IC E-Lesson: Real Estate GIGO
By now, everyone on the planet is familiar with the software engineer’s term GIGO, or “garbage in, garbage out”. It’s a way of saying that you can’t get good results with programming. And, unfortunately, our business is VERY susceptible to GIGO.
Let’s look, for instance, at a “wholesale” deal I was recently sent:
“Great rental property, 12% ROI. Rents for $785/mo, needs $5,000 in work, $62,500”
What caught my attention about this deal is that it’s in an area where I would expect a fully renovated/stabilized house to sell for around $55,000, and here’s one that apparently needs work for something like 25% above market—and yet, the “wholesaler” was claiming a fairly hefty return on investment for a cash buyer.
So I opened the calculator on my computer and did a quick calculation:
$68,500 (the “all in” price if the repair numbers are correct) * .12 = $8,220, which represents what the annual net cash flow would have to be if the return on investment was actually 12%.
$8,220/12 = $685, the monthly net rent if the cash flow on this house is $8,220
$785-685 = $100, the total monthly expenses if the gross rent is $785 and the net rent is $685.
In other words, what this wholesaler is claiming is that the total monthly expenses on this property will be just $100/mo.—a number that any actual landlord would know to be total garbage.
In fact, a quick look at the tax rolls says that the CURRENT taxes are almost $70/mo, and that’s at an tax valuation of $42,000. Should some dummy actually pay $62,000 for this property, they’ll go up to over $100/mo just based on the new sale price.
Plus, there are other expenses in owning a rental, like, oh, vacancy, and maintenance, and reserves for capital expenditures, that aren’t LESS than 20% of the gross rents.
So the BEST case real scenario is this:
$785 gross rent
$519/mo net operating income
$519*12 = $6,228 annual income/$68,500 “all in” price = 9.09% return on investment.
Which sounds like a pretty good return for the buyer, except for 2 things:
- The fact that a FIXED UP house in this area, which should have the same expense and income ratios, sells for $55,000, tells us that buyers in this area aren’t happy with a 9.09% ROI. What they’re willing to pay tells us that they want a higher return for whatever hassles come with ownership in this particular neighborhood, and that number is roughly $6,226/$55,000, or 11.3%
- The fact that there’s still garbage in the formula, to wit:
I emailed this wholesaler to inform him that his numbers were off and that if he really wanted to offer a 12% ROI, he’d need to be selling for more like $6,228/.12 or $51,900 LESS the $5000 in estimated repairs, or $46,900 total.
He responded by asking if I’d be interested in the property should he actually get it for $46,900. I said I might be, but would need to see it first. So he sent me 28 photos of the property that indicated that:
- The roof has been patched multiple times and is past the end of its useful life
- The furnace is EASILY 60 years old, and probably about 30% efficient
- The electric panel is a fuse box
- The kitchen and baths, while workable, are original to this 1940s cape cod
Here’s the asterisk at the end of “It costs at least 20% of the gross rents of a property to deal with vacancy, maintenance, and capital reserves*” *Assuming a fully stabilized property.
In other words, if the roof is bad, which this one is, you can replace it now (at a cost of about $4,000 for this roof) and start saving for when it goes bad again in 20 years, or you can spend money every few months continuing to patch it, which will cost MORE. If the furnace is ancient, you can replace it now, or you can lose tenants every winter to the incredibly high heating bill. 20% of gross will only work as a maintenance/vacancy/reserve factor for this property if you spend the ENTIRE $25,000 or so it needs to be stabilized, rather than the $5,000 it needs to be painted, carpeted, and patched back together.
This sort of “I’m going to fool myself by looking at what MUST be done instead of what SHOULD be done” is very common among wholesalers and new landlords alike, and with that sort of garbage in, it’s not too difficult to see why garbage like “This house is worth $13,000 more than market” comes out.
The real, real value of this property to an experienced landlord is closer to $13,500 than $62,500, and you’ll come to that conclusion had you done the math right in the first place.
Using the usual “ARV x .7 – repairs” formula, you’d get:
-$25,000 repair costs
If you don’t understand the math of real estate, you shouldn’t be trying to sell wholesale deals based on it: you just look silly. And you CERTAINLY shouldn’t be buying properties to hold if you don’t know the realities and practicalities of the business; you’re just a danger to yourself and your lenders and partners when you do.
Garbage in, garbage out. Learn the numbers or stay home.