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.
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.
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).
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.
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.
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?