I always want to reduce my risk when I am shopping for a potential rental property. I accomplish this two ways: 1) Do enough research to feel confident the rent will cover the costs of ownership (including ownership disbursement) and 2) Hidden equity.
Hidden equity takes a few different forms, but normally I am looking for what I call UFUOs – Unique Fixer Upper Opportunities. These homes generally offer the greatest potential return, if I am willing to put in the time to fix the house. Once the house is fixed and rented, I will refinance to extract the equity and keep my portfolio growing. I think of this as a “flip-to-hold”. I still control the houses (and associated cash flow) while monetizing my time and efforts through a cash-out refinance.
When you look to purchase a UFUO, you again want to minimize your downside risk. When I look for properties, I specifically want to know the following: Will the rent from the improved property easily cover my loan plus the improvements? Will the equity cover the improvements? Am I comfortable completing the improvements myself? Am I able to exactly pinpoint the necessary improvements?
On occasion, I will purchase fully rented houses or duplexes which need to be improved only if the current rent will cover the operational costs plus loan servicing. I know that when a tenant leaves, I can then fix the building, which will improve the rent to the next tenants while increasing my equity stake in the building.
Everyone’s definition of a UFUO is different. Maybe you only want to paint and replace the carpeting. Maybe you’re willing to purchase a real dump for $10,000 (they do exist) and completely rehab the entire place. I usually look for something in between.
UFUOs offer ‘hidden equity’ if you are willing to complete most of the work yourself. An appraiser will consider ‘replacement cost’ as part of the appraisal (this is only one part of the appraisal). The replacement cost includes the cost of materials as well as the cost of labor and any associated markup on materials. The ‘hidden equity’ is created by saving on labor and any associated mark up on materials.
The first house I purchased needed minor repairs; new outlets and switches, some plumbing work and a really good cleaning (also a paint job, but that was minor). Then I needed to find tenants. While the first house needed very few repairs, the whole experience was so new to me that I was pushed to the edge of my comfort zone. When I signed and handed over my $17,000 check, I nearly cried because I was so scared of this investment. Leaving my Realtor’s office, I thought “what have I done?”
Driving home, I knew my brand new rental business was no longer a game. Not simply a pastime of mine, looking at dilapidated properties with my Realtor, imagining myself owning them with cash coming in every month. Now I was into it. I owned a property that needed to have work done.
When I picked up the keys and walked into the house, I felt like vomiting. I was that scared. I told myself that I was dead if I stopped moving; if I became paralyzed with fear. I had no choice but to keep pushing forward, so I did. I got the plumbing system working, I fixed the electrical system and I found tenants.
I chilled my heels for, oh, about four months. Then I was on the hunt for another property. This time, I wanted to bag a big one. A real UFUO!
After my first experience, I learned that traveling 25 minutes to the investment property wasn’t a huge deal, so I decided to allow my MLS search to extend to a 25 minute drive from my house. This opened up a few additional markets for me to explore.
The most recent UFUO I purchased was a half rented duplex. The rented side was in OK condition. It needs a paint job, new flooring and minor touchups to the kitchen. The rented side was also under market rate by about 15%. Upon my purchase, I immediately increased rent 7.5% with a planned increase of 7.5% at the beginning of the lease’s renewal.
The unrented side almost needed to be gut rehabbed.
There was human and pet urine soaked into the subfloor, the wiring was old knob and tube (with a shoddy Romex patch job), the bathroom was horrendously small, there was pet urine on the walls, the kitchen had two different counter types at different heights, there were moldy things left in the cabinets, and last but not least, the steps going to the second floor were falling apart (as in the treads were not secured to the floor and fell out as I walked on them).
I purchased the duplex knowing that it would cost me between $40 and $80 per month to own, excluding utilities. These losses were paid for through the profit from my single family home. Using my APOD calculator, I knew that once the full duplex was fully rented, I would make about $500 per month, or I could cash out the equity to purchase another property and still make about $100 per month. This $500 per month actually represents a swing of approximately $600 in profit from the $500 per month plus the $40-$80 and utilities.
When I brought my parents through the duplex, I had only been working on the wiring. Looking back at that visit, I’m surprised my mom actually set foot inside. I had completed the wiring in two rooms plus the basement. There were still urine stains on the floor, dirt and debris from some demolition, stained walls and ceilings, two HUGE holes in the kitchen ceiling from where the ceiling collapsed on me and a huge hole in the bathroom subfloor from where the toilet had leaked for ages and rotted the floor away (yes, really disgusting).
Most people could not get past the current state of disrepair in the building. I could see the potential; what the duplex could become. There were good bones in place.
The duplex was a potential goldmine; it just needed some work to unlock the $500 per month cash flow. If you do the math, that’s a $3 per hour raise for completing the rehab work and managing the property. When this whole project is complete, I estimate that I will have between 400 and 500 hours working on the duplex, which roughly equates to three month’s work.
Before I purchased the duplex, I knew I was going to have to spend a lot of time getting sweaty and dirty and spending time away from my family, but my wife and I knew this temporary sacrifice was worth it. Specifically, this property represents 16.6% of my goal of bringing home at least $3,000 monthly from my rentals.
This UFUO presented an excellent opportunity for me. This property may not have been the best opportunity for you however. The duplex was an excellent opportunity for me because I knew I could accomplish all of the tasks by myself, saving all of the labor and materials markup expense. When I purchased the duplex, I did contact a variety of contractors to determine what they would charge for various improvements.
I received quotes for the electrical work ($5,500), painting ($3,000 excluding materials), flooring refinishing ($4,000), misc carpentry work ($3,500), new bathroom ($3,500) and new kitchen ($4,200). The total expenditure, if I had used subcontractors was $23,700. I knew I could save at least half of that amount if I were to complete the work myself. I have decided to sub out some of the work, but my total investment into this property will be approximately $13,000, or a savings of nearly $11,000. That $11,000 will become my equity once I have the project completed.
This UFUO will be successful for me because of the following:
1) The future potential rent is in line with the local market and easily carries the operating expenses and loan servicing,
2) I knew I was able to complete the work myself, and
3) The increase in the equity of the duplex should more than cover my investment.