Paid off Rental Property Needs Work

[robbinew]

Hi all - Please help!

My parents have decided they're done with their rental property.  It's a 10 unit building in a fantastic part of town.  It's paid off, would sell for 400-600k and needs maybe 75-100k of work.  The city found several code violations, so the work has to be done.  My parents have puttered around doing little repairs themselves, while the big ones were ignored.  The property's in their name - no LLC.  The plan was always for my brother and I to inherit this property and maintain the rental.

Option 1: Sell as is and let new owner deal w/ repairs/city.
Option 2: Get a business loan (if possible??), do the repairs, I take over as property manager.
Option 3: Convert to LLC, basically do the same thing as option 2.

Other options?

Questions: Can a brand new LLC get a loan based on the value?  Are there any pieces of this I should be thinking about that are more important than others?

Thanks!

[Telecaster]

The value of the project is based on the future income of the building.   That's the part that will let you know if everything else makes sense. 

[CashFlowDepot]

It would be a shame to sell this property which has been in your family for so long.  It could provide cash flow for your family for many years to come if you get it fixed up. But, instead of getting any kind of bank financing, it would be better to find someone who will put up the necessary funds for repairs in exchange for "equity participation"

Alternately, you could sell the property then reinvest the money in to something less labor intensive. 

You definitely need to get it out of their names.  A living trust is the way to go because it already has estate planning and asset protection built in.

Do something quick before the city code enforcement starts putting liens against the property.

[Bearded Man]

I'd do some number crunching and determine what it will cost to fix (get three quotes) and what expected cash flows will be - expenses, for a net profit. Also factor in the time you will put into managing it. Is it worth it to you?

[robbinew]

The value of the project is based on the future income of the building.   That's the part that will let you know if everything else makes sense. 

Rents were about 4300/mo, 52k last year.  After repairs, taxes, depreciation, other expenses, income was 12500.  This seems like sufficient performance to warrant significant investment.  I'm trying to figure out how much though...

[Telecaster]

The value of the project is based on the future income of the building.   That's the part that will let you know if everything else makes sense. 

Rents were about 4300/mo, 52k last year.  After repairs, taxes, depreciation, other expenses, income was 12500.  This seems like sufficient performance to warrant significant investment.  I'm trying to figure out how much though...

Hmm, that's pretty marginal.    You have to spend basically $100,000 to get $10K per year.  Which is not bad.

But if you had $500K cash, you should easily be able to get more than that over any reasonable period of time.   

[dpfromva]

I guess the best you can do is try to project cash flows and returns. One positive, your parents aren't emotionally attached to the place and pressing you to keep it going. Other "soft" issues are is your brother going to help? Is it OK with you if you do a heap of work and he also benefits, as heir or part owner of LLC, if that is your parents wishes? Do you work well together as partners?
So for sale, proceeds minus capital gains and depreciation recapture taxes, then project investing the cash in x fund for x years.
For repair, cost of financing (if you can get it), cost of construction plus contingency factor, cost of your time managing, compared to rental cash flow and appreciation. If a silent partner, put in some probability factor that they flake on you or cause you stress, in addition to them getting their share. There's that vision of keeping a "hot" property vs. the potential that the repair effort will reveal more and more hidden costly problems, gradually sucking up all your time, money and sanity . . .
I agree you might want to talk to an attorney about a trust, dependent on your parents financial situation, to protect the asset now while they are healthy. If either or both got seriously ill, do they have resources, long term care insurance? If there is any possibility they could end up financially wiped out and looking at Medicaid for home care or assisted living? (Medicaid has a five year look back period. Medicare doesn't cover that stuff.)
And a final, I guess, Mustachian question, even if the numbers work, do you have "enough" without going through the repair/rehab effort to make the property viable. In other words, what is your reason to want to do this -- Is it, "Damn, I can't stand the thought of somebody else waltzing in and grabbing that upside," or "I'm really excited about and interested in rehabbing and managing a sizeable property, what a great experience and learning opportunity," or "The return outweighs the alternative of investing the sale proceeds so much and it is essential to cover college costs for my and my brother's kids (or provide a living for the entire family, or . . .)" Only you can answer that one.

[Johnny Aloha]

Rents were about 4300/mo, 52k last year.  After repairs, taxes, depreciation, other expenses, income was 12500.  This seems like sufficient performance to warrant significant investment.  I'm trying to figure out how much though...

You might already know this, but I figured I'd state the obvious ...

The value of the building will be (or should be, but perhaps not in this insane commercial market) based on the net operating income (NOI).

To determine NOI, take the gross rents ($52k), subtract the operating expenses such as taxes, management (even if self managed), repairs and maintenance, utilities and insurance.  Note: depreciation and mortgage interest DO NOT count as expenses when determining NOI.

Once you have NOI, you divide by an appropriate capitalization rate to determine value.

Let's make the following assumptions:
Gross income:: $52k
Operating expenses: $23k (roughly 45%, which is reasonable in the short term if utilities are included. Would be higher if you count CAPEX reserves)
NOI: $29k

For the asset you described, I assume it could be considered a "C" class building in a "B" or even "A" location.  As a result, market CAP rate would probably be around 6% - 7%.

Based on those assumptions, the value would be in the ballpark of $414k to $483k.  ($29k / .07 = $414k, etc).

The cap rate is completely set by the market, which of course is very local in nature.  There are some great, free resources to help you understand the local dynamics.  One of my favorites is www.irr.com.

Many small and regional banks would love to loan you money at 40-50% LTV on this asset so you can do the improvements and keep the building.  Just make sure you understand the loan type and terms, which will be different from the 30yr mortgage you are used to.

[Johnny Aloha]

You definitely need to get it out of their names. 

Agreed.

A living trust is the way to go because it already has estate planning and asset protection built in.

Hmmm ... I am so not sure about that.  My understanding is that a living trust, if revocable, does not provide any asset protection.

Most RE investors use LLCs in situations like this.

Either way, consult with proper experts and make sure you understand why you implement a strategy.  It will keep you sleeping well at night.

[Kouhri]

I'm assuming that this property was meant to help fund your parents retirement as well as be an inheritance for you and your brother. Although this sounds like a really cool project ,  would the payoff be worth it. I guess I'm asking if the capital tied up in the property could be put to work harder somewhere else. Of course there's likely to be other factors that will play into your family's decision including sentiment, personal inclination (do you love property and have been itching to get involved in this type of property), and probably a whole host of other factors that we as strangers on an Internet forum are not privy to... but just make sure that your parents retirement plan A isn't sunk by turning this cool project into a big sunk cost.

[SwordGuy]

The value of the project is based on the future income of the building.   That's the part that will let you know if everything else makes sense. 

Rents were about 4300/mo, 52k last year.  After repairs, taxes, depreciation, other expenses, income was 12500.  This seems like sufficient performance to warrant significant investment.  I'm trying to figure out how much though...

12500 annual net profit on a 10 unit building that's paid for is terrible.   $430 a month/unit?

I'm expecting an annual net profit of about $4800 from a single house that cost me circa $45,000.

Can you raise the rents after you fix the place up?

[adamcollin]

I think you should repair the damages and rent out the property.

[Bearded Man]

Goodness those numbers are AWFUL. It's worth 400-600K and barely makes you 12K profit, and needs 100K of work? lol, Good luck selling that, only a fool would buy something with such terrible numbers at that price, needing that much work, for that little profit. My ONE house I paid 64K for near Seattle a few years ago makes almost as much profit as this 10 unit does, and I only have to deal with one tenant, and a FRACTION of what your building is worth. This doesn't warrant significant investment at all, I suggest you study up on Cash on Cash returns, rental expenses, cap rates, etc.

[zephyr911]

12500 annual net profit on a 10 unit building that's paid for is terrible.

Goodness those numbers are AWFUL. It's worth 400-600K and barely makes you 12K profit

$12.5k was after depreciation and other costs listed, so I'm assuming it's just the Schedule E number. Without knowing the cost basis, we can't calculate the actual profit, but adding back depreciation could easily double it.

[zephyr911]

Separately:

Can a brand new LLC get a loan based on the value?

Yes, but most offers of credit to LLCs with less than two (2) years of tax returns and financial history will require that all the LLC members personally guarantee the loan using their own credit. I'm chafing at the bit for this coming spring when my LLC books its first full year of revenue and files its second set of returns so new acquisitions are 100% based on company financials.

[Le Poisson]

What would happen if you bought the building from your parents conditional on the repairs being completed prior to closing date.

The  price you pay for the building is the equal to the cost of repairs.

The bank should be willing to write a $100K mortgage for the sale and you can get a good interest rate and 30 years. If you sell the mortgage goes with it, but you have a clear and free building, which means easier sale for more $$$.

Of course, I'm not at all an expert in these things, so wadda I know.

[sokoloff]

Look into the step up in basis rules (and your parents overall financial situation, plans for late life care expenses, etc).

If the building is paid off and has been in the family a while (being depreciated), your parents basis might be very, very low, and getting a step-up in basis upon inheritance might be worth almost as much as the repairs. That would argue to consider keeping it in their name.

Don't let the tax tail wag the dog, but do be aware of the difference in tax treatments of your different options.

[Bearded Man]

12500 annual net profit on a 10 unit building that's paid for is terrible.

Goodness those numbers are AWFUL. It's worth 400-600K and barely makes you 12K profit

$12.5k was after depreciation and other costs listed, so I'm assuming it's just the Schedule E number. Without knowing the cost basis, we can't calculate the actual profit, but adding back depreciation could easily double it.

How does getting back .28 cents (let's say typical tax bracket on forum) of every dollar spent on maintenance come out as profit?

I live in a nearly 400K house (wohoo, appreciation!) and depreciating the house over 27.5 years, and even depreciation the cost of re-roofs, remodels, etc. doesn't come nowhere near covering the actual cost of maintenance over 27.5 years. I don't think it's the free money some people think it is.

 

[andyp2010]

What sort of repairs are you planning on doing for $100k? Must be a lot of structural work? That's $10k per unit which is a big expense in a mustachian property investors outgoings I reckon. I repair houses and haven't really spent more that 4000USD equivalent and that usually includes a kitchen revamp (new bench, new door handles) a full house paint inside and out, new carpet and vinyl and a reconditioned bathroom. I'm guessing you're willing to put effort in if you're willing to manage the place?

To me, one off upgrades like that are a capital investment, not part of your annual cashflow. So if your place was worth $400k and you are going to spend $100k and the valuer reckons itll be worth $650k after, it's probably worth it. THEN decide whether to keep it based on it's new yield. I'd suggest making sure, if you do it up, that your rents are keeping pace with the market and that you're taking advantage of any opportunities that may have been missed (advertising hoarding on the side perhaps? Shop on the bottom, roadside?).

p.s. Paint sprayers will save you tens of thousands in other peoples labour and a small saving on materials. I'll repaint an entire 150m2 house inside and out in 2 days for essentially the cost of the paint. Reclamation yards are great too and you've got a massive boost in terms of economies of scale on anything new.