Either Prices Have to Come Down Or Interest Rates Have to Decline
On today’s podcast episode, I talk about why I believe that either interest rates need to go down or prices need to go down.
To illustrate this, and to show you the simple math, I use a current example of a market that I have been buying houses in for the past 21 years which is Port St Lucie, Florida.
The typical 3 bedroom 2 bathroom house in Port St Lucie sells for $325,000. For a 1,181 SF House, this works out to be around $275 per Square Foot. This house would rent for around $2,100 per month.
Now there are three different types of buyers for this type of house.
So let’s review each of these different buyer scenarios:
Retail Investor Buying A Rental Property
Let’s assume a retail real estate investor is looking for a rental property and sees one for sale at a list price of $325,000. But since it has a tenant in place, and needs some cosmetic repair, and has deferred maintenance (and some wear and tear), the investor offers to purchase the property for $300,000.
On investment loans, the bank usually requires the borrower to put down a 25% down payment which is $75,000.
Today’s 30 year fixed rate is 7.5%
that works out to be a monthly payment of $1,573. Property taxes are around $5,000 per year and insurance is around $5,000 per year so that works out to be $416 per month for property taxes and $416 per month for insurance. The total monthly cost including property taxes and insurance would be $2,405.
The monthly rent of $2,100 would result in a negative cash flow before maintenance, repairs, vacancies of $305. So it’s not very likely that an investor would put down $75,000 to buy negative cash flow (especially considering that we have not even factored in maintenance and repairs). So that retail investor buyer is probably not a buyer at the current prices and prevailing interest rates.
FHA First Time Home Buyer
Let’s say that an FHA buyer is looking at a 3 bedroom 2 bathroom house that is in great shape with brand new kitchens and bathrooms, quartz or granite countertops, and stainless steel appliances. The Purchase price would be $325,000.
FHA requires 31/2 percent down, so that would be a down payment of $11,375.
This works out to a monthly mortgage payment of $2,189, property taxes of $416, insurance of $416, and PMI of $143 per month. That’s a total cost of $3,164.
Renting that same house would cost $2,100 so there are a few issues here. The first is that the buyer may have a hard time being approved for the loan amount. The second problem is that the borrower’s debt to income ratio would be a challenge. The monthly payment for this house has gone up by more than $1,000 with the interest rate increase, so affordability and being able to be approved by the mortgage broker is a major issue. Someone who can afford a $2,000 payment can probably not afford a payment of $3,164. That’s a more than 50% increase in monthly payments and will wreak havoc on their debt to income ratio.
If you were that same FHA home buyer you might ask yourself, why not rent? Previously the reason would have been because you don’t want an old beat up house as a rental. But now the market has changed.
Nice rentals that are completely brand new and remodeled inside are currently listed for rent at $2,195. I see one owned by Main Street Renewal which is the rental arm of Amherst Holdings which owns 44,000 single family rentals listed for rent at $2,195.
So there is no shortage of nice remodeled homes to rent. So that FHA buyer may prefer to rent and not be a buyer anymore at current prices and current interest rates.
Wholesale Real Estate Investor
That leaves us with the last type of buyer which is the real estate investor. Someone like me who is looking for a deal and to buy a property at less than market value.
The ARV formula that an investor would use would be:
After Repair Value (ARV) x 70% less repairs.
So if I was an investor and I was looking at purchasing a 3 bedroom 2 bathroom house that I planned on remodeling, a full interior remodel would be $25 per Square Foot x 1,181 square feet which would work out to be $29,525. Let’s round that up to $30,000 and add another $4,000 for appliances and $6,000 for miscellaneous repairs that we might encounter. That puts our rehab budget at $40,000.
So using the ARV formula, $325,000 x 70% is $227,500 less $40,000 in repairs would work out to a purchase price of $187,500. That would be a very good buy and there would be a lot of equity since with an all in cost of $227,500 if the house is worth $325,000 that’s almost $100,000 in equity. After deducting the $40,000 that I spent in repairs that would be a net of $60,000 in equity. So equity would be great, but let’s take a look at cash flow!
Let’s say I borrow $187,500 at 10% from a private lender. This is what my payments would look like:
If I rent that house at $2,100 per month I am still negative cash flow. And when I go to refinance then if I borrow $225,000 from a bank with a conventional mortgage I am still negative $300 per month (same as the first scenario). So I don’t have cash flow when I buy with a private lender, and I don’t have cash flow after I refinance either. Buying a property and having continuously negative cash flow is a problem.
It’s an even bigger problem when you consider that I am not even accounting for maintenance and repairs. So even buying at a wholesale price with a good discount I still cannot cash flow. Equity is nice but cash flow is crucially important. Why can’t I cash flow when buying at such a discount? Because interest rates have moved from 3% to 7.5% and that changes everything. Let’s look at another scenario.
Let’s Look At What Would Happen if Prices Declined
Let’s say prices declined by 20% and that $325,000 ARV house is now worth only $260,000.
Using the same ARV Formula, 70% of $260,000 is $182,000 less $40,000 in repairs equals a purchase price of $142,000.
Let’s say I borrow $142,000 at 10% from a private lender. Now my payments look much better:
Now if I rent out the property for $2,100 a month, I am not negative cash flow. And when I go to refinance I am not negative cash flow either. Since the ARV is now $260,000, the mortgage amount would be 75% of that amount which is $195,000. Borrowing $195,000 at 7.5% would work out to a monthly payment of $1,272 so after adding taxes and insurance, the monthly payment would be $2,104 which is the same amount as what the house would rent for.
Let’s Look At What Would Happen If Interest Rates Declined
Let’s look at what would happen if prices stayed the same but interest rates declined. So let’s assume the same ARV of $325,000 and a mortgage of $225,000 but the 30 year fixed rate declining from 7.5% to 5.75% and the payment would be $1,262 and after adding taxes and insurance the monthly payment would be $2,094 which is the same amount as what the house would rent for.
So in short, either prices have to come down or interest rates need to come down or the numbers simply don’t work. We would need prices to decline by 20% or interest rates to decline to 5.75% for the numbers to be aligned. My guess is that we will have lower interest rates and also lower prices as demand decreases and price follows. The economy getting worse will mean more foreclosures which will result in more short sales and more REO’s. So I would not be in a rush to buy. Instead, focus on learning how to buy bank owned properties, short sales and foreclosures for cash directly from the bank at huge discounts. I will be teaching this at my next Foreclosures, Short Sales and Bank Owned Properties Boot Camp in February. Call our office today to get registered 561-948-2127 or click the button below to learn more about the Boot Camp:
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