Why You Can’t Make Money on $30,000 Houses

There’s an old Russian saying that goes something like this:

When two men argue, one is necessarily a fool, and the other is an ass!

The moral: While the fool argues about things he does not know nor understand, the ass knows full well that he is right, but still argues with the fool.

Now, those of you who know me well are well-aware that I am never the fool. Indeed, I know lots of stuff — that’s the good news. The bad news, if you choose to look at it this way, is represented with the following syllogism:

Major Premise: When two men argue, one is always a fool, while the other is an ass.

Minor Premise: Ben Leybovich knows lots of stuff, but always argues; therefore…

Conclusion: Ben Leybovich must be an ass!

To this I say, what the hell… somebody’s got to do it. I might as well take the bullet. Basically, as I see it, so long as I teach you something, I figure I have the green light to be an ass all day long (and twice on Tuesdays, when my articles come out)!

Well, that was my intro, y’all. Thoughts? I’m pretty pleased with myself, actually. And what’s been said thus far is nothing in comparison to what’s coming…

Extended Intro

Last week a good friend of mine, Serge S., called me. I don’t mean to say that this in and of itself is anything special, cause Serge and I talk three times most days. Twice per day Serge calls to tell me to quit being a judgmental ass, and one time per day he calls to tell me that I am right and to ask for my opinion. Haha!

So help me God if I am lying, y’all…

The following is a transcript of conversation #3 from about a week ago:

Serge: You keep telling them to quit buying $30,000 pigs, and you get a lot of support in the comments section from people that have been around for a while, but the newbies keep arguing. Why don’t you just write an article and show them the accrual of CapEx, and how they will spend all of the cash flow that they think they have…

Me: Dude – they already think I’m an ass. I know I am right. You know I am right. Who cares what they think – like I got time. If they want to buy pigs, let ‘em buy pigs. It’s called school of hard knocks…

Serge: Dude – I’ll create the spreadsheet so you don’t have to. All you need to do is just write an article around it. People should know the reality of these numbers!

Me: Fine, but we’ll get 200 comments on this one. You better help with the responses…

Serge: OK – I will.

And so, ladies and gents – put aside your feelings and intuition. In this article, Serge and I will show you the numbers behind the statement of truth: Don’t buy $30,000 pigs in Ohio (or anywhere) – You’ll lose money! This is unbiased truth that your turnkey provider will not tell you.

There Are Two Ways to Look at Numbers

One way is something we refer to as pro forma. This is akin to a snapshot in time, whereby you put the numbers on the page and assume that these will be the numbers going forward, and nothing will ever change.

The other way of analyzing property is to understand that just because something looks today the way that it does, doesn’t mean that tomorrow it will look the same. There are many items we can discuss under this heading; however, the one that Serge and I want to focus on today is CapEx – capital expenditures which pay for replacement of aging components of the physical property.

About Depreciation

You’ve heard the word depreciation tossed around a lot, I am sure. The context in which it is used most often is as it relates to paper write-offs against income from income property; depreciation is thought of as a tax break the IRS gives us.

Important to realize is that the reason the IRS gives us this shelter is because they, unlike many investors, understand that property actually does get older and depreciates, which means that over time we, as owners, have to step up and upgrade items which have depreciated beyond useful life.

The presumption the IRS makes, which is logical and reasonable, though missed by most investors, is that property owners are setting money aside to be deployed in the future to cover the items on CapEx list. For this reason and to encourage us to be responsible owners, the IRS allows us to depreciate and save on taxes today (and hopefully save that friggin’ money!).

Yes indeed, stuff really does get older and needs replaced. And eventually, the shell of the structure itself is so old and with so many functional deficiencies relative to modern consumer’s expectations (functional obsolescence) that it becomes painful to put money into components because having spent sufficient money to bring the thing up to par, your investment of capital is greater than the market valuation of the house — financial obsolescence!

This constitutes the end of the road for a property, and this defines a PIG! Why else do you think the marketplace has decided that a house is only worth $30,000…? C’mon — it’s a 1,100 sq. ft. 3/1 SFR, which at today’s prices carries replacement value of at least $110,000, and yet the marketplace has decided it’s only worth $30,000 — good luck with that math!

“That doesn’t matter…”

This is what you say. It doesn’t matter because you are buying for (these are the buzzwords) cash flow, and at such a low basis, you’ll just make money hand over fist every month…

Well, let’s look at that:

Depreciating Items and Annual Accrual

The following is a chart Serge put together and I added to:

As you can see, in the first column we list the depreciating items; I am sure we missed a bunch, but this is a good start.

In column 2, we indicate the number of years in the useful life of an item. This comes from our personal experience of owning lots of units for a decade. HUD and IRS have their charts, but in looking at those, it becomes clear that their numbers are just stabs in the dark. We feel that our numbers are much more “true” to what happens in reality.

Important to note as well is that these useful life numbers will vary a bit with location and climate. For instance, in CA or parts of AZ, an asphalt roof may need replaced every 10 years because of the extreme heat, while in the Midwest, the same roof might last 23 years. The same is true of the HVAC. However, property taxes and insurance costs in AZ are a fraction of what they are in OH, so things even out over the course hold.

In column 3 we show the yearly accrual for each line item — and at the bottom cumulatively. This is the amount you have to set aside in anticipation of having to replace each at the end of useful life.

And in the last column, we show the monthly breakdown.

This initial table presumes SFR, and it presumes a B Class asset, which attracts B Class tenants. Let’s not beat around the bush — life of equipment is shortened the harder it is used, and C, and especially D Class tenants, will likely be taking less care than B and A Class. In another chart we make adjustments to reflect this.

Additionally, in apartment setting everything can be either less or more expensive, and we make those adjustments as well below. More on that in a bit…

And finally, this table presumes you start out with brand new equipment, and accrual of replacement costs is based on a full lifespan of this equipment. This is important to note, as it really does not matter if you’re doing a “tenant proof” remodel. Obviously, if appliances can be expected to last 8 years and you’re starting off with a 5 year-old appliance package, then you would need to accrue replacement reserves at a much higher rate so that you’re ready to deploy in 3 years, and this can really add up quickly. Furthermore, if you are inheriting 20-year-old appliances, then it’s likely wise to have the full replacement cost on hand from day one!

This logic applies to all of the items on the list.

As you can see, the reasonable expectation of replacement costs seems to be about $257/door per month in a B Class Single Family. This means that if you are going to be a reasonable owner, you would need to set aside this amount of money every month so that you are prepared for the eventuality of replacing items as needed. And while this dollar amount can be argued all day, most reasonable, experienced SFR operators will concede that the number will be most certainly be over $200 a month.

Keep in mind that this is not your maintenance and repair budget; this is CapEx, and is (or should be) a totally separate line item in your underwriting of expenses.

What Does This Mean?

Well, let’s just create a pro forma for a typical older house in a so-so market in Ohio; a place like my hometown of Lima, or Toledo, or Dayton, or Cleveland, or Cincinnati, or Columbus, or any place. Let’s presume an all cash purchase, and let’s just say that you are local and are going to self-manage.

• Cost: $30,000
• Rent: $700/month
• Taxes/Insurance: $200/month
• Vacancy: 10% ($70)
• Maintenance: 10% ($70)

With just those costs, presuming a cash purchase and no management expense, pro forma indicates cash flow of $360/month, or $4,320/annum. This, on an annualized basis, looks pretty good at 14.4% CCR.

Now let’s subtract the CapEx replacement costs:

• Cost: $30,000
• Rent: $700/month
• Taxes/Insurance: $200/month
• Vacancy: 10% ($70)
• Maintenance: 10% ($70)
• CapEx Replacement: $257

What you are left with is $103/month of CF, which on an annualized basis constitutes a 4.12% CCR against the purchase of $30,000. Not so good!

But we are not done, because if you are not local, your pro forma looks like this:

• Cost: $30,000
• Rent: $700/month
• Taxes/Insurance: $200/month
• Vacancy: 10% ($70)
• Maintenance: 10% ($70)
• CapEx Replacement: $257
• Management: 10% ($70)

And now your real CF after you set money for replacements is a whopping $33/month – 1.3% CCR.

And this is presuming you are starting off with brand spanking new equipment and can benefit from full life to accrue replacement cost. You know this isn’t realistic. Why? Because it costs more to replace all of this equipment upfront than what you paid for the house!

You’ve bought a pig that’s going to bleed you to death. If you are at least local and can do the work yourself, then what you’ve bought is a job, but there is a reasonable chance that you can build some CF. If you are from CA and you are buying turnkey, meaning that you can’t do the work at cost and you have to pay for management, even presuming B Class tenant base, you cannot make money at $700/month rents – period.  It’s just math, y’all.

One final point on this: We are not even including the cost of the initial rehab, the cost of the retail rehab when you’re ready to sell, the legal costs of the inevitable evictions, and the consistent turnover. Neither are we including lease-up pay to your property manager, which they most certainly will charge you. It’s normal practice. I tell you, it’s the pits — the management fee of 10% never costs 10%; at least 12%, guys. I know, I’ve seen the numbers.

C Class

Now, what you need to realize is that there are no miracles in this business. In Ohio, a $30,000 SFR is by definition at best a C Class. The market says so; otherwise, you’d be paying $70,000. And with this being the case, you can expect to have to turn it more often, to have turns cost more, and to have to replace equipment sooner than the above table indicates!

That being said, the table below adjusts CapEx up by 15% for C Class and 25% for D Class. You do that cash flow math:

What About Apartments?

Apartments can offer some efficiencies with a shared roof, fewer windows, smaller square footage and convenient management. But there is also higher turnover. Apartments that command average rents of under $500 combined with C class tenants will have a very low likelihood of cash flow. This is irrelevant of the purchase price. Most of these buildings Serge and I would not take for free because they are nothing but liabilities in the long run.

Underwriting to IRR

Internal Rate of Return is a metric which tracks the flow of capital, both in and out, and times it to adjust the resulting ROI with regard to opportunity cost and time.  I have no intention of being specific about it here; I’ve written about this elsewhere. But I do want to point out that in order to underwrite to IRR, it is necessary to predict all of those movements of capital, beginning to exit. The distribution of cash at the time of disposition is 80% of what drives the IRR. The other 20% is CapEx.

Segue: Whenever you are seeing an investment proposal which represents your projected ROI in terms of Cash on Cash (CCR) only and makes no representations of IRR, one or more of the following is necessarily true about the company/person floating the investment opportunity:

1. They are not sophisticated enough to underwrite to IRR. They live and die by CCR, in which case it’s only a matter of time before they die and take you with them.
2. They target investors who are not sophisticated enough to expect underwriting to IRR. Are you one of those?
3. They have not projected all of the cash flows and have not underwritten the exit – plain stupid. They truly believe and sell you on messaging that exit doesn’t matter because you are buying for cash flow — which, having read thus far, you now know is a fart in the wind, cause if you hold too long, CapEx will kill you!
4. They know the IRR will tank because the exit looks too muddy, but they float the investment to you anyway.

Let’s assume that #4 is never true. But this leaves us with the other 3 options on the list, none of which are good… just sayin’. Are you in one of these investments?

When you buy a pig, something is true. If you bother to look, you’ll find out that this house was valued $30,000 twenty years ago; it was also valued $30,000 ten years ago; it’s valued $30,000 today; and you’ll be lucky to sell it for that much when you’re ready. We know; Serge and I bought some pigs before we realized what the game is all about!

What this means is that you are not getting any help relative to realized equity when you sell, which tanks your IRR and necessitates incredibly strong, stable, and growing every year cash flow. Unfortunately for you, CapEx won’t let that happen…

Congrats – you’ve bought a pig!

Conclusion

Do not buy $30,000 pigs in Ohio or any other place unless you are local, will manage them yourself, and are looking for a hell of a job! Due to nothing more that this CapEx number, it takes a minimum of $1,000/month rent to even begin to think about cash flowing SFRs, and you ain’t getting that for $30,000…

Read more at biggerpockets.com

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