very low. He even said that when he has had vacancies that he has not done any marketing, just a sign in the yard and they have filled up right away. Friends of friends, etc. 

    Things always sound too good to be true but sometimes it's just a good deal. I really don't know what to think here, pretty torn. Do you have suggestions on specific items to ask the seller for, other than cap ex, to try and lower my risk here?

    Thanks!

    0Reply
  • Richard Dunlop
    Investor · Detroit, MI · Member since 2014 · 755 posts · 462 votes
    11y

    Drive there in a Black Escalade with 24" wheels and see if the neighbors come running to you like kids to an ice cream truck. 

    4Reply
  • Zach Mitchell
    OP
    Investor · Orlando, FL · Member since 2012 · 183 posts · 155 votes
    11y

    Well I did drive there in my Harley F-150 with 22" wheels and they didn't come running. Not sure that comment has any merit though. How about something with substance?

    0Reply
  • Blair Poelman
    Real Estate Broker · Provo, UT · Member since 2013 · 689 posts · 511 votes
    11y

    @Zach Mitchell true that a lot of that is jus hood-house typical. I've done enough that the low price tag has lost its luster to me. 

    I would likely pass on it but that's just me. 

    0Reply
  • Shaun Reilly
    Landlord and Rehabber · Newton, MA · Member since 2010 · 2k+ posts · 877 votes
    11y

    Why are they selling the place?

    If they have stable long term tenants that always pay and the place has a lot of upgrades and low expenses with good returns why do they want to get out?

    Even if they want to get out why are they so anxious to get out that they are selling so cheap to give such a crazy high return AND are willing to finance the majority of the purchase price to be able to sell it that cheap?

    That is the red flag that makes me skeptical of everything else.  I would want to hear there was a pretty compelling non-property related reason they want to sell. 

    5Reply
  • Matthew Schroeder
    Investor · Carmel, IN · Member since 2014 · 332 posts · 245 votes
    11y

    Some things to consider:

    (1) What are the comps in that neighborhood? Putting aside "pro-forma" cash flow for a moment, are you paying a fair price in the market's opinion? If the comps are say $50k, you have more support for your investment decision. If you find comps are $30k - $35k, you might ask why. If you cannot find any MFR comps in that specific area, as a fall back, look at what SFRs are doing in that neighborhood & ask why a person would live in your property vis-a-vis the SFR.

    (2)  Who is going to manage the properties?  It is easy enough to say I will have a property manager but who specifically (which company?) will manage the property.  Given the profile of the property (neighborhood, very low rents @ $350/unit), you will find many property management will simply not be interested in managing it.

    (3)  If you decide to purchase the property, I would absolutely ensure that I had a detailed walk-through / inspection of ALL units BEFORE closing, so that you can evaluate the units, and importantly, the tenants (e.g. any illicit activities?).

    I hope that is helpful.  Let us know your final decision and how it goes.

    1Reply
  • Andrew SyriosPro Member
    Moderator
    Residential Real Estate Investor · Kansas City, MO · Member since 2014 · 10k+ posts · 5k+ votes
    11y

    You didn't include anything for maintenance and turnover, and in low income areas especially, there will be plenty of those. In fact, I would say that you might want to put your vacancy factor at 15%. Our experience has been that it's really tough to get things to cash flow when they rent for less than $400. The problem is a roof, hotwater heater and furnace all cost the same there and in a place that rents for $1200/month. Other things like appliances, flooring and the like are still close in cost. And the odds of having economic vacancy (Tenant stops paying) is much higher).

    The price point still looks very attractive, but I would rerun your numbers with a higher vacancy percentage and add in the maintenance expenses. Finally, do you think there's a chance you could raise rents, even to $395? That would certainly help.

    Podcast Guest on Show #121
    0Reply
  • James DeRoest
    Investor · Century, FL · Member since 2015 · 950 posts · 603 votes
    11y
    Originally posted by @Zach Mitchell:

    Well I did drive there in my Harley F-150 with 22" wheels and they didn't come running. Not sure that comment has any merit though. How about something with substance?

    Stranger things have been said in jest.

    We've toured 'hoods thinking we're onto the deal of the century. Big SUV, big wheels, really do bring the drug dealers out, and you do get offered various drugs. On one occasion, after declining the offer of 'a bit of weed', the guy took it in good humor, walked off, and took a piss against the house we're about to look at lol. It was just that sort of neighborhood!

    We passed on that house.

    1Reply
  • Zach Mitchell
    OP
    Investor · Orlando, FL · Member since 2012 · 183 posts · 155 votes
    11y
    Shaun Reilly , The story is that he's a builder and selling because he's looking to cash out to focus on new development. He's also selling a $500k motel he owns. My guess is that he's just sick of dealing with it.
    0Reply
  • Blair Poelman
    Real Estate Broker · Provo, UT · Member since 2013 · 689 posts · 511 votes
    11y

    @Zach Mitchell

    By protect yourself I mean you've got to really dig into the details of the past in order to get an idea of what to expect in the future.  Build a little calculator in excel and look at it a couple different ways - one perspective that everything will work out perfectly and you'll be at 31%, and then another that has 1 or 2 units go late, then one vacates, requires some rehab, etc... If you don't already, you should build out some of these models using some simple excel formulas.  I have a couple different calculators that I built using Numbers (mac) that I can plug in best and worst case scenarios that will at least help me to know what could happen. 

    Maybe ask to do the downpayment in installment payment the course of the first year or to.  $10k over a year is $833 / month plus the normal monthly finance payment.  The rents might cover that, or they might not.  But at least if you say "Screw this" early on you won't be losing your entire downpayment.

    Be sure to run title and review the abstract.  If you see the deed has been transferred from the seller and then back to him again, you may be just another seller finance default waiting to pay the seller another downpayment.

    2Reply
  • Richard Dunlop
    Investor · Detroit, MI · Member since 2014 · 755 posts · 462 votes
    11y
    Originally posted by @Richard Dunlop:

    Drive there in a Black Escalade with 24" wheels and see if the neighbors come running to you like kids to an ice cream truck. 

    @Zack Mitchell

    I tried to convey a real idea in a humorous way. Sorry if you missed the implications.

    I'm in Detroit, the fact that you wont ever have to go to the property yourself tells me that your hoping to pass off the physical risk of life or limb to your property manager. Detroit has Beverly Hills type homes less than 100 feet from total dumps (Indian Village) I've not seen that elsewhere.

    The street and the neighbors make a big difference in the viability of your investment. Are your tenants doing the break-ins on your street?

     Or are they the victims that will eventually give up? 

    When a unit is needing repairs will a reputable handyman go there?

    Does he need an armed guard for his work truck while he is inside working?

    I know more than most about the environment you describe. People try to paint all of Michigan like you portrayed your potential neighborhood. Metro Detroit has problems Yes but it also has SF houses that would sell for $10,000,000.00 in today's down market.

    To summarize I would avoid areas in Detroit as you describe your area to be. But it could make a profit but the risk is not worth it. I have lots of Great areas to choose from but maybe you don't. Hope that helps. 

    4Reply
  • Jon A.
    Investor · Near San Diego, CA · Member since 2012 · 176 posts · 96 votes
    11y

    You been given great advice, all of which is backed up by history here in this forum.  You seem to be pushing back because of dollar signs in your eyes.  I think that you could just had the seller 10K and walk away, and lose LESS money than by doing this deal.  Stop and think!

    0Reply
  • Zach Mitchell
    OP
    Investor · Orlando, FL · Member since 2012 · 183 posts · 155 votes
    11y
    Richard Dunlop , appreciate the reply. Jon A. , I am trying to present the positive side of things because I know everyone on this site is as skeptical as they come. Half the people on here are afraid to even pull the trigger on any deal. I also know that sometimes these deals actually work out. Yes, chances of things going south are probably much higher than some other deals out there but like I said before, just trying to measure the risk on such a low priced opportunity. Appreciate all of the responses and will keep everything said in mind as I move into due diligence. Thanks again!
    0Reply
  • Drew McLaren
    Investor · Carlsbad, CA · Member since 2015 · 27 posts · 11 votes
    11y

    Too good to be true?  You've already figured out that the deal, as presented by the seller, is a no-brainer, grand slam home run.  What you're really trying to figure out is whether the facts presented by the seller are completely accurate, mostly accurate or in no way accurate. 

    Outside looking in, it seems like either the facts you have been presented with are somewhere between moderately and extremely exaggerated OR there are variables not being presented that are extreme.  Otherwise, to me, it seems unlikely the seller would choose to get out of the property under these terms.  If it was simply a matter of wanting/needing cash, it doesn't make sense for him to agree to take only 30% of his price and extend seller financing for the rest (he's already pricing it at a level that would be extremely attractive to any all cash buyer).  Let's look at what the seller gets/gives up by making this deal:

    1.  He gets $10,000 now minus fees for closing costs.  This is the one and only positive for him in this deal.  But realistically, if all of his assertions are correct, then the deal is a no-brainer for any all cash investor.  So why accept $10,000 rather than take the full $35,000?

    2.  For the next 5 years (the term of your loan) he is choosing to take $500 per month from you instead of $895 per month in net rents.  And this $895 figure includes 10% for vacancy even though supposedly he's had no vacancies over the last 5 years!  So net rents, according to his assertions are even higher than $895.

    3.  At the end of 5 years, he has received a total of $30,000 in principal + interest payments from you + your original $10,000 (minus fees) = less than $40,000 total and no longer owns the real estate versus collecting the net rents for that same period of time and ending up with $53,700 and still owning 100% of the real estate.

    Bottom line is that I can't find any motivation by which this could possibly make sense for the seller so it feels as though details are being manipulated or withheld.  If you decide to move forward and put this property under contract, just make sure you use every moment of your escrow period to fact check and turn over every stone with your due diligence.  But mostly, please keep us updated whichever direction you go so we can learn from your triumph or mistakes.  Thanks for sharing!

    4Reply
  • Bogdan Cirlig
    Real Estate Investor · Los Gatos, CA · Member since 2014 · 226 posts · 89 votes
    11y

    Agreed. Don't buy a property just because the "investing fantasy game" shows the numbers make crazy sense. Class "D" assets are un-collectable by legit means, you're making a huge assumption that you can collect your $350/mo w/o twisting tenant's arm in a dark alley at night and sharing the protection fee with the "street landlords" who help you collect so to speak :). Check the foreclosures in that block, recent sales, who parks at night, schools and crime rate and also boarded houses. 

    I have first hand expertise in a C+ turning D- and not even Sect 8 wanted to rent there... you won't even be able to rehab a place to try to rent because the night after it's rental ready it will be looted (again) by your friendly neighbors... so you will be in complete deep hole at that point.

    There's the big IF: are you able to rent it and collect every month? If yes, you have a fantastic deal.

    2Reply
  • Ben Leybovich
    Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes
    11y

    You can absolutely go wrong with this ...lol

    Some property is worth less than $0 - are you sure this isn't it?!

    :)

    0Reply
  • Michael Lauther
    Investor · Hampton Bays, NY · Member since 2009 · 907 posts · 258 votes
    11y

    @Zach Mitchell

     I own 5 low rent single family properties in Dayton Ohio . on paper the returns look good.

    In practice replacement of some systems will cause profit to vanish.

    property purchased for 24k gets 530 month rent. from sec 8 between taxes 1100 ins 700 and estimated maintenance 600 should leave me a positive cash flow of 4900, bring in 2900 to replace furnace over and above scheduled maintenance and you begin to see the problem develop. The tenant is now behind I his share of the rent and if I have to evict him the cost begins to mount.

    my point is that a good profit can disappear quickly. How old is the furnace, the roof the appliances. replacing these items will be necessary a some point. the question is how soon.

    your seller may feel its time to get out before these expenses materialize.

    1Reply
  • Mindy JensenPro Member
    BiggerPockets Money Podcast Host · Longmont, CO · Member since 2014 · 7k+ posts · 10k+ votes
    11y

    @Zach Mitchell There is a lot of good advice given on this thread. Experience from each person ranges, but there isn't one person responding that they think this is a good deal.

    If you go through with this, you will wish you had taken all the advice telling you to pass on this deal. Yes, it is too good to be true. If something seems to good to be true, it is. This rule holds true approximately 112% of the time. Always.

    That said, if you jump in with both feet, I hope everyone single one of us is wrong. But we aren't. I hate to be negative, but these deals just don't work out.

    [email protected]Podcast Guest on Show #261
    BiggerPockets
    0Reply
  • Jared Lichtin
    Contractor · Cleveland, OH · Member since 2014 · 317 posts · 181 votes
    11y

    @Zach Mitchell I would go talk to the neighbors too, if you get a chance.  I know it might not be the ideal thing to do in that area, but at least you can get a sense of the 'behind the scenes' stuff going on w the property.  Has the owner proven to you that the tenants have all been paying on time for a long period of time & how has he proven this?  Just my pov... rentals aren't exactly my thing but I can see where your concerns lie.  Completely valid.

    0Reply
  • Account Closed
    Real Estate Agent · Orem, UT · Member since 2012 · 164 posts · 49 votes
    11y

    All about risk tolerance and purchase price.  I have owned many "felony flats" and "war zone" properties over the last 20 years.  Everyone needs a roof over their head - just know the risks going in, and assume the worst!

    2Reply
Join the conversationCreate a free account to reply, vote on answers and follow this thread.
Log InJoin for Free