Real Estate 011: Cash Flow Analysis and Market Research

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Cash Flow Analysis and Market Research

When people ask me how I can invest thousands of miles away in the midwest while living in California, I tell them that your confidence build the more research you do on your markets as well as your local team on the ground. That is why I started to build my own team after purchasing a couple turnkey houses. Mainly, a realtor (who gets paid when you close a deal) is going to see a project differently from a contractor (who gets paid by the amount of work performed) and that will be entirely different from a property manager’s perspective (who gets paid by the amount of income it produces) By looking at a property and its market through the lens of a team who all have different opinions, you will get a better view of the whole picture.

Here is the recommendation I received from a local property manager when I was starting to research my market:

1. Using an Agent/Realtor

If you are buying a property through the MLS, have your realtor go out to the property and take photos/videos. Ensure that they get pictures of the roof, mechanicals, foundation, and plumbing/electrical systems. These will make a bigger impact on your investment as a new roof and furnace doesn't necessarily demand a higher rent rate but it may lead to loss of tenants and in turn, revenue for your business. These capital expenses don't usually have much impact on the rent rate, so if they need to be updated, you want to ensure that it's figured in the rehab budget. Unless you are doing a full gut-rehab, I always recommend getting a home inspection and having a General Contractor walk through the property as well. Your realtor should be able to coordinate these activities.

2. Researching the area

How is the crime? Is the school system a factor in vacancy? What conveniences and amenities are nearby? Are there any industrial areas nearby (landfills, recycling facilities, wastewater treatment facilities, train tracks, air ports, prisons re-entry program, etc.?) Is it in a flood zone (High insurance deductibles)? Are there problematic homes in the immediate vicinity (boarded up homes, illegal dumping, abandoned cars, unkept yards, etc.?). These potential issues should be communicated by your agent and/or property manager who are your local boots on the ground.

3) Tenanted Properties

If the home you wish to purchase is tenanted, make sure to get copies of the leases and rent rolls. What are the tenants paying? When does their lease end? Are they current? How much is being held in a security deposit? Is the security deposit going to be rendered to the buyer at closing? Newbie investors may think that “cash flowing on day one” is an advantage, but note you may be paying a premium to take on someone else’s problem. Buying a vacant property allows you to have your trusted/vetted PM place a qualified tenant, even though that may mean your property sits vacant for a month or two, and will be paying a lease up fee.

4) Proforma vs Actuals

Most of the time, an agent or the seller may provide you with a proforma, or estimated cash flow the buyer may expect to see with the purchase of the property. Based on my experience, these numbers are optimistic at best. Ensure that you get market rent rates from both the realtor and property manager (This information can also be cross referenced to websites like Zillow, hotpads and Rentometer). Frequently, realtors are not as accurate with their rental information unless they work heavily in that space, where as property managers should always have the most current data based on their experience and inventory.

You will also want to understand property taxes, HOA fees, and get an idea of insurance costs. Your realtor should be able to help with this as well and a good insurance company should be able to assist with the insurance costs (Obtain an actual quote).

After verifying against the location criteria, understanding the scope of any rehab and having a budget built, and getting a good understanding of the probable rent rate, you plug these new numbers in the original underwriting you did with assumptions and see if it fits the original plan. If it doesn't, negotiate the deal to better fit the criteria that you set up in advance.

Here's a checklist to help assist your research:

  • Get opinions on specific location. Crime, School, Flood zone, Specifics to that location?

  • Get market rates to determine ARV / Fair Market Value. In some markets you will want retail prices and as-is, distressed prices if investing in areas with lots of rehabs. A realtor should be able to provide a broker’s price opinion (BPO) or Comparative Market Analysis (CMA), sometimes for a fee.

  • Understand the property taxes, HOA fees, property management fees, and insurance costs.

  • Get rent rates for the location, size, amenities, condition, time of year, etc.

  • Get a home inspection and have a General Contractor (GC) build a rehab budget.

  • Verify tenant information (if tenanted).


Plug all of that data that you obtained yourself into your calculations and see if it still performs against your criteria. Do not fudge the numbers to make it work because you want to close. The only thing worse than no deal is a bad deal that loses money. Don't take a bad deal because you are eager, ensure that it's a deal and get a third party to help you put an eye on it.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision.

Good Luck!


Market Research

Book Review 005: The Slight Edge - Jeff Olson

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The book Slight Edge by Jeff Olson explain how our philosophies shape our attitudes, actions and results, which in turn shape our lives. This book has a repeating theme which is that small habits, if performed over time, will get you the results that you want. Many of these small things are easy to do, but because they are easy, people pass on further consideration such as choosing a cup of fruit over a side of fries, or deciding to buy the latest and greatest smartphone over using the one you have until it needs to be replaced. However, over time, the results of these small decisions produce massive results.

1. Power of the Slight Edge
You may have heard of the story where a person was asked if they want to receive $1 million dollars today, or take a penny, but double it every day for a month? Most of you would choose the million dollars, however, if you were to take the penny, the following would occur: the first day, you have 2 cents, the second day, you have 4 cents, the third day, you have 8 cents, but at the end of the month, you will end up with over $10 million dollars. They started with just one penny, but with time and compounding, it has produced 10x the results. This is the slight edge working either for us or against us. Once you embrace this philosophy, you will know that if you do something long enough, you will get the results you want. But, if you make the small errors of judgement long enough, you will also suffer the consequences.

2. It seems simple, but will you do it?

People may be wondering, if small actions will yield massive results, then why doesn’t everyone do this? Its precisely because its so “easy” and will not impact you immediately, people do not think twice about doing it. This gets even harder with the development of technology and instant gratification we receive through social media and the internet. For the slight edge to work, you have to do something, and keep doing it until you succeed. You need to follow the Plant-Cultivate-Harvest cycle. However, many people either expect something from nothing, or they want to go directly from plant to harvest. The results are not immediately visible. The small activities are undramatic and seemingly insignificant. In a society that tends to worship breakthroughs and quantum leaps, it’s easy to give up or stop doing the small actions required to deliver results.

Favorite quote from the book:

“The truth is, what you do matters. What you do today matters. What you do every day matters. Successful people just do the things that seem to make no difference in the act of doing them and they do them over and over and over until the compound effect kicks in.”

Good Luck!

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Real Estate 010: How to buy Real Estate through Seller Financing

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How to buy Real Estate through Seller Financing

A lot of newbie real estate investors have a common problem when first starting out - lack of capital. As discussed in previous blog posts, there is more than one way to successfully invest in real estate, and that includes financing. An investor can save their money and purchase a property all cash, obtain a conventional or commercial mortgage, or look for private or hard money lenders. Another method that experienced investors love to use is seller financing, or owner-carry.

This simply means that the seller of the property becomes the bank and the buyer will now pay the monthly loan amount to the seller, and not a bank/private institution. Let's take a quick look at some of the advantages and disadvantages of seller financing:

Advantages:

  1. Flexibility of terms (Interest Rate, Downpayment, Amortization period, payback period, balloon payment amount, etc.)

  2. Easier to qualify (No bank involvement means less paperwork, as long as you and the seller agree)

  3. Cheaper closing costs (No bank fees, appraisals)

  4. Purchase through an entity (Corporation, LLC - this is generally not allowed for conventional mortgages)

Disadvantages:

  1. Premium for flexibility (Higher interest rates/purchase price)

  2. Balloon payment

  3. No bank underwriting (No objective third-party that may identify blind spots in the deal that may make it a “dud”)

  4. Property may not appraise for expected ARV (After repair value)

These are general pros and cons, and typically, the pros far outweigh the cons. Experienced investors know that conventional fannie mae or freddie mac mortgages are the cheapest money that an investor will find in the market. This is because they are backed by the government, have no balloon payment, and the loan is amortized over 30 years, which drastically improve your cash flow numbers as long as you are a long term buy and hold investor. However, there may be situations where investors have issues with repairing their credit, do not have enough reserves to meet fannie mae guidelines, or want to purchase a distressed property to rehab and refinance down the road. These issues may lead to the investor not being able to obtain a conventional mortgage, and where seller financing comes in handy.

Case Study: Bo’s seller financed deal.

Let me give you an example of a recent deal I took down with a partner of mine in the midwest. These two duplexes that were in the same neighborhood (Not same street) were being listed on the MLS for above what I thought market prices were at the time. However, I knew the market well and wanted to explore the option of “making” it into a deal that would work for me.

(Note: The best advice I got from my mentors is that in real estate, you only need to win ONE of the two: purchase price or terms. If the seller is focused on receiving an X amount for his properties (within reasonable range of course), then you can dictate the terms to make it into a good deal. Contrarily, if he was Y terms, you can negotiate the price to still win on the deal).

I flew out to the market and looked at both duplexes and knew that it needed a little bit of work to get it to my standards (read: meat on the bone). The properties have been on the market for quite some time so I knew I can negotiated. My first order of business was to talk to the seller and agent to understand why they are selling and what their motivation was. Through multiple conversations, I found out that the seller was an experienced investor who has owned the duplexes for 20 years free and clear, looking to retire and move to another state. I verified this information through online searches as well as looking at his other properties he had in the area that he was selling off one by one.

This taught me three things: 1) The seller is motivated 2) The seller may also benefit from a stream of cash flow, and not necessarily a lump sum. 3) The property is owned free and clear which is perfect for owner financing (No bank involvement and triggering of the “due on sale” clause).

I ran my numbers conservatively and made the following offer:

  • 40K off of purchase price X

  • 6% interest

  • 10% downpayment

  • 10 year balloon

  • 20 year amortization

Quickly thereafter, the seller accepted my terms, but countered at only 20K off of the purchase price. I called the seller myself explaining my reasoning for requesting 40K off of the purchase price (read: its very important to build rapport with the seller/agent and not get emotionally tied down). He agreed at came down to 30K off of the purchase price. I agreed to the terms and we signed the contract.

I quickly performed full house inspections, sewer scoping, termite inspections on both properties and found multiple issues, and estimated that the property needed atleast $15-20K worth of work after closing. This was not too far off from my estimate at $10K, but still higher than expected.

I went back to the seller and told them I will need to go back to my original offer of 40K off of the purchase price for the above reasons. (At this point, the seller was irritated that I was attempting to “retrade”, however, the inspections discovered new issues that I was unaware of before, as such, this is normal in the due diligence process and I knew I needed to be courteous, but firm in my numbers and reasoning).

After multiple emails and not gaining any momentum, I decided to let go of purchase price X, and focus on terms Y. I adjusted the numbers in the calculator to make the deal still work for me. As I am a cash flow investor, I crunched the numbers with the following new terms:

  • 30K off of purchase price X (Same)

  • 5.25% interest (Down from 6%)

  • 12.5% downpayment (Increased from 10%)

  • 10 year balloon (Same)

  • 30 year amortization (Increased from 20 years)

As you can see, I left the purchase price and balloon payment period the same, reduced the interest amount, and amortization period, thereby increasing my monthly cash flow, but also increased the downpayment amount by 2.5%.

Negotiations is a relationship game (refer to my blog post on Book Review: Never Split the Difference), and I knew that if I only “took” from the terms without giving anything back, the seller would feel it as another loss and possibly want to increase the purchase price or back out of the deal. As I realized from previous conversations that purchase price and cash at closing was somewhat important to him, I increased my downpayment by 2.5% (couple thousand dollars), but reduced the interest rate and amortized it over 10 more years. This move allowed my property to cash flow $150/month better than the previous offer and made this financing much more competitive that a traditional conventional mortgage which would have required 25% down for 2-4 units and had quotes for 5.875-6.125% interest rates at the time of this deal.

I knew that in 10 years, we would have heavily paid down the loan, property appreciate it value, and cash flowed enough that we could refinance the balloon or pay it all off if we wanted to. In the end, the seller accepted my terms and we created a win-win deal. The seller received steady monthly mortgage payments and a nice interest rate on top of his equity in the property, and I did not have to use my conventional mortgage slots, and obtained 4 units with only 12.5% down. Further, I feel with the relationship built with this seller, I can reconnect in 6-8 months to inquire about purchasing his other 10-15 properties in the area.

The biggest lesson learned for me was that to succeed in real estate, you have to have many tools in your toolbelt and think outside the box. Figuring out the seller’s why, solving their biggest problem, and offering multiple options is a sure method for you to get your deal accepted.

As Brandon Turner from biggerpockets often says, to an investor who only has a hammer, every problem is a nail. Many investors say, I cant invest because I dont have THIS: time, knowledge, money, confidence, etc. I highly encourage you to think outside the norm and ask yourself the question “how can I do X”. By changing your mindset from a fixed mindset to a growth mindset, you will be able to force your mind to come up with new solutions.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision.

Good Luck!


FSBO