The Best of Both Worlds
As real estate investors we tend to stick to a single strategy that works for us. For most that either means fix and flip or long term rentals. But those two strategies don’t have to be mutually exclusive. If you mix them the right way it can lead to a very profitable hybrid.
The Pros and Cons of Flips
Buying property that has been mismanaged or that is in bad physical condition and turning it around is a time tested strategy. It can be very lucrative; the time needed to complete the job is relatively quick compared to rentals and you get the satisfaction of seeing the beginning, middle and end of a project while helping to revitalize a neighborhood.
The downside is that it is speculative in nature and you can find yourself having finished the renovations and ready to go to market just as the economy turns on you. If you happen to hit an upswing, you look like a genius; if you happen to hit a down market, you can lose a significant amount of money. The risks are high. Flips are also not conducive to regular cash flow as you don’t see any return until the final sale.
The Pros and Cons of Rentals
The beauty of rental real estate is that you have three streams of income working for you:
- Long term appreciation (typically & historically)
- Month to month positive cash flow
- Long term principal pay down of the mortgage
Time works in your favor to make rental real estate investing one of the safest options available. Long term rental real estate isn’t about getting rich quickly; it is about getting VERY rich slowly.
The problem with rentals is that it takes a long time to get your original investment back. You either have to wait a few years to refinance or sell the property. Plus there is usually not a lot of cash flow available to you during the first few years of your investment. Finally, you are usually buying your property at full retail and not a wholesale price.
Merging the Two Strategies Together
A better way to invest may be to merge these two strategies together. The general concept is:
- buy a property that is really beat up at a wholesale price;
- renovate it;
- get it rented out at higher rents;
- refinance it, based on its new, higher value;
- get most or all of your original investment back, and then
- continue to hold it as a long-term investment.
With our merged strategy, we take the best of these two strategies and eliminate the worst. By buying a building that is beat up at a wholesale value (it doesn’t matter if it is a single-family home, a multi-family apartment building, a commercial unit, or an industrial building), you can get an immediate profit boost once it is fixed up.
As we have seen, normally long-term buy-and-hold makes money in three ways: long-term value appreciation, month to month cash flow, and mortgage pay down (done by your renters bit by bit each month). Buying wholesale adds a fourth element to that mix. This is a definite plus.
Not selling that property once it is fixed up eliminates the speculative nature of that strategy. By renting the newly renovated property instead of selling it immediately, you can wait until the market is right for you to sell at a high profit thereby eliminating a lot of risk.
Keeping it over a longer period can even ease some of the hit you would normally take if you spent too much or took too long to complete your renovations. A $20,000 overage doesn’t look quite as bad over 10 years as it does over 10 months.
Finally, because you are refinancing the property as soon as the renovations are done and getting most or all of your original investment back, the cash flow that does come from that property is mostly free.
You have an income stream that you put little or no money in to. So as long as it cash flows positively (which it should or you shouldn’t have done the investment in the first place), whatever cash flow it does provide is a bonus.
This strategy is very resistant to down markets; in fact, it can work in any market. In a down or flat market, hold onto the status quo and rent it out, making sure that you are at least breaking even. In an up market, you can decide whether you want to sell the property for a nice profit or increase the rents and continue to hold for the long term.
This strategy works for all budgets as well. It works on a single-family home just as well as it does on a fourplex, an apartment building, a commercial property, or an industrial property.
A Real Life Example from My Own Portfolio
The following example is an eight suite apartment building that I renovated but the concepts would work just as well with a single family home.
A joint venture partner and I bought an eight suite apartment building out of foreclosure. It had been empty for two years. The roof leaked and as a result there was grass and mushrooms growing on the carpet on the top floor. There was no heat, light or power to the building and most of the windows had been broken by kids.
We bought it for $900,000 with my partner putting up the 25% down payment. We then obtained an 8% loan from a private lender (banks tend not to loan on mushrooms and grass). After that we spent $500,000 to renovate the building.
Once completed the building looked great and we were able to fill it with great tenants within six weeks. The rents we were able to charge were on the higher end of what similar suites in that neighborhood could command. We then went to a normal lender and had the property appraised at $1,750,000 as an apartment building. The building had also been condominiumized and as eight individual units it appraised at $2,000,000.
We had several choices. We could have flipped it relatively quickly as an apartment building and made between $350,000 and $400,000 after commissions. Alternatively, we could have sold the eight units individually, which would have taken longer, but we could have made closer to a $500,000 profit after commissions. Instead, as a third option, we decided to refinance and keep the building long term.
We were able to obtain a new first and second mortgage for a total of $1.45 M, which as you will recall, is higher than the original purchase price ($900,000) plus total renovations and interest costs ($500,000). In short, we got all of my J/V partner’s money back plus paid back the higher interest lender AND still owned the property. The property has a positive cash flow of $1,500 per month and that income is FREE as neither my partner nor I have a penny invested in the building. Plus the equity of $600,000 is still there waiting for a future sale to be claimed.
Recycling Your Money
We were able to accomplish the above in about 18 months. Think about that. A normal J/V partnership o a long term rental typically takes five years. During which time the money partner’s money is at risk. While real estate is far less risky than most investments anytime your money is out working for you there is an element of risk.
By getting my J/V partner his money back early we eliminated that risk while at the same time greatly increasing his yield. The yield of an investment is the return compared to time. The shorter the time frame the greater the yield. Not only that but we were able to redeploy that same money on another investment. We recycled that money. If you are able to do this every 18 months you could conceivably use the same money three times over the same period of time as a normal joint venture partnership. That is a very effective use of cash.
You might say this is a unique experience but I have been able to do this several times in my investing career with properties of various size and dollar amounts invested. Sometimes I have gotten 100% of mine and my partner’s money back, other times I have gotten a significant portion back. It is definitely possible. Once I was even able to refinance and received $100,000 profit over and above getting everybody their initial investment back.
To make this strategy work look for properties that are in rough shape or that have been badly mismanaged without any serious structural defects. Then instead of flipping, as you normally would as a flipper, or ignoring it altogether, as you might do as a rental investor; give some serious thought to what the returns on a fix and hold might look like. You might be pleasantly surprised.
Read more about this in Comparing Real Estate Strategies.