Investment Pass: We Won’t Buy This House

Sitting on a pile of cash this big and knowing that Mr. PoP’s parents would be A-ok with us keeping the $50K we owe them for a couple more years (they like those interest payments!) instead of paying them back on August 1, has been making us even more aware than usual of possible investment opportunities. 

We’re considering these investment opportunities carefully, but wanted to share some of the investments we’ve passed on recently and why.

 

We Won’t Buy this House

Regular readers probably remember that we bought an empty residential lot in 2011.  As a quick recap, it’s on a saltwater canal in a growing area.  Our goal is to flip it in 10 years (so by ~2021) for at least $200K, hopefully more, and hopefully sooner… but that’s the goal.

Well, recently a dumpy little foreclosed house in the same neighborhood came on the market at an asking price of ~$130K, so we just had to take a look at it.

Would it be possible for a renter to “buy” us another lot in this neighborhood where we think there will be decent mid-term growth opportunities? 

 

Low Down On the House

  • Asking Price: $130,000
  • Estimated Rent: $900/mo
  • Immediate Inspections/Repairs Needed: $10,000 (like we said, dumpy!)

Additional Operating Costs: Insurance, Taxes, Vacancy / Repair Allowances – High, estimated same as for the duplex, could be even higher depending on flood insurance premium.

Did I mention the house was on a similar canal as our lot?  So this tiny little house on the ground flood would definitely be in need of flood insurance, and probably has a pretty hefty flood premium since it’s not technically up to current code/flood standards.

 

Cash Flow Prospects Not Great

Modeling out an 80/20 mortgage at a rate of 3.5%, and estimating a purchase price of $130K, this property would be cash flow negative for the first ten years of ownership as a rental unit.  So it’d actually be sucking money from our pockets year in and year out for ten years while we wait for it to appreciate as we believe our other empty lot in the neighborhood will.

Here’s what it would cost us:

Year $ Out (In) $ Out Cumulative
1 $36,000 $36,000
2 $947 $36,947
3 $845 $37,793
10 -$1 $40,776

In year 10, with these terms, the property might actually make a $1 after tax profit.  Smokin’!  But right around then is when we think that lot values in the neighborhood are going to be hitting our sweet spot, and we’d look to sell it for $200K.

At the end of year 10, we’d have put $40,776 into the deal, and if it’s like the canal lot, it might sell for $200K.  Great, right?  Not so fast.

There’d still be a mortgage balance of $80.5K on the property, so after selling costs (6%) and paying off the mortgage, we would net $66.7K on a sale of $200K.

It doesn’t look nearly as impressive as that $200K number does, but it still gives a CAGR of 10%.  That’s more than the 5% interest we’d be paying by putting off paying Mr PoP’s folks back for another 6-12 months.  So we should do it, right?

 

So Why Aren’t We Buying This House?

For 1, there are a lot of “if’s” involved in these estimates.

Costs: We try and make conservative estimates on costs and estimated repairs.  But when a seawall is 40+ years old, and we’d be responsible for taking care of it until it’s 50+ years old – that has the potential for some BIG COSTS to blow up unexpectedly.  Big. Big. Big.

Sale Price / Timeline:  The future (10+ years away) for this neighborhood isn’t in dumpy little houses like these.  Heck, these houses don’t even conform to current building code anymore.  The future for this neighborhood is in big McMansions.  So, in 10 or 15 years, I think this place is going to be considered a tear-down.  (That’s a house that’s purchased just for the land underneath it if you’re new to the lingo.)  Tear-downs tend not to sell as quickly or gain quite as much from a sale as a lot that’s already cleared and “ready to build”.  So the $200K and 10 year timeline might be right for the empty lot we already own, but perhaps too optimistic for this little dump.

But when it really comes down to it…

 

We’re Not Gamblers

And buying this house feels a lot like doubling-down on an investment that we already look at as our riskiest.  (Though at a price of $90K, we could probably be convinced to take on the risk… though the likelihood of an offer of $90K getting accepted is pretty slim considering there’s an empty lot down the street pending for $85K.)

 

Would you go for it?  Those are potentially very good returns (and could be even better!) if the stars align correctly.   Or are you like us and think the rewards might not be high enough for the risk involved?

38 comments to Investment Pass: We Won’t Buy This House

  • It is great that you are nearby to oversee if something goes wrong, however it seems to be a bit of a low rent for the price and repairs needed. How about you put down less cash than you have to get a negative cash flow property on purpose, in order not to pay tax on rent? I found out that possibility lately and it sounds better than locking up a ton of cash and paying tax on top on the rents since the property has positive cash flow.
    Pauline recently posted..Defining my dream, little guest house in GuatemalaMy Profile

    • Yeah, the problem is that it’s small enough that the rent comps are double-wides. So the rent right now isn’t making it look like it’s worth it as a cash flow property.

      As for not paying taxes, this model actually assumes that we don’t pay taxes in years when we don’t have any positive net income on the property. (In the US we don’t pay taxes on the gross, but on the net. Not sure how it is for you.) I’d have to check with our accountant to see if that would be treated as a loss carried forward on this property or whether it could count against passive income on another property at a different address.

  • I am not a gambler because I cannot afford to lose but you are in a solid financial situation so you could afford to take some chances but if the thought of it keeps you up at night then pass. Investing is all about security and if this home investment messes with your peace of mind then it is not worth any rate of return.

    • You’re right, maybe we could afford to take more chances. But I think we’d still like to be more diversified than this one would make us.

  • Interesting analysis. You’re right, there are a lot of ifs, that’s what would scare me off. Plus you’d have 2 properties in the same area, so you’d have a double whammy if they flooded or were attacked by a hurricane. What CAGR do you use for property appreciation?
    CashRebel recently posted..Do You Work For Passion or Money?My Profile

    • Well, the empty lot would have minimal damage in a flood or hurricane. That’s the big benefit of an empty lot. =)

      As for CAGRs, when estimating future returns, you can check out THIS POST (http://www.plantingourpennies.com/how-to-look-at-real-estate-values/), but we typically use the CPI and linear projections to make forward projections on RE market values. Where that falls apart is actually the sweet spot for this neighborhood – that the fundamental characteristics of the area have changed. We’re talking an influx of a lot of high paying jobs, excess housing inventory absorbed, responsible city planning and urban development. These were partially started in the early 2000’s, but there was a bit too much exuberance and when the housing crash hit in 2006-2007, the pause button got hit. But over the last year or so, they hit “play” again, and the area is definitely moving into growth mode.
      So our guesstimates for the lot’s future value (and that’s what they are) are based on how much homes sold for in the past (> $500K), and $/sqft to build (~$150/sqft is a NICE house in these parts), and backing out construction cost to estimate lot cost. If a 1500sqft house cost $525K, well… we back out $225K for construction costs, and see that the price suggested the lot was worth about $300K. Not horribly scientific, but when the area is just still in so much flux, that’s part of the risk/reward proposition.

      Hope that makes sense!

  • I’m not a real estate expert, but I definitely wouldn’t do it if you’re counting on significant price appreciation above inflation. It might happen, it’s just not a reliable thing to count on. The real strength of real estate to me seems like the cash flow potential, and this property sounds like the exact opposite.
    Matt Becker recently posted..Optimizing My Work Commute: Challenging One of My Money RulesMy Profile

  • Given the potential negatives I think it’s pretty wise to stay out of this investment since you’re relying on some nice appreciation to really provide the returns. Thanks for going into detail about the process though, I need to learn more about valuing real estate and this glimpse helps out. Eventually I think I’d like to have some rental properties, of course that could all change once I actually jump on it.
    JC @ Passive Income Pursuit recently posted..Option Expiration Friday and a Closed OptionMy Profile

    • Glad to share the details. I’m a bit of an excel junkie, so whenever Mr. PoP says “what if” I pull out excel and try and make some estimates. =)

  • Thanks for going into detail on how you value rental properties. Great insight! I don’t think this is a good investment, especially if you can find another property not as dangerous as this one.
    SavvyFinancialLatina recently posted..I Got My First RaiseMy Profile

    • That’s the thing, there’s already been such a rebound in the prices in this area that most of the rental properties are betting on appreciation in some way to justify the prices that they are selling for, since the cash flow just doesn’t seem worth it.

  • I don’t even know what a seawall is, but it sounds scary, especially considering the age.

    I do agree with you assessment. Rental homes are like kids; if you’re not pretty sure about what you’re getting yourself into, hold off.

    On a related note, we are negotiating to buy a rental property now. My favorite rental homes are those that are structurally sound, but need cosmetic work (bring on the pink toilets and brown tile!). The reason being is that a home like this usually sells at a discount and I can rehab it quickly myself.
    Mr. 1500 recently posted..Ask the Readers: What would you do if you held the sole winning ticket?My Profile

    • A seawall is basically a concrete wall that’s built to prevent the lot from eroding into the canal. They go pretty far down, and are usually integrated into a system of pilings and have to do with keeping the land from washing away. Ours looks similar to the one shown in the pictures here with the boat lift attached. http://www.acresales.com/listing700.htm

      Seawalls last many many years, but they do sometimes need maintenance, and when something DOES go wrong, they can be incredibly expensive to fix because of all the permitting to work below the water’s surface. (It’s far more engineered than acinderblock wall…) It’s very specialized work and we wouldn’t want to even attempt a DIY for seawall repair. =/

      As for the pink toilets, I love them! My last apartment before moving in with Mr PoP was pink everything. =)

  • It sounds like you thought it out!

    If you think that the house will likely be a tear-down, then I think you did the right thing. I’m not familiar with your area or real estate outlook, but it sounds like your decision and thought processes made sense!
    Holly@ClubThrifty recently posted..3 Big Mistakes Couples Make With MoneyMy Profile

    • We’re going to keep our eyes open and keep saving, so hopefully you’re right and another good investment opportunity will come along. But we’re going to keep being picky. =)

  • It sounds like you thought it out!

    If you think that the house will likely be a tear-down, then I think you did the right thing. I’m not familiar with your area or real estate outlook, but it sounds like your decision and thought processes made sense!
    I’m sure that something else will come along.
    Holly@ClubThrifty recently posted..3 Big Mistakes Couples Make With MoneyMy Profile

  • Whoa my head is spinning right now. It looks like you’ve got it figured out! I may have to beg you to make one of these charts for me when we go to loose our real estate virginity…
    femmefrugality recently posted..The Cost of WalkingMy Profile

    • haha, your RE virginity! Love it! When the time comes, let me know and I can walk you through excel spreadsheets that I’ve got to help forecast forward.

  • Anne

    Totally agree with the logic. You have another property in that area, so you’d be putting more eggs in that basket, and 10 years to get cash flow positive sounds absurd to me for something that high risk. After all, you could have major repair issues and a long vacancy if that area floods, which is almost a non-issue with the empty lot.

  • CF

    I don’t mind a bit of risk, but with a rental, I’d prefer something with fewer repair needs. Even with the potential for higher resale later on, I think you made the right decision. Keep looking!
    CF recently posted..May garden update: Seedlings!My Profile

    • We’re always on the lookout! I sometimes wonder if we’ll ever really stop looking at RE deals we’ve grown to have so much fun looking at them. =)

  • Good move. Your house is going to cost a ton more than you expect, with ongoing problems and hidden expenses. That $60k would vanish in a hurry!
    AverageJoe recently posted..Teaching Children About Money – Stacking Benjamins Episode #1My Profile

    • It definitely could. I’ve heard quotes of seawall construction at $1000 linear foot. Repairs surely wouldn’t be nearly that high, but those kind of numbers make me want to gag! The lot has probably 60-70 feet of seawall attached to it!

  • All sound logic. Better opportunities than this will likely present themselves. Did you cast a pretty wide property search net?
    Mr. Bonner recently posted..Driving is more expensive than you might thinkMy Profile

  • Sounds like you guys made the right decision to me. We’re on the more conservative side about decisions like this too. Too big of a risk here….
    Laurie @thefrugalfarmer recently posted..Why You Should Choose to Start Your Journey to Debt Free TODAYMy Profile

    • Thanks, Laurie! Time will tell what happens in the neighborhood, but we’re not going to kick ourselves about passing on this one, I hope.

  • Smart move. There are so many “ifs” in a house like that. An inspection report can find a lot of them but not all.
    Kyle | Rather-Be-Shopping.com recently posted..Frugal Hack #10: Lessons from Warren BuffettMy Profile

    • True, and for the seawall stuff, that’s a separate inspection (to the tune of a few hundred $), so it costs more from the beginning. =)

  • Since buying my first home last Fall, I have become aware of some of the unexpected expenses that come up with home ownership. I do still hope to own a rental property (or two) down the road, but I will certainly make sure I have a large cash reserve for these expenses. I guess what I’m saying is, I can’t blame you for being conservative.
    DC @ Young Adult Money recently posted..5 Ways to Stand Out and Provide Value early in your CareerMy Profile

    • Sounds like you’ve had a couple of ugly surprises in your first year of home ownership. Not fun, but hopefully you guys handled it with grace.

      We’ve had our share of big things that need to be replaced ASAP, so we’re definitely on the same page with large cash reserves. =)

  • I think you’re making the right decision. If you don’t feel sure that it’s the best investment decision, I wouldn’t make it (mind you I’m probably too conservative for my own good, but still), you’ve done your due diligence.
    KK @ Student Debt Survivor recently posted..Sometimes I Don’t Play Nice: Killing My DebtMy Profile

  • I think I’d always pass on a property that didn’t have a positive cash flow. Breaking even isn’t even something I would consider, but that’s just me. I guess I am not much of a gambler either.
    Kim@Eyesonthedollar recently posted..9 Mistakes I’ve Made Flipping HousesMy Profile

  • Tabby Cat

    Did someone say “seawall”?

    [cartoon sound: fleeing]