Wednesday, February 5, 2014

What's been causing my frustration: Rental Propportunity

The name of my blog is Passive-Income-Pursuit and up until now it's been focused solely on investing in some of the best companies in the world in search of dividends and dividend growth.  Well it's time to branch out a bit to cover another form of passive income.  I'm sure most of you have noticed by now that I'm excited about some of the rental property opportunities, or propportunities, that I've been finding.  This is a big goal of mine for the year as interest rates continue to be low in a historical perspective and the monthly cash flow can be awesome thanks to using leverage, i.e. debt.  I'm sorry if I've been bombarding all of you in my comments and posts but I'm trying to keep the goal fresh in my mind to keep me from running through my cash.

Of course the markets decided to sell off so far in 2014 and finally we're seeing some great values in the market.  I've already made several purchases including shares of Chevron, Target, Phillip Morris, and on Monday I picked up some Unilever (UL).  There's so many more companies that I want to add to in order to average down my cost basis, but doing so depletes my capital for the rental property.  I'm leaning towards adding some shares of Phillip Morris because I'm currently down over 10% on the position so it's a great chance to lower the cost basis.  I wanted to share with all of you one of the propportunities that I've found and why it's causing some frustration for me.

My original plan for a rental property was to completely outsource the management so it's a very hands off investment.  But this one property is a very interesting situation.  The property is currently leased out through August 2017.  That's right it still has over 3.5 years on the current lease.  I've spoken with the realtor for the property about the current rent which is $1,000 per month.  There's a few caveats in the lease agreement which makes this an interesting investment.  The current tenants are required to make some repairs and upgrades to the property in exchange for reduced rent.  If the repairs aren't completed by August 2014 then the rent will jump to $1,250 for the duration of the lease.  The realtor told me that the tenants are responsible for all repairs to the property, but obviously I need to read through the lease agreement to make sure that's the case.

I wanted to run through a few different scenarios with this property to show what kind of numbers it could provide.  A few details though that we'll keep constant:  Asking price $105,000, 25% down-payment, 5.25% interest rate on a 30 year mortgage.  Property taxes, HOA fees, and insurance costs remain the same in all scenarios.

Scenario 1
Upgrades are completed prior to August 2014 and rent stays at $1,000 per month for the duration of the current lease.  I'll set aside 8.33% (1/12 of monthly rent) for vacancy reserves and 10% maintenance.


The cash-on-cash return is essentially you're dividend yield based on the cash that you've put into the deal.  6.05% isn't exactly the best but that's with accounting for maintenance and vacancy which with a 3.5 year lease and possibly no responsibility for repairs to the property might not need to be set aside.  In this scenario I'd receive $132.42 in positive monthly cash flow as "profit" as well as the principal pay down.

Scenario 2
Upgrades are completed prior to August 2014 and rent stays at $1,000 per month for the duration of the current lease.  Assume that all repairs are made by the tenants and not the owners' responsibility.  Set aside 10% total for maintenance and vacancy for when the lease is up in August 2017.


This is looking a lot better with a 9.86% cash-on-cash return or yield.  While the returns would stay this rate through the end of the lease, that's still a solid return and would provide $215.72 in positive monthly cash flow and the principal pay down.  Of course this is taking a bit of a risk that maintenance and vacancy costs at the end of the lease won't run more than $4,200 (savings of $100 per month for 3.5 years).

Scenario 3
Upgrades are not completed by August 2014 and rent increases to $1,250 for the duration of the lease.  Assume all repairs are still made by the current tenants and not the owners' responsibility.  Set aside 10% total for maintenance and vacancy for when the lease is up in August 2017.


This scenario would be great from a cash flow perspective as almost all of the rent increase would drop to the bottom line as extra positive cash flow.  Cash-on-cash returns would jump to 20.15% and provide $440.72 in positive monthly cash flow as well as the principal pay down.  I'd also have $4,500 in savings to handle repairs and vacancy costs while trying to get the property leased back out.

Scenario 4
Tenants move out at the end of the lease and the property is rented back out through a property management company for at least $1,250 per month.  Property management fee of (9%), vacancy reserves of 8.33%, and maintenance reserves of 10%.


Even though the rent was increased 25%, the property management and higher reserves for vacancy and maintenance take up a lot of the increase.  Cash-on-cash returns would be 10.24% and the positive monthly cash flow would be $224.10.

Things I like about the property:
1.  It's in a great location as you get the advantages of The Woodlands (middle class and up area with lots to do) without The Woodlands sticker price.  ~10 minute drive to The Woodlands.
2.  ExxonMobil is moving their headquarters to The Woodlands area and the house is about a 10 minute drive North of the headquarters.
3.  ExxonMobil moving in could provide for appreciation and higher rent prices.  Also could provide a larger tenant base.
4.  Tenants are doing upgrades on the property which could provide additional appreciation and higher future rent prices.
5.  Cash flow is much better than from an equivalent cash investment in DG stocks.  Assuming 3.5% YOC from a DG company, the down payment would provide $918.75 in annual dividends versus a worst case scenario of $1,589.08 from Scenario 1.
6.  Tenants build equity in the house for me while also providing positive cash flow.

Things I dislike about the property:
1.  Area flooded in the 1990's so potential is there for another flood.
2.  Cash flow only works on current lease by assuming lower vacancy/maintenance reserves.
3.  I haven't seen the area yet.  (Homework for when I get back home)
4.  Scenarios 1 & 2 assume no property management company to make the cash flow work.  Due to my job having me out of town and not always accessible by cell phone this could be a problem in case the tenants need something.
5.  Since no property management company I'd be having to get a P.O. Box for the tenants to mail the rent checks to.  My wife would have to pick up the checks and deposit them.
6.  Would have to go almost $80,000 in debt, although it's "good debt".

Even though the cash flow numbers are awesome in Scenario 3, I would prefer that Scenario 3 wouldn't come to light.  A happy tenant = a happy landlord.  My wife wants no part of being a landlord, and I can't really blame her, so eventually we would need a property management company to run the property to make it a truer source of passive income.

Mortgage rates have recently retreated to November 2013 levels so I should get a better interest rate which would only help the cash flow in all scenarios and speed up the principal pay down process as well.  Also, this assumes that I pay full asking price for the property, which that's not the plan.  If I move forward on this property then we'll be offering at least $10k below asking price as the property has been on the market for quite a while.

Given my need desire for a hands off rental property there's a lot of homework that I need to do on this property.  I need to sit down and read through the lease thoroughly and then I'll also need to get someone with more experience to look at it as well.  Hopefully my realtor can take a look at it and tell me what she thinks about it.  I think this is a great opportunity but I don't really know that specific area/neighborhood all that well.  I need to check and see if I can get in to see the property as well, but I'll be making a drive by at the minimum whenever I get home again.

My biggest concern is whether I would need a management company to run the property as it is right now.  I'm leaning towards trying it on my own since the tenants seem pretty good and have signed a long-term lease.  What really surprised me is that the tenants are doing upgrades as well as signing a 4 year lease.  Clearly they like the property.  This deal seems pretty good in pretty much all scenarios although Scenario 1 wouldn't provide the highest cash flow to start off I think I could probably get away with a mix between 1 & 2.  I've been finding some really good opportunities and there's another one that's a straight turnkey operation that I hope to go through sometime next week.  With interest rates falling that just makes the cash flow look even better and has me excited to move forward towards purchasing a rental property.  And of course the markets decide to give some great value opportunities right when I need cash reserves.

Big thanks go out to FI Fighter as he's been a great sounding board for my questions about venturing into rental property.

*Author's note: I heard back from my mortgage broker and he told he can get a 4.75% 30 year FRM for an investment property.  Revised cash flow/cash-on-cash returns are as follows.  Still assumes paying full asking price of $105,000 and all assumptions under each scenario as listed above.

Scenario 1:  $156.49 / 7.15%
Scenario 2:  $239.79 / 10.96%
Scenario 3:  $464.79 / 21.25%
Scenario 4:  $248.16 / 11.34%

What do you think about this propportunity?  Any concerns that you see that I haven't thought of?

21 comments:

  1. If you are anywhere between Spring/Magnolia/Woodlands/Conroe/Kingwood, that property will most likely be a goldmine for rental income with Exxon coming to town. I would imagine you can increase the rent to $1500-$1700 easily for a good property in that area when the lease is up. My wife and I own properties near the energy corridor on I-10 and have been entertaining buying some properties near the woodlands with Exxon coming in.

    ReplyDelete
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    1. Anonymous,

      I have to agree with you and I expect the rent price to be much higher than the $1,250 when the lease expires. I think this is a great opportunity and it's a great location the house looks good from the pictures, although those don't always tell the true story. I'm definitely going to do my best to get something done and moving forward on this when I get home again. If it turns out I just don't like it then we can always sell in a few years when there should be some appreciation tacked on after Exxon gets fully moved in. I've been targeting the Spring/Woodlands area but haven't really thought about Conroe. Love going on the lake though.

      Thanks for stopping by!

      Delete
  2. PIP,
    Lots to think about here. Good cash flows without a big entry price. I also like the XOM aspect of this property. Forget about the PO box, you can use a service like Rentmatic to collect the checks. Set it up and forget it.
    -RBD

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    1. RBD,

      I think the cash flows are pretty good here, not the best because I think it's probably below market rent but I'll sacrifice cash flow for a good, long term tenant. Even better is that they're making upgrades to the property anyways so they should take pretty good care of it. Hadn't heard of Rentmatic but that definitely sounds like a plan. $3.95 is going to be much cheaper than a P.O. Box plus it's automatically done which is even better.

      Thanks for stopping by!

      Delete
  3. I'm with RBD that you can get rent checks without a PO box, plus it allows for electronic payments. The Exxon aspect of this is huge. You can't understate the potential benefits of that amount of additional demand for places to live and the bump from (assumedly) reasonably compensated individuals. Definitely intriguing for sure.

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    1. w2r,

      Exxon moving in is what really drew my attention to this area. It was already a nice area before but Exxon is kind of icing on the cake. Hopefully more demand will allow for higher rent prices because that just makes the cash flow even better. I like that pretty much worst case scenario it should be over $150 per month in positive cash flow. And it should probably be $300+ by the time the lease is up and that's with including a PM then taking over management of the property. I've been finding some really good deals which is what's been so frustrating. I need to just move forward one way or the other so it stops bothering me. Although this looks like a winner as a first rental.

      Thanks for stopping by!

      Delete
  4. Those look like decent returns. I'm actually starting to look for another rental now. If the market keeps going lower though, I may just put the extra money in the market for now. The market in Austin has shot up over the last year so it's tough to find a decent cash flow property without going way out of town. I'm considering opening my search up to another city.

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    1. AAI,

      It's been hard to balance the getting a rental property with finally getting values in the stock markets. Houston hasn't seen any crazy appreciation like some other parts of the state/country which is good for me. I don't think it's the best deal I could get for cash flow but I think it looks pretty solid considering it's still got over 3.5 years on the lease and the tenants should be kind to the property.

      Thanks for stopping by!

      Delete
  5. Thorough analysis. I might lean towards including the costs of a property manager in all scenarios, just in case that ends up being the route you go down. Still, seems like there's a reasonable chance for double digit cash on cash returns. Tough to not like that!

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    1. Done by Forty,

      If I use a PM to manage the property on the current lease then it essentially makes it a no go. There's better opportunities that I've found given that a PM would take pretty much all of the remaining cash flow in scenario 1. Of course scenario 1 could work if I use the reserves to cover both vacancy and maint as well as the excess cash from my job. I've got a few other ideas that I'm hoping to write about and hopefully see when I get home too. I lived in the neighborhood and I like the area. Although the other properties wouldn't have the Exxon factor for appreciation. It's a bit too far away.

      Thanks for stopping by!

      Delete
  6. That's a great! Where and how are you finding these opportunities?

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    1. Marvin,

      Honestly it's just browsing around the internet and different real estate sites. 2 more houses are up for sale in the neighborhood I used to live in and I hope to be able to walk through those whenever I get home again. The cash flow numbers should be solid even when accounting the full reserve amounts and for the PM. Although there's not the Exxon moving in factor so there's a lot of decisions to be made. All the properties are around the same asking/list price though.

      Thanks for stopping by!

      Delete
  7. Sounds like a good opportunity JC. A couple things:
    1. What do you know about the tenant and their ability to continue to pay and fix things? It strikes me as odd to have a multiyear lease signed by an individual. I have know companies that sign them for their work crews, but I'm just curious. Remember the lease is only as good as the tenant. I've learned that the hard way as a commercial developer.
    2. If you're worried about flood risk, email me the address and I'd be happy to take a look at the flood maps and historic aerials. I used to do this for a living.....so I'm sure I can track this info down in a couple hours. Also, if the structure flooded itself recently....there will be a record....so the broker could provide that to you.

    Exciting man. It looks like a good prospect. My wife doesn't want any part of landlording either. She wants me us to buy an apartment complex when she goes back to work. I suggested i do it now and we live there until the trip......NO WAY!
    -Bryan

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    Replies
    1. Bryan,

      1. I need to do more research on the tenant before moving forward with this. It's actually a family husband, wife and I think 2 kids, have to double check the lease agreement. So the lease makes more sense for someone wanting stability for their children. Especially if you can get a good rent rate.

      2. I'll probably be using your skills/connections to check out the property. The realtor said that it's not in the flood plain but I'd rather have confirmation from someone not trying to sell the house. Although I'm sure that would go against any kind of ethics/review for their license.

      I say go for the trip ASAP. The longer you wait the more excuses that can be found to not go and to wait until "next year".

      Thanks for stopping by!

      Delete
  8. Since the standard is 10% maintenance...the renters have a sweet deal. 20% off rent for them to handle the repairs. Is there really $3,000 worth of repairs a year needed and that is only repairs I presume its not including replacing major things like furnace, AC, water heater? You may not need to calculate an additional 10% on top of it. Though it might be a good idea to do so until you have a cash reserve.

    I would be concerned of quality of repairs and maintenance. I can't see them doing a good job as you would nor hiring someone who wants to have a long term working relationship with you and your unit.

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    1. PMU,

      I need to double check what all is covered but I know they're doing some upgrades on the house as well in exchange for the reduced rent. The current lease does specify that a licensed contractor must be used so it should be relatively good work. Definitely seems like a big discount though so I need to see what all is covered by the tenants and what I would be responsible for. Although roof and HVAC were replaced within the last 2 years so they should be good for a while.

      Lots to think about because the cash flow numbers will be much less than the potential that the property has after the lease is up.

      Thanks for the concerns because I'm trying my best to not just jump in full bore on this.

      Delete
  9. Thanks for the mention and you're more than welcome!

    Cash flow is always the name of the game, but the great thing with real estate is you have 4 pillars effectively working for you.

    1. Even at current market rents, you are sitting right on the cusp of meeting the 1% rule. That's a good place to start, and even better for yourself because you are renting below market value right now. If things don't work out with this tenant, simply raise rents back to market at $1250. This will help bump up the cash flow. Also, 5.25% interest seems a little on the high side... I was quoted 5.0% for rental #5. If you can get a lower rate, that'll help the cash flow slightly.

    2. 4 year lease still seems strange to me, but if that's what it is, then that's what it is. If the tenants are on-time with payments and keep good upkeep of the place, you are in a great position, even with reduced cash flow. And there are some really high quality tenants out there, they're just hard to find... if you luck out, you might be able to put a big fat 0% on vacancy and maintenance (assuming they actually do make repairs) for the next 3.5 years. When the lease expires, raise rents. From my own experience, my first tenant extended a 2 year lease back in August. If that lease goes to completion, I will have had the same tenant in place for 3 years. Rent has stayed fixed since Day 1, but when starting out, I'll gladly take a frozen "dividend" in exchange for zero vacancy. In the meantime (through one and a half years in my case), that same tenant has paid down $7,000 in principal... Those returns aren't accounted for in any cash flow analysis, but they are very real returns! Principal paydown is a wonderful thing.

    3. Also, depreciation will help lower your tax bracket. The interest payments, property taxes, insurance, etc. will also be tax-deductible come tax time. There’s more you can do too, but that’s a good place to start.

    4. Exxon moving into town seems like a pretty big deal. You know your market better than me, but if this move bolds well for appreciation, it sounds like a deal! With a mortgage, you're only putting in $26,250. If the property appreciates 10%, the value will go from $105,000 to $115,500. That’s $10,500. That’s 40% return on your money, for maybe a few year’s worth of time? You’ll be collecting cash flow every month, anyway…

    Also, great location (middle class) is a huge plus. My biggest concern, along with yours would be the flooding that occurred. Definitely do some more due diligence on that.

    In regards to collecting rent, it shouldn’t be too difficult for your tenant to pay you via direct deposit. That’s how I have things setup with both my local tenants. Saves you a lot of hassle of needing to collect/deposit checks.

    You’ve obviously done your homework, but from the sounds of it, looks like you found yourself a great deal.

    Best of luck!

    ReplyDelete
    Replies
    1. FI Fighter,

      1. I heard back from the mortgage broker and he was quoting me 4.75% for a 30 yr FRM. Cash flow and CoC returns were updated at the end of the post and they look much better. The numbers assume paying list price as well which I won't be doing.

      2. The principal paydown is the hidden gem with REI. And I can't agree more that a quality tenant is worth static cash flow numbers. A bad tenant can easily cost you a year or two of cash flow. I might shoot the lease over to you to see what you think.

      3. There's so many hidden benefits to being a landlord to let you keep most if not all of the cash flow. Big bonus!

      4. I really like the area because it's already a great location and then when you add in Exxon moving in that's just gravy. I have no idea what to expect from appreciation but there should definitely be some. Do you use Rentmatic or something else? I think it was Retire Before Dad that mentioned it above and for $3.95 you can have the rent collected and transferred to your account. Not bad considering a P.O. Box the last time I had one was $8 per month.

      My biggest concern is whether I can truly manage this on my own because a PM would take a huge hit out of the cash flow if I keep maint. and vacancy reserves. Given that it's a family living there and they signed a long-term lease and they are doing upgrades to the property I have a feeling they should be really good tenants and take care of the property. Vacancy reserves might not be needed given the long lease. Like I mentioned before the location is awesome and the schools are great and probably bodes well for getting higher quality tenants upon releasing the property.

      I've got 3 other properties in mind and the numbers look good but the location isn't quite as good. Great access to 2 major highways but I don't think there's much chance for appreciation besides keeping up with inflation in the long run.

      Of and of course the flooding being a problem. Still plenty more homework to do and I'm hoping to be able to go check out the other properties when I get home and if possible at least meet with the realtor for this house to get some more information.

      Thanks for stopping by!

      Delete
    2. 4.75%, even better. Yeah, if you can talk down the purchase price $10k, things will be looking good.

      I don't use Rentmatic and just have my tenants sign up for direct deposit at their local bank. So far, no problems and no fees that I'm aware of. Can't beat direct deposit for convenience.

      Hope the flooding concerns get resolved. Yeah, that's a great idea to keep looking at more properties. Keep your options open and you never know what you might find.

      Good luck!

      Delete
  10. Interesting new venture. Any worries about becoming a landlord?

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  11. I'm very impressed by the detail of your blog posts about some of the rental property opportunities. This is going to be very helpful. Thanks for sharing your thoughts..

    Investment Property UK

    ReplyDelete