In my last post, I discussed the idea of putting together a business around buying distressed properties, rehabbing them, renting them, and then selling them for a profit when the market improves. To clarify what the business model might look like for this type of endeavor, I want to outline a hypothetical (but very realistic) scenario for a rehab and rent project. While every real estate transaction is unique, this one fits the profile for a project that could easily be available in our area.
Hypothetical Rehab & Rent Scenario
Our buyer looks at a bank owned (i.e, foreclosed) property in the west suburbs of Atlanta, GA, listed for sale at $82,000. Based on local comps, the ARV (“After Repair Value,” which is the expected value after renovation) of the property is $120,000. Given the current real estate market, our buyer believes that she’s unlikely to sell the property at that price in the next 12 months. Our buyer runs an initial analysis to determine whether the property will cash flow as a rental, and under what circumstances.
Our buyer makes an initial offer of $65,000 for the property, and after multiple rounds of negotiation, a purchase price of $75,000 (including closing costs) is agreed upon. Our buyer purchases the property in cash for $75,000. (Given the state of the foreclosure market, this is a very realistic scenario)
Over the next 45 days, our buyer hires sub-contractors to perform rehab and remodeling work. The total remodeling costs plus carrying costs for the 45 days is $15,000, with that money coming directly from our buyer’s cash reserves. The finished house has required a total investment of $90,000, and after rehab, the house will appraise for $120,000, creating $30,000 in total equity.
In the following 90 days, our buyer works with traditional property lenders to refinance the property, ensuring that the resulting loan balance (and mortgage payments) are low enough to allow the property to sufficiently cash flow (in other words, the loan will be small enough that our buyer will be able to rent it out and make a profit each month).
Based on the following assumptions (also completely realistic for this area):
- Market Rents: $1050
- Average Vacancy Rate: 8.3% (one month per year)
- Expenses: 40% of Net Income
- Loan: 6.5% Fixed for 30 Years
Our buyer decides to refinance the property for $80,000.
Our buyer’s initial out-of-pocket costs were $90,000, and the new loan allows our buyer to recoup $80,000 of that back. With 2.5% closing costs on the refinance, our buyer’s total out-of-pocket expenses after refinance are $12,000.
Given the assumed income and expenses data above (again, perfectly realistic in this area), our buyer can expect the following ROI in Year 1:
- Cash Flow: $862
- Equity Accrual from Loan Payments: $894
- Cash-on-Cash Return: 7.43%
- Total Return: 15.14% (not including tax benefits, which are investor dependent)
But, let’s not forget the fact that our buyer generated instant equity from her rehab work. The ARV of the house is $120,000, and after refinance, the amount owed is $80,000. So, our buyer has created an additional $40,000 in equity/profit on this house.
This takes our total return for Year 1 to 348%! **
Now, you might say, “But our buyer can’t sell the property in Year 1, so those profits are just on paper.” Very true. But, given the historic cycles of the real estate market, it’s very likely that our buyer will be able to sell the property within 5 years.
To figure out our 5 year return on this property, let’s make the following assumptions:
- 2% annual increase in rental revenues
- 2% annual increase in expenses
- 2.5% annual increase in property values
- 6% sales commission on sale of the property
Given these parameters, if the house is sold after Year 5, the total income/expense on the property will consist of: Initial Investment (-$12,000), Sale Price of the Property ($135,769), Loan Payoff Amount (-$74,888), Accrued Cash Flow ($6,431) and Sales Commission ($7,200). Total net income on the property at sale will be $48,112.
The resulting ROI over 5 years is just over 400%. This is a return of over 80% per year, and an annualized compounded return of over 32%!
Try getting that from the stock market…
** Total Return = ($40,000 in equity + $862 in Cash Flow + $894 in loan equity) / ($12,000 investment)