Is this crazy? I sat there with my 23-year-old head spinning—looking at the first $400,000 multifamily rehab project that I had just put under contract.
You’ve probably asked yourself (at least) a couple times if it’s crazy to get into real estate, too. If you asked your friends and family instead, they probably immediately answered, “Yes!”—followed by a spiel about whatever aspect of managing a real estate business that scares them most.
Maybe they mentioned the risk of a market crash, the challenge of dealing with tenants, or the pitfalls of negotiating with contractors. It’s only human. We fear risk.
We fear risk even when our fears are irrational.
Even if you drink the real estate Kool-Aid and know that real estate can be an amazing way to build wealth, the fear probably hits you each time you’re about to write an offer on a building. Do I really know what I’m getting myself into?
Right Before the Plunge
On that night in May 2017, I was on the verge of taking what—to many people—would look like the biggest risk of my young life. I was 23, had recently graduated from college, and had barely six months of real estate experience. This project would pit me and my business partner against countless situations we were not prepared for, faced with countless questions we didn’t know the answers to.
Luckily, as real estate investors, it’s not our job to know the answers. It’s our job to know the numbers.
The numbers on our first rehab deal told us that even in our worst-case scenario—even if everything that people warned us about went wrong—taking the plunge would get us closer to financial freedom than sitting “safely” on the sidelines ever could.
Why are we comfortable losing money, as long as we know how much we’re going to lose?
As a recent grad, most of my college friends ended up in big cities on the coasts.
In 2017, the median rent in Manhattan was $3,150 a month. According to Rent Jungle, the average rent for a one-bedroom apartment in San Francisco was even higher: $3,334 a month. Over the course of a year, that adds up to $40,000 in rent for a one-bedroom apartment.
For reference, the median family income in the city of St. Louis is $52,000 a year. In St. Louis, that money can buy buildings.
On the coasts, it buys you the right to spend up to 39 percent more than the national average on basic necessities like groceries. The costs are pretty crazy, but the craziest part is that spending a family’s annual salary on rent is somehow considered a perfectly normal financial decision for a young person to make.
Young people spend that money with no expectation of getting a return. Rent, groceries, and transportation are costs—not investments.
What is the risk of embarking on a rehab project compared to the 100 percent certainty of spending $40,000 a year on rent?
How We Measure Risk
Risk is exposure to uncertainty. Because of this, renting doesn’t feel like a risk. Neither does spending a lot to live in a big coastal city. The costs are large, but they’re constant. We know them up front: $40,000, paid in tidy, predictable monthly increments.
Or do we?
What is the real risk of renting away your twenties—and how do you compare it to the risk of a rehab project? Does renting in a big city make your financial future—not in 10 months, but in 10 years—more certain or less so?
When you’re embarking on a rehab project, uncertainty stares you in the face. The risks are all right ahead of you, a landmine of knowns unknowns:
- Do we have our contractors lined up in the right order?
- Have we done everything we need to pass inspection?
- Will we hit our rent targets once all the work is done?
- Is it cheaper to fix this or replace it?
Those seem like hard questions to answer. Small wonder that most people warn you away from real estate.
Except when you’re following a safe, “normal” path, uncertainty isn’t gone. It’s just waiting for you out of sight.
Five years from now, will I be working at a job I don’t like? Or will I be free and doing the things that matter to me most in life?
Ten years from now, will I have the resources to protect what I love? To support my family, friends, and community?
Those are hard questions to answer.
For me, those questions would have been impossible to answer if I lived in a big city on the coast, took a fancy job where I was well paid but spent most of my salary on rent and groceries, and had to spend most of my time working for someone else.
We are conditioned to deal with long-term uncertainty the same way we’re taught to deal with short-term risk: by avoiding it.
But avoiding risks doesn’t make them go away. It doesn’t teach us anything. It doesn’t get us any closer to answering life’s hardest questions.
The numbers on our first rehab deal told me two things. In the worst-case scenario, I would come out of the deal not losing any more money than someone who chose to rent in a big city. In the worst-case scenario, I would come out of the deal with an education that would allow me to take control of my financial future.
I could live with that.
The Numbers Tell the Story
My business partner, Ben Mizes, and I started our real estate portfolio with an FHA loan. We were only required to put a small down payment on a relatively stress-free, low-maintenance fourplex.
Five months later, we were planning to borrow $315,000 from the bank and $105,000 from private family investors and spend as much of our own time, sweat, and money as it took to come out the other side of our first four-unit rehab.
The project would be our first BRRRR (or buy, rehab, rent, refinance, repeat).
We were upgrading kitchens, bathrooms, and AC units to bring the rents up from $825 per door to $1,400 per door—a 70 percent increase.
With renovations complete, Ben and I would try to appraise the building for $700,000. Depending on the lender, you can borrow between 70 to 85 percent of a building’s appraised value. In this range, as long as we hit our numbers, we could completely repay our investors, recoup our costs, and walk away owning a cash-flowing castle.
The potential upside was clear. Just as important, we looked at our downside.
Ben and I modeled a worst-case, “do-nothing” scenario, trying to understand what would happen to us if we got stuck and couldn’t complete the rehab at all.
What Could Go Wrong?
Ben and I had a contract to buy the building for $420,000. At the closing table, the seller would credit us for the $20,000 worth of repairs that had to be done immediately: fixing a collapsed sewer, repainting and sealing damaged windows, and replacing falling fascia boards.
Note: We always, always, ALWAYS make our buildings watertight before doing anything else. If they aren’t watertight when we buy them, we negotiate for repair credits to fix problems on the seller’s dime—immediately upon closing.
The $20,000 repair credit provided by the seller brought our effective purchase price to $400,000. Combined, our mortgage payments, taxes, and insurance came out to $2,277 per month.
The numbers told us we could make our mortgage payments comfortably, even in its current (read: very rough) condition. The building was generating income of $3,350 per month, or about $825 per door.
Assuming we got completely stuck and had to keep renting the units out for their present value of $825, we would have $1,073 per month with which to pay all of our fixed and variable expenses. Utilities and HOA fees (the building is in a private subdivision with an annual assessment) came out to $380 per month, leaving $693 a month to deal with variable expenses.
In a worst-case scenario, we would be self-managing to save on property management fees. That would still leave us with vacancy, repairs, and maintenance costs, and the need to set aside money each month for a capital expense escrow.
Was $693 really enough?
Under our most-conservative model, we planned to put aside $10,000 each year for repairs and escrow. After five years, that equals $50,000 put into proactive maintenance—enough to deal with a roof, a complete tuck-pointing redo, and major structural repairs.
Then, we figured 10 percent vacancy cost—high for the area but not impossible if we had hard luck. What was the worst that could happen?
Under our worst-case model, we would be losing $600 every month. Losing $600 a month is a losing deal. That’s not a deal that gets you on a podcast. It’s not a deal that successful investors show off in a blog post.
Luckily, it’s not the deal we ended up with, either. (Spoiler alert: We came out of this rehab with a lot more paint on our shoes but a lot more cash in the bank, too.)
But when we talk about “risk,” here’s the curveball question: Would this “worst-case” deal be a step away from, or a step toward, financial freedom? Let’s look at those numbers again.
The Difference Between Costs and Investments
An investment is any place where you can put your money, such that it creates more wealth over time. In the model above, a lot of the expenses that look like “costs”—that is, look like places where Ben and I would have lost money—are actually investments, places where our money helps us build wealth.
1. Loan Pay-Down
In our worst-case scenario, we would pay $600 a month (on average) to cover the costs of repairs and build a sizable rainy day fund.
However, our $1,600-per-month mortgage would be completely paid for by our tenants. In the first year alone, our tenants would pay for our ~$14,000 interest payments and help us build $5,000 worth of equity in the building.
Over time, that equity build-up only accelerates. In our thirties, Ben and I will build up $85,000 through principal paydown alone (pun intended).
The amazing part is that would be the case even if the rehab project was a complete failure. Breaking even on mortgage and utilities and scraping out of pocket to cover unexpected repairs, Ben and I would still be positioning ourselves to accumulate passive wealth in the future.
2. Proactive Maintenance
If you spend $50,000 on a building in five years, it becomes a lot cheaper to maintain. Under our worst-case model, we would have $10,000 a year to deal with maintenance issues before they became more serious.
When you budget to deal with problems up front, it makes for a less-impressive pro forma—but it also means that maintenance costs get significantly lower over time.
If you plow $10,000 every year into it, even a problem-ridden property will get easier and easier to take care of. It might be a painful cost to swallow in the short-term, but you haven’t lost the money that you spend on a property you own. You’ve just re-invested it.
By contrast, if you spend $40,000 in one year on rent, the money is out of your hands for good.
3. Hands-On Education
When you buy your first rehab, the most important investment you make isn’t in the building. It’s in yourself. You’re taking out (quite possibly) the only student loan in the world that can pay itself off in less than a year.
The most daunting part of diving into a real estate deal—the part that makes people say it’s too risky—is that you don’t just stand to lose money but time, too.
The time costs on this project would have made this a losing deal for a veteran investor. We spent untold hours painting, fixing plumbing, and (like you saw above) drilling holes through concrete when a contractor dropped the ball on us.
But we weren’t veteran investors (yet!). As Ben and I looked at the numbers together, we realized we were buying ourselves both a building and an education, too. Even if we broke even, we would come out of the project with an education that in itself was worth hundreds of thousands of dollars.
A few years ago, I sat looking at the numbers on a $400,000 real estate deal that could either set me on the fast-track for financial freedom or go completely off the rails. In the end, both things happened.
My business partner and I got screwed over by not one but four different contractors before we finished the project. One caused thousands of dollars of water damage to the floors, embroiled us in a months-long insurance claim, and tried to take us to court after he lost.
We dealt with an irascible tenant who threatened us and damaged his apartment.
Time and again, things took more time, sweat, and money than we had expected. But the age-old mantra of real estate investing held true: You make money when you buy. The numbers of the deal were strong.
And now that we’re done dealing with contractors, tenants, and renovations (at this property), we have a building that rents for $1,400 a door, water-tight with low maintenance costs, and a fair market valuation between $650,000 and $700,000.
Now we are on pace to refinance the building, fully repay our investors in the first year, and walk away with the funds to do it all over again.
Taking the Plunge (Again)
Is this crazy? Fast forward and I’m sitting here, head spinning, looking at the numbers of a 20-unit deal in St. Louis.
Since starting our renovation project one year ago, we’ve used the education and cash flow we gained from it to build a 22-unit portfolio—and a high-growth startup.
Now, with a refinance underway, I am looking at a deal that could double the size of our portfolio overnight, all while working full-time.
A new project brings new unknowns. More questions we don’t know how to answer and lots more numbers to keep me and Ben busy.
Source: BiggerPockets.com – Luke Babich