“I found an investment that might work. It’s a single family home near Fashion Place mall. A new investor had it under contract for $200k. He found meth when he inspected it, got cold feet, and backed out. Now the owner will sell it for $180k. What do you think?”
— call from a realtor friend two days ago
In my intro post, I said I’d first post about my trip to Mexico with Choice Humanitarian. I actually wrote a draft for my first Choice post but I didn’t like it. I need to start over. In the meantime, here’s a post on one of my passions, investing. These days, I get calls like this weekly. Sometimes, the stories can be interesting.
My day job is in high tech but around three years ago, I got interested in real estate investing as a hobby. My interest was more academic than anything else. I just liked figuring out how it worked. Probably too much HGTV.
Regardless, I came across and added this book by Gary Elred to my Audible library to help pass the time on my commute. Listening to this book inspired me to do something we all fantasize about from time to time — making spreadsheets. Amirite?
Over time, I read several more books, evolved my spreadsheets, and even did a small coding project to download and analyze real estate deals off the Internet. I was probably spending ten hours a week on this new hobby if you include my commute time. It was like playing a virtual investing game, like Age of Empires. I’m enough of a geek to find this kind of stuff fun. Sad, I know. After a year of doing real estate thought experiments in my head and on Excel, I decided to leave the virtual investing world and enter the real one, no pun intended.
First, I attended a few real estate investor meetups in the area. I remember these as mostly really awkward. Half of the people there were new (like me) and looking to ditch their day jobs (not like me). The other half were real estate professionals or experienced investors there to network. We were supposed to introduce ourselves and network to make deals. I’ve always been in engineering, not sales, so this was a bit out of the comfort zone. I wasn’t even ready to jump into any deals yet. I also remember noticing a common assumption that I thought was odd. Meetings would start by someone telling the room that real estate is the only safe way to invest. “Did anyone see the market today?” If it was going down, it was proof of the central banks or wall street insiders preying on the little guys. If it was going up, the bigger players were laying their careful traps.
As a guy who loves his day job, feels comfortable in the stock market, and was new to real estate, it was hard to identify with most of the folks I met. My default position going in was that real estate was interesting but risky. It was unfamiliar outside my virtual gameplay and wasn’t diversified. Plus, it seemed surrounded by an industry of thousand dollar self-help seminars which always trigger the skeptic in me. Even more, I’ve never been a fan of the bandit signs advertising that you can make $10k a month as someone’s intern (yes, they are bs). It always seemed a questionable marketing choice to use a ‘ransom note’ as the aesthetic for your ads.
In spite of my initial apprehension, I was able to meet a few interesting folks. My first real estate deal was the purchase of two condos with an investor friend I met at an open house. He’s a smart guy and has a track record of successfully flipping houses in the area. For our partnership, he brought a seller financed deal, did the rehab, and managed the condos. I contributed the down payment. We split all the gains 50/50.
This deal turned out ‘meh’. My spreadsheet said it would deliver 13% ROI comprised of cash flow, appreciation, and tax benefit. However, I made a rookie mistake and neglected to account for the HoA fees. That made the actual performance after 9 months closer to a 2% loss before tax. The tax write offs paid for the 2% loss and even made me a little money by the time I sold my half of the partnership for the price of my original contribution. To me, it was a good experiment and good learning.
My second deal turned out better. I decided to try the BRRRR strategy which is to buy a distressed property, fix it up, and rent it out before financing it. In theory, this gets you a higher ROI because the value you create through the rehab may be applied as part of the down payment on the mortgage. Your amount invested is less for the same return. In my case, this really worked.
As I completed couple of deals, I started getting introduced to more real estate professionals which in turn exposed me to more potential deals. Now I could play my Age of Empires game on actual real world deals that my friends were making or that I might even have the option to make. I probably analyze 3 deals a week, still not that many by the standards of my professional friends but pretty good for a hobby, I think. It usually takes ten minutes for me to get a pretty good analysis. Sometimes, there are interesting stories in the deals. Fast forward to today and I’m getting regular calls/texts like the one that opened up this post.
Speaking of the meth house call this week, what is the right answer?
I had never purchased a meth house before but I know folks who have done it more than once. It costs around $5k to hire a disaster recovery company to remediate the meth. Once they are done, the house gets a clean bill of health. Apparently, the house is also free of all mold, bacteria and many other contaminants. Maybe that’s good enough for you and maybe it’s not. A decision to never buy a meth house is a fine answer, IMO. I feel like I’d try it for a really exceptional deal. For this post, let’s assume we’re comfortable that the house can be adequately remediated. Now the cost is $185k.
When I got the call, I happened to be on the freeway very close to the house. I took the 10 minute detour to stop by.
The house was ordinary for the neighborhood which was mostly pretty well kept. Comparing it to similar properties, it should sell for $260k and rent for $1.3k, data my realtor friend compiled. At a purchase of $180k plus $5k in meth remediation and $25k of other rehab, the total acquisition is $210k.
I’ve set up my spreadsheet to have assumptions entered in the blue cells. In this case, I really only needed to enter the acquisition cost, after repair value (ARV), the expense ratio, and the rent. The rest is pretty standard for the area. To calculate the expense ratio, I had to look up the taxes for the property on the county assessor website. I guessed at the insurance cost and figured $200 in reserves for repairs seems reasonable. I also assumed that a future tenant would pay all utilities.
So after driving to the property and doing some excel work, I’m about 20 minutes into this analysis. We now have some performance metrics.
You can google the terms if you’re curious or leave me a comment and I’ll explain.
You’ll see that the investor would have to put down $58.8k. After all expenses are paid, this property is expected to yield $14 a month which equates to an annual cash on cash return of 0.3%. That’s not awesome which is why my spreadsheet tags it as red. I really want to see 5% cash on cash return or better. However, keep in mind that the ROI is made up of more than just return on cash. Believe it or not, this property would actually yield almost 20% a year for the first 5 years in spite of the low cash return. More on that later.
The other thing to call out here is that the DSCR (debt service coverage ratio) is marked red at 1.02. You really want that to be 1.25 or higher. The DCSR is a number that gets higher when you have more income left over to pay your mortgage after you pay your expenses. If you wanted to get a commercial loan on a property (which you couldn’t on this residential property) then the bank would require the DSCR to be greater than 1.25 because the banks have done research that suggests that properties above 1.25 DSCR are unlikely to default. Even though we’re not commercially financing this property, I like to know what a commercial lender would think about its financial performance. If a commercial lender would be concerned about default, I figure we should too.
Now that we have all of these metrics calculated, we can forecast the performance of this investment. We’re still only 20 minutes into the analysis.
Here’s where we see that there are some positive aspects of this investment in spite of the initial low cash on cash return. The cash return does not account for the appreciation of the property nor the equity captured by buying the property at a discount up front. To find the total return of a real estate investment in a given year, I add up all of the cash flow it generated in the past (accrued cash flow) and then I add that to the proceeds after selling the property and paying the selling costs. In this investment, we’d get $95k if we sold the property after a year. Our $58k grew to $95k which is a 63% return. That’s mostly because we had 50k of equity by buying at a discount up front but had to give up some of that in selling costs.
Consider, however, how the 3.0% appreciation factors into the return. On this $260k property, that’s $7.8k of added value in the first year. That $7.8k adds 13.4% return to the $58k originally invested. Do you see why? The 3% appreciation is on the $260k value of the property, not the $58k down payment.
This is the magic of debt as applied to a real estate investment. Some people say that debt is what makes real estate investing work. Others say, pejoratively, that you can write your own ROI on real estate because of debt. The implication is that the debt is a two edged sword. While it does boost the ROI, it also adds risk.
Now let’s talk about the RRI. Once we know the Total Return each year, we can calculate the RRI. The RRI tells us what interest rate we got. So in this example, we start with $58k investment and end with $145.9k after five years. That $145.9k is what you would end up with if you put $58k into a savings account and got 19.9% interest each year for 5 years. Hence, I consider 19.9% to be the annual yield for the first 5 years on this investment. The icing on the cake is that the return can be achieved with minimal tax consequence. This post is already too long to cover tax efficiency though.
One thing to notice is that the RRI goes down each year. That’s again the magic of debt, this time working against us. We can chose to minimize debt or maximize return. As the debt is paid down, the return goes down as well. The initial equity gain is also being amortized over a larger number of years.
After a few years, many investors will exchange their properties into more valuable properties. This resets the RRI curve. Alternatively, they may refinance their properties to pull cash out that can be invested elsewhere. This also resets the RRI curve, increasing the debt, the ROI, and the risk. I am oversimplifying a little because there are other factors but you get the idea.
You might say, “In the table above, we’d get 63% return by selling in year 1. Why not sell immediately”?
This is where you get into an interesting debate between flipping a property or holding it. It’s tempting in this example to just flip the property and take the $50k minus $20k selling costs = $30k of free equity on day 0. There’s a catch though. If you sell within a year, the proceeds are considered ordinary income to the IRS. Depending on your tax bracket, another 20k of that 50k could be paid in taxes, leaving you with as little as $10k. By holding, you eliminate most of the tax.
But for fun, let’s suppose taxes are the same. Holding still wins for a reason that wasn’t originally obvious to me. By holding, we end up with an asset that is appreciating and kicking off cash flow each year. How do you compare the future appreciation and cash flow against a cash payout ($30k) today?
You need a way to quantify how much the future appreciation and cash flow are worth today. This is called the Present Value of that future cash flow and appreciation.
The present value is the amount you’d have to put into a bank account (or otherwise invest) in order to draw the same amount you’d get from the appreciation and cash flow. The present value tells you how much your future payouts are worth today. That’s because if you had that amount today, you could invest it and get the same future payouts. Make sense?
It’s like the lottery. Lottery winners can take a lump sum payment today or they can opt to take payments over time. In theory, the lump sum should equate to the amount they’d have to put in the bank in order to get similar interest payments over the same time period. The lotto can pay you a million dollars today or $40k per year for the rest of your life. Assuming some interest rates, the lump sum would have an equal value to the present value of the future payments.
All of this means that if we can calculate the present value of our future payouts then we should be able to compare that to the lump sum today. That will tell us whether it’s better to take the lump sum or take the future payments. That’s really the critical question to ask if you have a choice to flip a property or hold it. Flipping is a lump sum today. Holding is a set of future payments. Use present value to make an apples to apples comparison.
In the meth house investment, the total return for the first five years is around $18k per year: (145-58)/5. How much money would we have to put into a bank account (or invest in the market) in order to get $18k per year for 5 years? To some extent, it depends on how much interest the bank will pay us. If the bank paid 0% interest, then to get 5 payments of 18k, we’d need $90k (18 x 5). If the bank paid 1%, we’d need $97k.
For this example, let’s be super conservative. Let’s say we put the money in a bank account and got 0% interest. The present value of those 5 future 18k payments is then $90k. The value of taking the lump sum from flipping is $30k (minus taxes). Holding wins.
So in summary, this investment makes more sense to hold than to flip and is expected to yield 20% in the first 5 years barring any 2008-style market correction. However, it’s financial performance is still not good enough for a bank. I take that as a good indicator that the investment is too sensitive to the economy softening or us miscalculating something. I’ve analyzed other deals that can yield a 20% sustained return that a bank would underwrite.
In the end, I told my realtor friend that my opinion was to pass on this investment based on the numbers. There are investments out there that mitigate the future financial risks better. If you’re going to deal with meth remediation, you should get paid better for it. To eliminate the red cells in my spreadsheet, you’d have to acquire the property for 170k including rehab and remediation. Or you’d have to find a way to get $1550 rent. Or you’d have to put more money down and take a lower return. Or some combination. If a good scenario existed to eliminate my spreadsheet warnings, I’d say go for it.