You can read Part 1 here: 19 Fatal Investor Mistakes
6) Since I can’t get a 30-year mortgage on the un-renovated property you’re selling, I’ll have to borrow money from a private lender and then do a second closing once the property is habitable. What are the pros and cons of this type of transaction versus buying a property that is already renovated and cash flowing?
I’ll admit that this is a loaded question because there’s hardly any comparison between the two options. Without a doubt one of the biggest ways new or out of town investors get in trouble is by purchasing a vacant, distressed property based on the seller’s opinions of the following:
- The supposed condition of the property
- The hypothetical cost of renovation
- The proposed market rent
- The estimated length of time between your purchase date and the day the property becomes occupied and cash flowing
Even if you’re dealing with an ethical seller, any of the above factors can easily experience overruns or not go as expected, ultimately costing you money and lowering your anticipated return on investment. If everything were to go exactly as projected, you’re still looking at several months without cash flow and the risks associated with vacant property. See question 15 for more info on the dangers of vacant property. In addition, if you’re borrowing money from a financial institution, you’ll have two closings, which ultimately doubles your closing costs. In short, if you’re going to buy distressed property outside of your own market, please be extremely careful and certainly don’t compare it with a true turnkey investment.
7) What kind of guarantees do I have regarding the overall quality and depth of your renovations?
Look for a turnkey seller that offers a one-year home warranty. If you’re buying a property, this should not be negotiable. If your seller is not confident enough in their product to offer a home warranty, you should insist on a detailed home inspection from a third party inspector. Home inspections typically cost $30O- $500 and are a must have if your property does not come with a one-year warranty.
In question 11, we address the importance of your seller and property manager being one and the same, keeping all the accountability under one roof. Nothing is worse than finger pointing between the seller and property management company over repair and warranty issues.
8) Have you ever lost any of your investment properties to foreclosure?
I know that this may be a tough question to ask, but it’s very important not to do business or take advice from someone who does not have a fundamental understanding of how to make this business work.
Do your homework. Ask sellers the tough questions, and then do your own research to verify their answers. This is your hard earned money we’re talking about. Protect it.
Many investors bought properties before 2007 when rental properties could be bought and financed at 100 loan to value. Most of those investors are now bankrupt, as their down fall was over leveraging. They didn’t simply buy their properties and put loans on them for the amount of their investment, they made a poor business decision and participated in what has rightly become the dirty word in banking nowadays: “cash out refinances.” A cash out refinance is a type of loan in which the owner refinances a property they’d previously purchased. Upon closing on the refinance, they pulled “cash out,” ultimately removing the equity from the property.
This was bad for several reasons:
- Because they pulled cash out on the refinance, they incurred more debt to service, which decreased their cash flow.
- All of the closing costs associated with the second closing were rolled into the amount of the new loan. This added even more debt to service, further diminishing cash flow.
- The owner now has an over leveraged property that according to federal guidelines must now pay mortgage insurance as part of the monthly payment. This again further decreases cash flow.
- Cash out refinance loans received higher interest rates because they were riskier. Higher interest rates = higher monthly payments = less cash flow.
Investors kidded themselves into thinking that the borrowed funds from the cash outs were profit, and would float the negative cash flow from their rentals. Cash out refi’s were easy, so a lot of investors jumped on the bandwagon, increasing their lifestyles by doing as many of these as they could and living off of the borrowed funds. When the music stopped and the cash out refis were no longer available, a lot of investors found out the hard way that their business models were very flawed. Their properties didn’t cash flow in the long term because they couldn’t withstand the occasional vacancy and repair associated with investment property. The only way their business model could sustain itself was through continued cash outs with new acquisitions. Needless to say, investors with this business model ultimately met with financial disaster.
Most of these investors were never particularly good at renovating or managing property, they simply bought them, removed the equity with a cash-out refi, and handed their properties off to a third party management company.
Today, you’ll find a lot of these same individuals posing as successful turnkey real estate investors; however, most of them still don’t renovate or manage property. Their forte is now just good marketing, and because they’re no longer able to secure financing, they market other people’s properties as their own, increasing the purchase price while rarely providing any additional value.
9) I’ve noticed that there are properties in your city selling for $125,000 with a $290 month cash flow, and there are properties that are selling for $62,000 with the same $290 month cash flow. What are the pros and cons of these two different types of investments?
What you need to consider when comparing two investment properties with similar cash flows, but different purchase prices is this: What ultimately determines your overall return is the cost of your initial investment combined with the cost of vacancies over the long term.
I advise each and every investor I counsel to treat their investment property like a business. One aspect of this is understanding that at some point in the future, your property will experience turnover. In this graph we compare a typical $62,000 investment property with a typical $125,000 investment property. You may be surprised by how two properties with identical gross cash flows have such a large variance in returns. Notice how the difference in square footage and initial down payment drastically affect the return.
*This Graph is based on 24 months of occupancy and 1 month of vacancy.
This graph assumes that all features and amenities are identical. However, the typical $125k rental property will need to come with a stove, refrigerator, microwave, dishwasher, garbage disposal, and often an automatic garage door opener. All of the above are maintenance heavy items and are not offered in lower end rental property. Continued service of these items over the life of your investment will even further decrease your return on investment B, beyond what is shown here.
This Graph is based on 24 months of occupancy and 1 month of vacancy. Annual ROI = 12 months of cash flow divided by your initial investment (down payment).
As you can see, identical cash flows do not create identical returns.
10) What type of neighborhoods are your properties in?
The main thing you are trying to discern is whether or not the properties are in what investors call the “war zone.” Different investors have different goals in regards to investment property. Some investors are more interested in long term appreciation, while others are looking for the highest cash flow possible. No matter what market you’re interested in, all major cities will have neighborhoods you don’t want to invest in, regardless of the price of the property. I’ve passed on property that was literally offered to me for free because it was in a war zone.
If one end of the property spectrum is the war zone, the other end is the million dollar neighborhoods. Neither of these neighborhoods tend to be desirable from an investment perspective. In the question above, we addressed how investors can get into trouble on the high end of the spectrum. The war zone is of course the low end of the spectrum. Somewhere in the middle is what we call the sweet spot.
The sweet spot occurs when the relationship between purchase price and market rental rates produces the highest cash flow possible.
The relationship between purchase price and market rental rates varies from city to city, and is one of the largest determining factors for how well your property will perform. It’s your job to research and find the sweet spot in the market you want to invest in.
*Values above based on the author’s market. Sweet spots vary city by city.
11) Do you own the property management company that will be managing the property you’re selling?
The answer needs to be yes, and if it’s not, keep looking. Besides the purchase price of your property, the number one factor for how well your investment performs is the quality of management.
A turnkey seller that also manages your property has a strong financial interest in making sure your investment performs long term. This increases the likelihood that you will become a repeat buyer and refer your friends and family. In contrast, third party property management companies benefit when your investment suffers, because they profit from maintenance and turnover.
The best performing properties experience positive returns because of the quality of the property, timely maintenance service and accessibility to management. When dealing with separate sellers and managers, there is often finger pointing from seller to manager and back again in regards to faulty performance. Do yourself a favor and leave the accountability in one spot under the same roof.
Another small but distinct advantage of buying from a seller who owns the management company that will manage your investment, is that the maintenance will most likely be performed by the same crews that performed the renovation. If this is the case, their familiarity with the property will eventually save you money on repairs down the road.
12) I know that the quality of the property management will ultimately determine how well my property performs. What will your company will do to maximize the return on my investment?
There is no way to overstate the importance property management plays in how well your investment will perform. Great deals can be managed into disaster with the wrong property management, and conversely, marginal deals can be managed to success, given enough time and quality management.
You should spend as much time and effort researching property management as you spend researching the property itself.
Tenants are the lifeblood of any real estate investment business. If they don’t pay the rent, the investment doesn’t perform. Make sure your property management company treats them like gold.