Hello, my friends and welcome to another episode of Ask Marco where I answer your investing related questions.
So today’s question comes from Jason and he sends this question in with some urgency. Jason, I’m going to provide you some direction. As you know, we don’t give financial advice and sometimes it’s hard to know what advice to actually give somebody without specifics on the situation. But I understand what is going on here from your email and I can feel your pain because I’ve been there many times myself. Anyway, Jason writes in and he says, Hey Marco, first of all, thank you for being not just a voice but the voice for us real estate investors. I have spent the last two years consuming as many books, podcasts and all things real estate investing. In my opinion, you are the authority that you’re way too kind. I’ve been networking with other investors and your name keeps coming up.
So from all of us. Thank you. Well, you’re very welcome. So he goes on to say, I closed on a property just as the coronavirus pandemic started. This property is in the Phoenix market and I think we both know this market is susceptible to a decline in values. I will be all in for $250,000 and I paid cash. This includes the rehab or renovation and all other costs including selling costs, as my intention was to flip it. If I don’t sell all in, it will be around $235,000 it will rent for 1400 to $1,500 a month. Obviously doesn’t come close to the 1% rule. I’m worried with what’s going on with coronavirus. I will not be able to sell it at a profit. The estimated after repair value at the time of closing was $270,000 so only a $20,000 profit margin. I feel like my biggest loss will be the opportunity cost.
If I leave $250,000 cash during what possibly could be a great time to buy? The return on investment is not attractive as a conventional mortgage and renter. My question is, what other strategies should I be considering such as a lease option providing owner financing, a home equity line of credit or a cash-out refinance. I greatly appreciate you taking the time to read this and I am open to a conversation since I am asking a big question. Thank you and stay healthy, Jason.
Alright, Jason. Great question. I can feel your pain and I empathize so I don’t have enough detail obviously to give you specifics because so much of this is going to be neighborhood-specific or neighborhood dependent. Phoenix is a big, big market had it has been a great market for many years just because of the tremendous growth that has been going on there.
However, having said that, as a flip property, that’s a pretty thin margin of 20,000 assuming you sell it for the 270,000 being a retail flip, you always have to account for fluctuations in negotiation with your potential buyers. If the market softens during the period of time that you are renovating your property, that 20,000 could be enough pretty quick. Ideally, you want to see a minimum of a 10% profit margin on a flip, and I’m talking about a net profit. Ideally, you want to be well above that, so I’m not sure where you got it or how you purchase this or how come you’re so deep into this property. But that doesn’t matter because that’s not your question. In regards to Phoenix, just a quick comment. You know, Phoenix has been one of the highest appreciating communities or markets, well not only in Arizona but nationwide and Phoenix.
Home prices were up roughly 7% over the last 12 months, which is a very strong price growth and that’s probably why you pick the Phoenix market as far as finding a distressed property to fix and flip. But despite the increase in property prices, the Phoenix market still is a good market even though it has been softening. And that’s actually what has been happening. So according to some websites, and these are automated models like Zillow’s model, they’re only expecting that market to appreciate about 1.7% as a whole over the next 12 months, which is virtually zero. That’s what I would call a flat market. The thing is, is the Phoenix market, as much as I really like it, it is on the tail end of what I’ll call a wealth phase. The last, let’s say seven years have been great as a real estate investor in that market because property values have been appreciating pretty strong.
You know, just the last 12 months we’ve seen about 7% that’s a very strong price growth. It hit a double-digit price appreciation in 2013 2014 and it stayed pretty strong even though it dropped off ever since then since about 2015 on. So, you know, it’s still, a good market and appreciating market and a great place to be if you could find a good deal where the numbers make sense. And of course in a good neighborhood. And again, I don’t know where your property is but let’s just assume that keeping it as a rental is an option. So if that’s the case you have from where I sit a couple of options. One is you can refinance the property and keep it as a rental to you can lease option the property, which I’ll explain here in a moment. Thirdly is sell it and really those are the three options I see.
I don’t think I would sell your property with owner financing. I think the closest I would get to that is just doing a lease option. Okay, so let’s break this down. If you refinance this property, you may want to consider an interest-only loan, which I’m not a big fan of, but in situations like this where you could potentially be in a flat or appreciating market, but your intention is to actually sell it in two to three years. This may make sense. Interest-only loans are also good when you know that you’re only going to keep the property for two to five years and you are in a strongly appreciating market. So your expectation of price growth is pretty high and you also don’t have a very high rent, which is the case here with such a low rent to value or rent to price ratio.
Now it’s not that low, but you’re not anywhere near 1% so I just did some quick math and based on a $270,000 appraisal with a 75% refinance, pulling out 75% of the cash that you put into this property because you bought it all cash, you could look at about an 800 to $850 per month interest payment on that mortgage. Remember, your intention in doing this is not to keep it forever because you’ll never pay down the principal or your tenants will never pay down the principal for you. So what you’re doing is you’re just carrying it for the cost of the interest for a two or three, maybe a four year period of time. So you’re going to hold it until you can sell it or until you can refinance it. Assuming that you can bump the rents up enough to make it worthwhile as an investment.
But what you’re ultimately trying to do is pull out as much of your cash, in this case, up to 75% pull it out for the purposes of investing it elsewhere, where you’re going to get a better return and probably be in a market that has more stability and protection from downside price risk. So this option is, is actually better than a HELOC with a hilar or home equity line of credit. The assumption here is that you are basically just putting a revolving line of credit on the property. So it’s a separate line but it’s attached to the property as collateral. I would personally prefer to go and get a 30-year mortgage with a rate. It could be fixed or adjustable, but it’s an interest-only knowing that you’re only going to keep it for a short period of time. So that’s one option. A lease option is essentially a lease to a tenant-buyer and then you’re selling them an option to buy the property at a certain price within a certain number of years.
And if they don’t exercise that option, you actually keep the option fee, whether that’s 5,000, 10,000, $20,000, whatever it may be, it’s completely negotiable and it’s whatever the market is willing to bear. But you keep the option fee that’s nonrefundable. Uh, they have the option, they are gonna take care of the property and be responsible for it. At least that’s what you hope. And typically that’s exactly what they do because they have 5,000, 10,000 reasons not to, uh, let the property going into disarray because they just gave you a big chunk of cash for the option. So the other thing with a lease option is at least this is the thinking, but often you can lease it to them for more than what plain vanilla market rent will be. So the idea here is that you can rent it for more than the 14 or 1500 a month that you think you can get for it.
Maybe you could rent it for 17 or $1,800 a month. Sometimes you can bump that monthly mortgage, excuse me, the monthly lease on the property and credit. Some of that towards their purchase price. You typically will do that in a market where you do expect prices to go up and the purchase price is going to be based on either an increase in property value or you’ve already baked that into the cake. And so the option already prices in a price increase in a year, two years, three years down the road whenever that option is due to be exercised or expire. So what you’re giving them in return for the increased rent is a credit towards that purchase price down the road. So often this ends up being a win-win. So that’s the lease option in a nutshell. But I do agree with you that your opportunity cost here really is the biggest downside.
And the reason I say that is because you’ve got this property you purchased all cash, your cash is locked up, you can’t do anything else with it right now other than get a very low marginal rate of return on the existing property and assuming that the market won’t appreciate very much, you’re not getting the cashflow, nor are you getting price appreciation. And if you have an interest-only loan on the property, you’re also not getting amortization or equity increase from the principal pay down on the loan. So you’re really not winning in any of those ways. The only thing you’re getting from it is the depreciation, which if you don’t sell with a 10 31 tax-deferred exchange, you’re going to have some recapture on that. So my suggestion, and again this is something you need to pencil out and think about and maybe talk to your tax advisor about if you know the taxes come into the equation here, I’m not telling you what to do and this is certainly not specific advice, but if I were in your shoes, I would sell it.
If you can, if the market is still strong enough and there are buyers out there for the type of property you have in the neighborhood that you’re in and selling it is a good option. I would probably do that. I would liquidate my cash in the property. Take the 20,000 in profit or whatever you can get and then look to build a, you know, a good, well-thought-out real estate portfolio in one or two other markets because, with $250,000, you can build a pretty darn good portfolio of single-family homes in about two different markets right now. Um, and we certainly can help you with that if you know, if that’s what you want. Conventional financing is abundant. It hasn’t been impacted by this a Coronavirus epidemic. So as long as someone’s got qualifying credit and they’ve got the ability to prove income, which certainly covers the majority of the population still today, even though a lot of people are huddled in homes, you can still sell the property and look at some point this thing’s gonna blow over, you know, whether it’s, you know, four weeks from now or four months from now, if you could weather through that, you’ll find a buyer.
So option one for me at least is to sell it and then reinvest that capital that I pull back out of that property into a strong portfolio. Number two is you can hold that property with an interest-only mortgage for a certain period of time, a short period of time, let’s call it two to three years while you’re investing in other markets. So that’s essentially meaning you refinance it may be a 75% loan to value loan. You pull that money out, you invest that in other markets where you’ve got better cash flows and stability and in the interim you hold onto the property in Phoenix and then you sell that in let’s say a year, two years, three years, whatever it may be. Um, and that’s just based on market conditions in a nutshell. That is the way I see it. So if that helps, great. If not, maybe shoot me an email and what I could possibly do is put you in touch with one of my investment counselors here and they can guide you through some of that as well.
And we can certainly put you in touch with some lenders and mortgage brokers that we work with. All right. I hope that helps there. I appreciate the question, Jason. So for everybody else, if you have any questions about real estate or investing or finance and you’d like me to answer it on one of the shows, I try to get to all of them. Simply email me at passiverealestateinvesting.com just go to the website or you can go to AskMarco.com and just click on the link at the top and remember to subscribe. I keep asking you guys this all the time and I know a lot of you do, but there’s still a lot of people I can see that actually listened to the show and then don’t subscribe. Help us share this with other likeminded people. If you have friends and family that love this kind of stuff, by all means, recommend the show and I would greatly appreciate it. So once again, thank you for listening. I will see you on the next episode.
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