Magic House for Sale.

     I have revisited this article because I have been seeing a resurgence of this type of deceptive advertising in my area recently (suburban Detroit). This has been, primarily, by out of State sellers who have been trying to pass off properties they purchased at very low cost (because they are junk) to local investors. This is an odd strategy. We know they are junk. You may still have success hawking this crap overseas, but, hopefully, enough of those potential buyers have been burned that they have finally learned their lesson. I recently saw a local seller advertise a property with a Gross ROI (return on investment) of 20.2%. This is a metric the seller created. (One might speak of a gross income or a ROI but the combination is nonsensical—or worse.) One should be cautious whenever they see the term ROI used in an ad and make sure they know how the seller is using the term as it may be defined various ways. 

Magic House for Sale.

      You’ve probably seen them advertised. Here’s a fairly typical one:

      Purchase price: $38,000

      Rent: $1,050/Month ($12,600/Year)

      Taxes: $1,500/Year

      Insurance: $1000/Year

      Property management: $105/Month ($1,260/Year)

      Net Income: $8,840/Year ($736/Month)

      ROI 23.2%

      Do you see what’s wrong? I’m not second guessing the figures…yet. In fact, let’s assume the figures are accurate and double check the ROI calculation. ROI = (income - expenses) / purchase price. Using the figures here it would be (annual rent - taxes - insurance - property management) / purchase price. Plugging in the numbers: ROI = (12,600 - 1,500 - 1,000 - 1,260) / 38,000= $8,840 / 38,000 = 23.2%. The calculation looks correct. A return of 23.2 % is pretty good. Right? Yes, but this “magic” house is not going to give you a return of 23.2% .The immediate problem is not with the information given it is with the information omitted.

      Where is the allowance for maintenance? I know, this house is “magic”. It doesn’t need maintenance…ever. Perhaps, all the mechanicals are new, the roof has been completely replaced, the deck rebuilt, …etc. So what? Unless that house is also under a dome (maybe even if it is) the roof will need to be replaced at some point. (Granted, if the roof is metal that can be a very long time). In Michigan, a properly installed 30 year roof often lasts 20 years. An improperly installed roof may start to show serious problems after 10 years. Even the best roof is not going to stand up to a tornado (yes, we do get tornadoes in Michigan).

      The water heater and furnace (is there an air conditioner?) will also need maintenance. Even if your tenants are the most conscientious and flush the water heater frequently and always change the air filters before they are clogged, the mechanicals will need to be repaired and replaced eventually. This costs money. It must be accounted for.

      How much should you allocate for maintenance? That is a judgment call. I like to use 10% of rent collected. I won’t actually know if that is an accurate figure for a specific house for 20 or 30 years but it is at least a reasonable guess. If the house is new, or really has been rehabbed recently, and the rehab was done properly, you should be building up a maintenance reserve for the first couple years. If the home has not been rehabbed, or was rehabbed poorly, you may be writing checks shortly after buying it. If it is an older house, you may want to increase your withholding for maintenance so you have the funds when the bills for those larger expenses come due.

      That figure for maintenance gets subtracted from income in the ROI calculation. With a 10% ($1,260) deduction the ROI is now 19.9%. Still pretty good? Nope, this is still a “magic” house.

      The income is dependent upon a tenant who pays rent. Is it possible that a tenant may stay for several years and continue paying rent? Sure, but you do know that tenant will leave at some point don’t you? Are there ways to encourage tenants to stay longer? Yes. You may offer a below market rent and be very slow to increase it. You may cover the periodic maintenance (filters, etc) so the tenant doesn’t have to bother with it (and you know it was actually done). Maybe you will offer to repaint certain rooms, or the whole house, or provide curtains, or some other upgrade every 3-4 years. (Don’t forget to increase your maintenance reserve if you are planning any of this). Regardless of how great the rent is or what a wonderful landlord you are, all tenants will move (or die) eventually. When they do, you will have an expense. A large one.

      In fact, vacancy is one of the largest rental expenses. Obviously, you have no income when the house is vacant. If the tenant was paying for the utilities, you must now do so and there is almost always, at least something, that has to be done to prep a house to be rented again. (I have had only one tenant turnover that did not cost me anything. The old tenant moved mid-month and paid rent for the entire month. The new tenant moved in within 2 days of the old one vacating and wanted the house so badly that they paid for a full month and did most of the clean up themselves. I collected 13 months rent that year. It is one of my greatest success stories but it has only happened once.)

      Turnover expenses can range from a few hundred bucks for a cleaning to many thousands when painting, carpet replacement, floor refinishing, etc., etc., are added up. Do you see any allowance for the vacancy in the figures advertised above? Neither do I, but you must add them in. What is reasonable? That will vary according to your skill in screening and retaining tenants and, to some degree, luck. The area the house is located in will make a big difference. The figures quoted in the ad are strong and it is possible to collect $1,000 rent on a $38,000 house, but this will usually be in urban areas, and urban areas will generally have more frequent tenant turnover and higher prep costs. Is it reasonable to expect at least a month or two vacancy between every tenant? I think so. Budget for it. I often use another 10% for vacancy (lost rent) expense. If you are new to this, it may be prudent to use a higher figure. Add that expense into the ROI calculation and you are now at 16.6% ROI. If you estimate $1,000 beyond lost rent for the turnover the ROI falls to 14%.

      14% is still a strong ROI. Does this mean this is still a good investment? Ask yourself this question: if someone just offered you an investment home at a 23.2% ROI that you suspect has a true ROI of 14% or less, do you trust them? Might they be withholding or concealing some other information? Might this be a high crime area? Might there be city licensing fees, and landlord licenses? Might the house really be worth a bit less than $25,000? Is the neighborhood declining? Is the rent really as strong as they say? How often is it actually collected? Always make sure you do your own due diligence. Don’t buy magic houses and avoid anyone who offers you one.

      If you would like to continue this conversation below I would be happy to.

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