Continued from Part 10: The living room of each unit was in front, looking towards the street. Behind it was the tandem dining room with built-in hutch, then the kitchen. The bathroom was behind the kitchen, with the rear bedroom having a view of the small back yard and garages. Emily thought of film noir from the late 1940’s. In her mind, Humphrey Bogart or Gloria Grahame might have lived here. The windows were double-hung. Each unit had one aging window air conditioning unit in the bedroom, which may or may not work. Every unit had its own gas wall heater. The kitchen had a linoleum tiled floor, ceramic countertops, and gas stove / oven. There was a small refrigerator, but room enough for a much larger one. The oversized bathroom in each unit had a porcelainized iron claw-foot tub, ceramic tile flooring, wainscoting, and small sink. There was no shower.
They finished the inspection and were on their way off the property, but Mr. Chicken didn’t even ask if she had any questions. He probably wouldn’t have heard if she’d asked one. All he said was, “Wanna write ‘er up?”
“What kind of income does it bring in?” Emily asked.
“It’s low. They haven’t raised the rents in years”, Stu D. Chicken replied. “There’s lots and lots of upside”.
Emily knew what that meant in real estate speak: the units were in such poor condition that they could only be rented by chopping the rents. Any upside wouldn’t be achieved until after she put a lot of money into repairs. She would be buying her own “upside”, which wasn’t really much of a bargain. But she didn’t breathe a word. Instead, she changed the subject.
“You know how much I like it,” Emily said, “My mother could have lived in a place like this when she was a girl. It reminds me of her. I still have some of the furniture she left me in storage”. Emily just made it all up on the fly, but she was very convincing. It was a gift, the way she could do it. “What are the sellers like? Have you known them long?”
“They’re five heirs from out-of-state. There’s no probate. The sale doesn’t have to go through the courts. Wanna write ‘er up?”
“Ok”, Emily said. “Is there any financing?”
“Nope. Notta dime. Paid off. You gotta pay cash or get your own loan.”
“Will the sellers carry paper?”
“I asked them. They won’t,” Stu snapped.
“Do the heirs get equal shares? Or does someone get more than another?”
“Don’t know. Don’t care. You gotta pay cash or get your own loan.” Stewed Chicken repeated. “Wanna write ‘er up?”
Emily no longer wondered why he was not married.
“Ok. Let me think about it for a day or two.” Regardless of the temptation, Emily did not add something silly like, “There are some more properties I’d like to see on the other side of town”. She’d been working very hard to convince him (she hoped) that she was, or at least could be, a sincere buyer of this listing and she didn’t want to blow it now. She wanted him on her side. She wanted to “flip” the agent.
Emily went straight home, driving very carefully because her mind was on the Chicken house. Being a film noir enthusiast (Bogart! Grahame! ) she knew from the time she inspected the units that she wanted the property. The issue now was price and repair costs.
She reviewed what she learned. She liked the area. The property itself was only a short stroll to a big shopping center. If you walked in the opposite direction there were several little cafes surrounding a neighborhood park. In between were all the local shops you’d expect: beauty salons, boutiques, a used book store, a couple of convenience stores, and two dozen Starbucks. The location was fine.
What bothered Emily was the property’s significant deferred maintenance. Specifically, she recognized that buildings wear out in two ways: first slowly, then suddenly. Fixing a poorly maintained property during its long decline was very possible. But eventually a precipice appears, and after that things that used to be repairable now had to be replaced. Recovery after the precipice took longer, was more costly, and often was full of expensive surprises. But this building, if it was returned to fully marketable condition, could be really attractive in a retro 1940’s kind of way. The problem was that she wasn’t sure she had the money for both a normal down payment and the necessary repairs.
One of the reasons 1 to 4 unit buildings can make splendid purchases for anybody, but especially for the new investor in training, is that owner-occupants can finance them like single family homes (i.e., low down payments and 30 year fixed rate mortgages are available). Being deemed a “single family home” by FHA means the property is eligible for down payments under 10%, and sometimes less than half that. Loan amounts vary by location. Some regions are considered “high value”. An owner-occupied loan for a fourplex in a high value location could be as much as $801,950. Necessary repairs can be included in the loan amount. Repairs only, not additions.
It occurred to Emily that if she could get a low down loan which included repair costs, maybe she wouldn’t have to spend much of her savings.
Emily spent some time on the phone with the same loan broker that helped her get the mixed-use house that she was now leasing to Shortsy Cake. Together, she and the broker determined that if Emily could buy the property at a favorable price, it might be possible to include most of the repair costs in the loan. Might be. No guarantees: something might turn up somewhere in the process that would preclude FHA financing. The loan broker reminded Emily, if she made an offer, to make the purchase contingent upon suitable financing.
Due to the mechanics of the FHA loan program, Emily wasn’t too worried about overpaying. There would be so many pairs of eyes on this loan (field appraiser and review appraisers, processors, underwriters, etc.) that Emily felt pretty confident the structure of the FHA mortgage process itself would help protect her from overpaying too much. But even in this there was no certainty, so she would still have to be watchful.
The issue now became pricing. Since the maximum loan would be whatever could be debt serviced from the repaired units (not forgetting that $801,950 cap), the less she could pay for the property, the more money would be available for repairs.
The first step was to focus on exactly what she was buying. She was not buying a stream of income: for a while, the monthly net income from a heavily mortgaged fourplex probably wouldn’t pay to get her hair done. At close of escrow, she would primarily be buying appreciation and equity build-up.
Appreciation and equity build-up are not minor benefits. Just counting the gain on equity build-up alone would mean her cash investment would compound over 10% annually simply from letting the tenants pay off her loan. Reasonably, if she added a little appreciation, a bit of tax advantage, and later a little cash flow she could probably get that ROI even higher.
In reviewing the pricing issue, Emily recognized that Stu D. didn’t really know the value of the property. A little on-line research showed the listing had been on the market for a touch over one year. One source she found said only five months, but the MLS showed it had first been listed with one broker, then when it did not sell, relisted with another broker. The current broker is the one who’s had it for five months. Every 90 days, when the listing was up for renewal, Stu D. Chicken managed to incrementally lower the price, but it remained unsold. That, to her, meant that the listing price was obviously still too high.
Later that evening, while she was doing her toes, she realized that maybe part of the pricing confusion was caused by the fact that the building presented two options. It could either remain four super-large 1,200 sq., ft. one-bedroom units or become (with a bit of permitted remodeling) four decently sized 3-bedroom units. While FHA might provide a loan that allowed for repairs to the one-bedroom units, they would not pay to turn 1-bedroom units into 3 bedrooms: this was not a construction loan. There would be a final bank inspection (usually they sent the appraiser) before the lender made the final payments on the repairs, and if the plans said 1-bedroom units, there had better be only one bedroom in each unit. The change into 3 bedrooms would have to be after the property was complete according to plans and specs, the local building department had signed off on the work done, and all the contractors were fully paid.
Ok, the bedroom change would be out of Emily’s pocket. But what could a couple of partition walls cost? And the change would bring a huge increase in value.
One-bedroom units in good condition in the area rented for about $1,000 or perhaps a touch more, meaning the building would gross $4,000 a month.
But three-bedroom 1,200 sq. ft. units, properly permitted, would rent for $2,500 to $2,800 each, or $10,000 a month for the four units.
So here was the plan: she would only negotiate on the basis of what was currently there: one-bedroom units. If Mr. Chicken even hinted at changing the bedroom counts, she would challenge him, “You’re making a lot of money if I buy this. Are you going to pay for all those added bedrooms?” By this time she had Stu D’s number. Like many commissioned people, he lived off credit. Whatever he earned from this transaction would pay down the various credit lines, and his financial cycle would start over. He was increasingly motivated to make the deal.
Emily’s initial negotiating position was that the maximum value of the property was whatever the bank would loan (plus her down payment) on a $4,000 gross . . . less whatever it cost to restore the units to a level that would support full $1,000 market rents.
It was time to call her mortgage broker. She was told that based on the current interest rate, $4,000 gross rents would support a mortgage of approximately $460,000.
Her next step was to call Stu D. and ask him to arrange three days next week and another three days two weeks later so she could have different contractors inspect the property for repairs. Mr. Chicken flew right to the ceiling at that request.
“No! Not a chance! The tenants wouldn’t agree for more than one – if that – inspection”.
Emily argued that if she made an offer, it would be net of repair costs. Didn’t he need a minimum of five or six bids just to show the sellers? Stu D. didn’t give an inch: “Don’t worry about me! One inspection! Only one and that’s it!”
She smiled at her outrageous request for six inspections spread over three weeks as she put her phone back in her purse, well satisfied with herself. First, she will be inspecting the property before making an acceptable offer. That was unheard of. Secondly, the sellers would not have several bids to cross-compare. There would only be one, and she resolved to make it as high as she could.
This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing real estate, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].
If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com