Investment real estate is all about the numbers. A property is valued based on it’s revenue and expenses, and how much it will cost to buy the property. Some factors in this are renovation costs, deferred maintenance, legal fees, inspection (structural, engineering etc) fees etc. Since you are most likely using a fairly substantial amount (usually 50-90%) of someone else’s money (usually a bank or mortgage underwriter) to make the purchase, the cost of borrowing the money needs to be examined.
Right now I’m working with clients who are starting their investment portfolio. They bought a 4- plex last year and are looking to acquire another one this month.
We’ve put in offers on two properties, both of similar size, near each other. One has been beautiful redone in the past six months, and has exposed hardwood floors, 12 foot ceilings, crown mouldings etc. It’s listed at $285,000 and generates approximately $30,000 in gross rental income annually. The second property needs
cosmetic work (new flooring, paint, cosmetic exterior work, kitchens and baths could use an update etc), generates approximately the same $30,000 in gross rental income annually, but is listed at $215,000 (and will likely sell for a few thousand less).
**UPDATE: Property 2 may need a new driveway as well, a $10,000 job, and we have yet to see the interior. Our counter offer is going in tomorrow…
For an investor who is looking to buy a property in tip top shape, the first property would be an attractive buy. You can get a mortgage on the 1st property that will allow it to carry with positive cash flow; you don’t need to be work to the property before renting, and you don’t have any deferred maintenance.
But if you are willing to do some work on a property, or contract it out, you don’t have to pay a premium for the property. You also avoid paying profit to the previous owner for having the work done.
How much does the $70,000 difference in asking price actually cost?
There are two ways to look at it. Option (a) says that the cost to borrow the extra $70K is only $408 a month. This rational is often used in residential real estate, where buyers are trying to justify spending a little too much on a home. ‘It’s only an extra $300 a month. We’ll eat out less!’ In an investment setting, I’d be cautious with this approach since it will eat up money you could put aside each month for reserves and improvements (let alone profit!).
Option (b) says that borrowing the extra $70K is $408 per month drain on cash flow, every month for 30 years ($4896 a year, $146,880 for 30). When you look at how much it costs over the time you plan to own the investment (and continue to have a mortgage on it), you may want to do the work yourself, and pay upfront rather than over 30 years.
My clients decided to do just that, and are going to do the work on the property themselves, with the help of some family and friends.
Remember, buying property for long term appreciation is great, but if it doesn’t make money each month, or at least doesn’t break even, it will be a drain on your bank account for a very long time, rather than a stream of passive income.
When faced with two properties, with a substantial (~15% ) difference in monthly cash flow, you’ll often find that it’s worth it to buckle down and do the work improving the property yourself.
You’ll keep, and put, more money into your pocket.
Benjamin Bach is a Real Estate Consultant with Keller Williams Golden Triangle Realty in Kitchener Waterloo dedicated to building wealth for his clients through smart Real Estate investments, and helping people achieve success. If you are interested in how you can start your Real Estate portfolio, or have any questions and buying or selling a home, you can email Benjamin (benjamin AT benjaminbach.com) or reach him at 519 772 4376.