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Considering Endgame Outcomes Before Beginning the Game

Recently at my company, I held a mandatory sales meeting for agents.  While we have been fortunate to have a very good year last year(our best ever), I was still not really satisfied with our sales numbers and how things were ‘stacking’ up, so to speak.  A good friend of mine had discussed this the week prior with me, and basically we came up with this notional summary:

  • I was dissatisfied with the current sales performance of the company, and sales staff;
  • I had a vision of the performance of the company that would generate a better sales performance while allowing the staff to participate in the revenue generated while making thoughtful and genuine contributions;
  • By sharing this vision and taking action with my staff, making tactical changes in our sales and marketing, I felt that we could accomplish our new goals within a reasonable amount of time and do so in an effective and easily duplicated way.

Shortly after the meeting, one of my colleagues came to me and stated that he had some investors who were very serious about buying some investment property – assuming we had properties that fit their criteria.  I will share their specific criteria with you momentarily, but first you need to know a few basics about my company, without me turning this into some marketing piece – primarily, we are one of the few, if only, discount turnkey real estate brokerage(s) in Memphis – that is, we offer turnkey property but our guidelines are that, generally speaking, a fully renovated home should come in at 20% or more below market value by appraisal.   Secondly, we encourage aggressive payoffs when possible, and also offer various, flexible rate private financing to our investors to try and accommodate their needs and varying financial situations.  Our advice to our investors is to buy, but unless necessity dictates, rarely, if ever, sell. 

This strategy has served me well, personally, but many investors of varying levels of experience have, understandably, different criteria.  This was the criteria of this specific group of investors:

– At least 20% equity at the time of purchase

– Positive cash flow of at least $100 a month per unit (40% expense assumption. 10% vacancy, 10% maintenance, 10% CAPEX, 10% Property management)

– Strong rental areas 

– Potential retail resale value in the future

 

The best way to analyze the feasibility of a desired investor’s criteria is to simply plug it into a formula and see if it works.  My sales agent was pretty serious about these investors being ‘ready’, so I used one of my personal rental homes see if it would work using the aforementioned criteria.  The sample home has been in my rental portfolio for almost 7 years, is in a great area, and worth 125k by appraisal based on fair market value.  For easy numbers in the analysis, I used a 100k value.  The home rents for $1050/month.

Home Example: Cheekwood Street, Memphis Tennessee

After Repair Value: 100k

Investor Needs to buy for 20% Equity Minimum: 80k Sales Price

Less $5000 in bank financing costs: (5k) – Sale Price 75k

Less 25k work needed(assumes distressed sale bank purchase[1]): (25k)

Less profit to turnkey company for overseeing renovation, locating, delivering and warranting property:(10k)

Maximum purchase price from bank our company needs to acquire to make sense: 40k

Rental Breakdown:

Income Information – Monthly
Monthly Rent $1,050.00
Management Fee(10%) $105.00
City Taxes $45
County Taxes $56.70
Insurance(Estimated) $60.00
Monthly Cash Flow $783.23
Cash on Cash Return 11.60%
Financing Information
Mortgage Amount $75,000.00
Down Payment $0.00
Loan Amount $75,000.00
Interest Rate 5.00%
Loan Terms(in months) 360
Monthly Payment(P & I) $402.62
Monthly Net Positive Cash Flow $380.61
Cash on Cash Return
Less 30% For Assumptions $65.61

 

Now, if you look closely at this rental analysis, you will remember that the investor required a minimum $100/month cash flow for assumption purposes, this was a prerequisite.  However, the net cash flow after all these assumptions is $65.61, meaning, the price would have to be several thousand dollars LESS to accommodate the investor’s sought cash flow of $100/month, or the rent would need to go up $75 to $1125 to get that $100/month the investor is seeking(again, based on their assumptions.).  For fun, I looked around at a few very successful turnkey companies in Memphis to see comparable pricing on property offering close to $1050/month, and here is what I found:

$84,900 Purchase    $950/month rent

http://buymemphisnow.realyields.com/listing/4914-childs-memphis-tn-38116

$89,900 Purchase   $995/month rent

http://buymemphisnow.realyields.com/listing/3644-sunnyside-st-memphis-tn-38135

$115,900 Purchase   $1095/month rent

http://memphiscashflow.realyields.com/listing/6922-stevenwoods-cove-memphis-tn-38141

(Note: none of these examples are remotely close to what my agent’s investor is seeking.)

Now, understand these companies are run by close friends of mine who offer an excellent product, and we routinely do business with them in a variety of ways.  But I also think they offer a very solid benchmark of what an investor who is seeking a Memphis property can expect in price for a turnkey product.  And, if you look at their websites, these homes are moving so the companies are doing something right, offering a value based investment with management that works for investors[2].

Now, returning to the clients that are serious about buying property using our brokerage, the truth is it is going to be a very difficult, if not impossible, task to find these properties for them for two reasons, both of which I will discuss briefly.  First, their assumptions for vacancy and maintenance, plus other factors, are so high, very few if any houses can fit their criteria.  Consider the house I used in the example worth 125k, which has served me  faithfully for 7 years – I would have to slash that price 50k from its fair market value, then increase the rent another $75(it is rented above market now,) to achieve the investor’s goal of $100/month.   It is unrealistic, to try to find homes of this caliber with these numbers in this kind of area.  It might work if you went into less desirable areas, or broadened your search far outside the city, to rural areas, or lower income ones – maybe then they would find homes that fit their criteria – the point being, while the Unicorn is allegedly out there, it is extremely hard to find.

Secondly, and most importantly, is that they may want to resell in the future, which gives me pause considering their future exit strategy.  Essentially, assuming you could find this deal, why would you ever sell it?  If you found the most precious gem in the world, wouldn’t you want to hold on to it?  To consider selling when buying for cash flow tells me one is looking for speculative appreciation, which for me is like gambling.  Why sell when you can have the cash flow, unless you needed the cash, obviously?

On the Cheekwood house, I used a simple method which didn’t have so many restrictions – I deferred the cash flow for 7 years, and bought the home from the bank at 70k(not 40k).   The banker offered me a five year balloon, but I negotiated a seven year full payoff instead, and they were agreeable to this.  The payment is $1000/month: I collect $1050/month and handle the repairs.  Mathematically, it is simple – I make $50/month if I have no repairs(I rehabbed the house, it is in excellent shape, and the tenant takes care of most minor maintenance items).

 I don’t, like these investors want to do, take $400 of the payment and pretend that the sky will fall each month.  Instead, I deal realistically with the maintenance if and when it arises.  However, in 10 months I will have the 125k house paid off, by the tenant paying my mortgage 84 times(they have already paid it 74 times).  I didn’t spend my time dodging the real unicorns with massive expense ratios and unrealistic expectations., or looking at this deal six years ago thinking it was a no go.

You will have to deal with vacancy and maintenance when handling a rental property portfolio, to be certain; however, to narrow your search criteria to the point where nothing fits what you are really seeking, or WORSE, to never have an adequate exit strategy(mine is to not really exit, just payoff and collect unencumbered monthly payments until I leave these assets to my children), makes the art of real estate investing look like a gaming casino.

You need to have realistic expectations when acquiring properties, and more importantly, manage the managers.  When you do that, you can be mindful of implementing smart mortgage retirement strategies and collecting rent from free and clear properties long before you are ready to retire.

Remember – you have to consider your desired endgame strategy BEFORE you enter the game.  Using unrealistic expectations, though, may keep you from ever getting into real estate at all.

[1] Obviously I am not slashing my home’s price 50k here and selling.

[2] Note that I in NO WAY endorse Real Yields which is used on both of these website examples.  I encourage investors to use their own assumptions in their real estate analysis.