What am I missing on this deal?? Let's talk $$$

21 Replies

Here is the story: I have partnered with two other individuals who are passionate about real estate, and have experience with rehabbing shotgun style homes, but I worry they have limited business savvy.

The goal is to buy severely distressed homes outright for <$25k, finance the rehab costs, and then rent them for 5-7 years as cash flow properties before selling when the market is in our favor. Sounds like a solid plan right?

Here is my dilemma - Yesterday the lead on the project, the guy who has experience with a rehab, said that he and the other partner had discussed paying $500 OUT OF POCKET per month for the first year or so to help pay down the loan for the repairs. I am not into this idea. It defeats the purpose of an investment. The idea is to make money. 

Here is the basic math House #1 - $7k purchase price, total gut job/rehab - estimated $65k in rehab costs. Rents in this area follow the affordable housing rates so we would be grossing roughly $650-750(max) - After our general expenses we would have a cash flow of $437/month - but this is without figuring the cost of paying back our rehab loan. 

Word on the street is that a business loan is hard to find with a term longer than 5 years, which at $65k over 60months is roughly $1083/month..... Not good.

Even if we all contributed $500 (an arbitrary number) we would still fail to pay off our loan even within the first 2-3 years! 

I feel like I am missing something in terms of how rehab financing or business loans work. If we can get a 20-30 term on our loans, we will be fine, but if not... there is no money. The property will not be cash flow positive, and we will have busted our tails, only to end up spending more money each month just to keep afloat.

The fact that the guys are ok with losing money the first few years is preposterous to me. 

How can we make this work? What am I missing in terms of the loan term and financing options?

In my mind, the gross rents simply won't fund the rehab costs. It seems like being able to acquire a property for so little would be an advantage, but right now I think I'm better off breaking away, shopping for good deals on turn key properties, and borrowing against them.

Any feed back (constructive and positive in nature) would be great! 

You are correct in your concerns.  Paying down the loan does defeat the purpose, and it is an illusion that it is helping.  All you are doing is two things:

1 - Reducing your cash flow

2 - Helping your tenant pay off the mortgage.  Let the tenant pay down the debt...that's their job...not yours.

Paying extra cash in per month just means you are taking your money, putting it into the house, only to take it back later...and while it is resting in your house, it isn't out making you any money....see, that's your job (actually, it's your money's job).

The tenant pays off the loan, the REI takes their money and invests it in other properties where the tenant pays off that loan, so the REI can...

...and you're right...these two partners have no business sense.  They don't know the difference between:

1 - Cost and expense

2 - Debt and Leverage

...and they don't understand how money works.

Money can't be a noun in REI...it must be a verb.  You lose when it's a noun.

Zach,

My advice would be (if possible) to fund each rehab out of pocket between the three of you. You'll have a little over $70k in the deal. If you have done proper analysis and the house will appraise at $72k (it really should appraise above, you want to CREATE value) then a 30 year mortgage, 20% down (take out $57,600 in equity), fixed at 4%, the monthly payment should be ~$277 based on a simple payment calculation in excel.

Taxes and insurance should be low on a property that is small and recently renovated (CAPEX shouldn't occur in 5-7 year span if your rehab is done properly).

If your expenses are in the ball park of $300, you could still cash flow a little over $120/month.

The key is eliminating risk for the bank. If you get the loan AFTER you have the rehab done, the bank can determine how much the property is actually worth and give you a conventional loan that they are comfortable with.

Paying down each month is not an option and not what a real estate investor should be doing.

Originally posted by @Zachary Peacock :

Here is the story: I have partnered with two other individuals who are passionate about real estate, and have experience with rehabbing shotgun style homes, but I worry they have limited business savvy.

The goal is to buy severely distressed homes outright for <$25k, finance the rehab costs, and then rent them for 5-7 years as cash flow properties before selling when the market is in our favor. Sounds like a solid plan right?

Here is my dilemma - Yesterday the lead on the project, the guy who has experience with a rehab, said that he and the other partner had discussed paying $500 OUT OF POCKET per month for the first year or so to help pay down the loan for the repairs. I am not into this idea. It defeats the purpose of an investment. The idea is to make money. 

Here is the basic math House #1 - $7k purchase price, total gut job/rehab - estimated $65k in rehab costs. Rents in this area follow the affordable housing rates so we would be grossing roughly $650-750(max) - After our general expenses we would have a cash flow of $437/month - but this is without figuring the cost of paying back our rehab loan. 

Word on the street is that a business loan is hard to find with a term longer than 5 years, which at $65k over 60months is roughly $1083/month..... Not good.

Even if we all contributed $500 (an arbitrary number) we would still fail to pay off our loan even within the first 2-3 years! 

I feel like I am missing something in terms of how rehab financing or business loans work. If we can get a 20-30 term on our loans, we will be fine, but if not... there is no money. The property will not be cash flow positive, and we will have busted our tails, only to end up spending more money each month just to keep afloat.

The fact that the guys are ok with losing money the first few years is preposterous to me. 

How can we make this work? What am I missing in terms of the loan term and financing options?

In my mind, the gross rents simply won't fund the rehab costs. It seems like being able to acquire a property for so little would be an advantage, but right now I think I'm better off breaking away, shopping for good deals on turn key properties, and borrowing against them.

Any feed back (constructive and positive in nature) would be great! 

I agree coming out of pocket to pay down the loan would be of zero interest to me personally. 

How much do you think the houses would be worth in the currebt market after rehab?

@Zachary Peacock , here's the rub as I see it: Buying small zombie shotgun shells that won't get you circa TWO percent gross return per month once rehabbed (rather than one percent), can easily be a recipe for disaster.

That is, unless their ARV is GENUINELY around the $110k mark. (But if rent is only ~$650/m, who'd pay $110k+?)

Your focus NEEDS to be buying properties that'll get you a much higher ARV than your dollars into it.

One of my biggest concerns is: how would the $65k of hard money be divvied up?

My guess is that MATERIALS would account for $15-20k (only), right? 

So, your people want to be paid out of HML money, up front? And want YOU to help them pay back quicker?

I agree with Charles: "get the loan AFTER you have the rehab done"! (ie. at a NORMAL investment mortgage rate!)

From all the suggestions you've been given, I'd say it's time to: go back to the drawing board. Right? My 2c...

Howdy @Zachary Peacock

Your primary goal is exactly my business model (with the exception I don't look only for "<$25K deals").  

What you are describing is what is known here on BP as the BRRRR strategy. Buy, Repair, Rent, Refinance, Repeat. I agree you should not use your cash to pay down your loan.

How are you financing your property acquisition and Rehabs?  Cash? Hard Money? Private Money?

You need to determine what the Fair Market Value (FMV) of the property should be after you finish the renovations. In other words what is the After Repair Value (ARV).

Use the ARV to help determine what your all-in cost limit should be. I use 70% of ARV. Your all-in costs include purchase price, Rehab costs, Holding and closing costs.

Once your Rehab is completed and you get it rented you will need to get it Refinanced. Using a Cash-out Refinance loan. Do this instead of each of you paying $500 per month each. Most lenders will require a seasoning period of 6 to 12 months prior to refinancing. The seasoning period starts when the property is placed in service available to rent. They will provide a loan that is 70 - 80% Loan to Value (LTV) based on a current appraisal. Typically it is 75% LTV. Hopefully the appraisal will be close to your ARV. This is why I try to keep my all-in costs to 70%.

If everything goes according to plan you should be able to get 100% of your costs out to payoff any loans and cash invested.  You are now ready to Repeat the process.

I strongly recommend you research BP for Podcasts and posts on BRRRR strategy.

Hope this helps.

@John Leavelle Thanks for this advice!

We are buying the properties outright for cash, very low price points, but again, the need significant amounts of work. 

The obvious plan is to rehab the homes and build value beyond the rehab and purchase price so that we can refinance and pay off our rehab loans quickly. We are still shopping for the best way to fund the rehab costs though. Any suggestions right out the gate? 

Is it a better idea to borrow in "chunks" as needed, or in one lump sum? I have been referred to a few small local banks and credit unions to shop loans. Any suggestions? 

@Zachary Peacock

Use the local banks and credit unions for the Refinance loans. You might find Hard or Private Money Lenders to help in the acquisition and/or Rehab. I have a Private Lender that funds 100% of my deals for a good return. You can try searching here on BP for Them. Go to the menu, click on Network, then click on Hard Money. It will display a map for you to search your State. You can also find local REI clubs and meet-up groups to attend to network with other investors, realtors, lenders, wholesalers, and contractors. They may be able to put you in contact with what you need.

There are several local banks and lenders here that will fund the purchase plus rehab if you want. You can later convert to long-term financing.  Twenty, twenty-five and thirty year products exist.

I don't know where this deal is, but make sure you understand the underlying fundamentals of growth.  Germantown had infrastructure (bars, restaurants, etc) as well as proximity to high-demand locations and it is conveniently located.  Based on your statements, I'm not sure these same principles exist where you might be buying.  Thus, banking on rapid appreciation is questionable.  There are people who are buying based on what they may hope will happen.  I prefer to do that at Churchill Downs.  The results are quicker.  

More importantly, it does not seem as though you are on the same page as your business partners.  This is a recipe for disaster.  You want to be in agreement before you buy the first house.  Unwinding the mess once you are a few deals in can be complicated and costly. 

@Erik Hitzelberger What are your thoughts on investing in the Portland Neighborhood? Are you familiar with the PII (Portland Investment Initiative) ?

My concern is that the appreciation will not be there. There seems to be very little infrastructure to lure in demand for rental housing. 

Where do you suggest looking for Turnkey rental properties in Louisville? I think Turnkey with minimal rehab needs is a better route. 

@Zachary Peacock - I think you'll be in for a real rude awakening if you expect property in the Portland area to triple in value in 5-7 years.

I've driven through that area exactly twice and both times I found myself asking "this is it?"  There are some very well versed investors involved in redevelopment there, but that neighborhood is not, nor will it ever be NuLu which is what a lot of people are trying to sell.  The market dynamics are vastly different and there's no real driving force in place to change them.

NuLu is a huge success because of continual reinvestment in the neighborhood and a proximity to money to fuel that reinvestment.  You've got all of the high-salaried white collar workers driving through or past it 2x a day to and from work downtown to their nice houses out east and you're a stone's throw from Highlands, Germantown, St. Matthews etc.

Portland has none of these things going for it.  It isn't convenient for the business crowd to trek out west after work only to have to cruise by the office again on their way home after drinks.  The people that live near or around Portland cannot afford to pay $6 for a coffee or beer, so where does the money come from to fuel that growth?

People are somewhat interested in the area today because it is cheap.  But I don't see any real drivers in place to move the shotgun homes around there from cheap to highly desirable.  I'll eat my words if I'm wrong, but $300K for 1000 s/f homes in Portland will take 40+ years assuming we run 3% inflation.

@Erik Hitzelberger I would love to talk with about better investment opportunities in the Louisville area in terms of Turnkey properties needing little to no updating or rehab work. I want to begin building a portfolio of cash flowing properties soon, but only after doing my due diligence and shopping my options. 

The Portland investment experience was eye opening, fun and educational, but after running all the numbers and listening to advice from other investors, I am positive I can find better deals and make bette money. 

Let me just add to this by saying, the people that rent in this area are MUCH more difficult to deal with than other areas.   I would be AMAZED if your new house was not trashed more than once in 5-7 years, especially if you're new to property management.  

I screwed up on the last property I bought in Portland and missed some expensive things (eg: electric, bad furnace, partial roof replacement, etc). I will most likely have $25k to $30k in this property and I feel like I've paid way too much, so when you talk about $65k in an Portland SFR, I gasped. I typically have under $20k in a Portland home and I typically get around $600 for a 2-3 bedroom home.

I could soooo kick myself in the rear for not buying Germantown properties in 2009 :(

Originally posted by @Zachary Peacock :

@Brent Coombs Immediately after the rehab is done, the ARV will be in the $80-$100k range.

A big part of me thinks the $65k rehab expense is high. Other investors in the area have succeeded with the same model. 

Look at what @Kevin Nally and @Michael Seeker wrote above. THAT's the sort of basic information you need. (I haven't verified it, but YOU should).  And as others have also inferred, if you're investing in areas that haven't ALREADY shown (much) appreciation historically, chances are, those areas will NEVER do as well as areas that have.

Alright, yes, many cheap areas get less cheap over time, but only if the less cheap areas nearby appreciate MORE!

ie. You'll likely do better buying in as SOUGHT-AFTER areas as you can afford, from day one (eg. Kevin's Germantown).

If you MUST go cheap, look at what Kevin did: an outlay of $20k there, gets him THREE percent gross return per month!...