Thursday, June 21, 2012

Irrationality in Residential Real Estate... AGAIN!?

Today, I got an email from my realtor in regards to a house that had a lot of potential that I didn't purchase... Here is the listing info:

It seems like a pretty nice house on the face of things. There were repairs that needed to be made to it. There were a few water problems, it lacked some insulation, had a decent bit of rotting wood, amongst some other things. Basically, I figured to get in into salable condition, so that it would be a truly nice house for people, that it would need about $20K in work. I also assumed that a safe sale price would be $120K, with the potential to get, say, $130K out of it... Given that it is about the smallest house on the street, Zillow and the PVA backed me up on that:

Now. MAYBE, just maybe, I undershot this house, and it would be worth $140K when dolled up really nice (but, you will have to spend a touch more). Granted, it has vinyl siding, an roof that certainly isn't new, older windows and such, but, still it isn't out of the realm of possibility... That said, here is my math for flipping it:

$80K Sale price
+.75K for closing costs, title insurance, and such
+8K for a new kitchen (1.5K for tile, 2K for cabinets, 1.5K counter tops, sink, and faucet, and 3K appliances)
+1.5K for Paint
+2.5K for some decent carpet
+1K for tile in Baths and entryway
+2K in misc. woodwork and other minor repairs
+1K for light fixtures
+1K for new vanities and faucets (which would actually be skimping)
+1K for 9 months in taxes (you want to be sure that you don't get too close to the line, here)
+.5K for insurance
+.75K for landscaping

That gets us up to 20K in known expenses, plus a sale price of 80K, bringing us to $100K invested into the house. This doesn't really include a contingency (say, for HVAC or a roof), borrowing costs (almost everybody has some form of leverage; a car payment, house payment, margin, interest, credit card balance, revolving line, ect) or, realtor's fee if you sell it. In regard to the kitchen, you could down grade it some, I would think that $5K would be the base line for it.

I get a pretty fair deal from my realtor; when I sell a place, I pay 5% (typical is 6%). If I sold the place for more than I thought it would be worth ($130K) when adding in commissions, I am left with $23K... Now, that isn't a bad return if you can do so in under a year, which there is no guarantee of. Granted, you will have to work for it, but, it's certainly not bad. If you borrow money at 6%, then, you get down into the teens. If you sell it for what I think is a more realistic price, being $120K, then, you are basically getting paid minimum wage to put your name on the dotted line for a good chunk of debt and in my mind, taking on a fair amount of risk.

Let's say that you turn it into a rental. I would think that it would take about $2K to do (mainly, wall repairs, paint, and minor things). The carpet and cabinets for example, still have a lot of life left in them, but it just isn't stuff that would help you in a sale situation. Say you bought it for $80K. You are looking at having $82K in a house that would probably generate $12K in revenue per year. If you are unlevered and have no expenses, that comes up to ~15% a year. Add in vacancy and repair allowances, plus, taxes, insurance and other items, and you are in the high single digits/low teens (but, do get the help of depreciation)... Granted, you could probably refinance out of it and pocket some money since appraisers generally don't know much when it comes to getting a good value on these things (I would generally trust Zillow over an appraiser, though, there are exceptions). But still, that reduces your margin of safety, and you will still have an asset that probably isn't worth what you owe against it. Inflation had better hit in a big way for you to do overly well. Even then, you may be left with no one that can afford to buy the house off of you since interest rates will likely be forced to rise to combat the very inflation that you are trying to protect against!

That said, the house still needs a fair bit of work at some point in the not so distant future... The new owners may not do it, but eventually, something will have to happen. Does anyone really want to move into a house that was recently a rental and still looks like it?


As such, it didn't do too much for me even at $80K. When I was going through it on the first day that it was listed, there were 2 other investors going through it... I decided that it really wasn't worth my while to even make an offer, as I probably would have come in at $70K for it, but still wasn't thrilled about it even at that price. I figured that it would end up going for something like $90K. As such, I didn't even bother making an offer.

So. What was the sale price of the house? $110K... That's right, it sold for more than 137% of it's list price.

You can't make this stuff up. This move seems utterly insane if the person buying it is an investor. To put this in perspective, my cousin, who lived in the same neighborhood, just got a sales contract on his house that has over 1,000 sq ft in additional living area, has a better lot with really nice landscaping, and is in immaculate shape, for $172.5K. Even if the person is going to live in it, they just made a deal that certainly isn't good- literally, there is  next to no upside in virtually any period of time.

Disclosure/Disclaimer: I and various members of my family own real estate in the rough area where this was sold, as such, I guess we are long the same asset class. I am in the process of buying more real estate in the area. We reserve the right to change our positions at any time. This post is my opinion. Always do a ton of your own research before even contemplating anything that I say, do, write, or so much as think about.

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