Gambling On New Orleans--Or Any Rental Property

Saw this article, Gambling On New Orleans, with the subtitle Buying real estate in the storm-ravaged city takes guts, but it could be a very smart move.  Maybe, but real estate investing is not as easy as it looks on TV or in the magazines.

The article had the usual example of an investor.  Ok, a loan officer for Countrywide Financial living in Valencia, California.  He bought four four flood ravaged properties in February.  One is ready to rent.

Lesson 1-California is a long way from New Orleans so he is not managing the properties directly.  Since people don't work for free he is paying someone to manage his investment.  Figure 10% of the rent to a management group.

Lesson 2-He bought in February and just getting around to renting one now.  Not four, one.  So he has paid out or borrowed money for five months to get the properties and start rehabbing.  Say average cost, including rehab, of $150,000 times four times the cost of a thirty year mortgage at 9% (banks charge more for rental properties) resulting in monthly payment of $4,827.  $4,827 with no cash coming in.

Here are the numbers on the one duplex unit ready to rent out.

Cost $110,000

Rehab  $40,000

Rent $2,400 (33% more than pre-Katrina)  Stop here--Lesson 3.  This is probably the max he can, or will get,  as there will surely be more house building, assuming New Orleans doesn't wash out to sea, and the supply will grow.  A basic rule of finance is more supply the lower the price.  Plus the population of New Orleans has dropped by a third.  You read right, a third.  But let us assume rent of $2,400 a month or $28,800 a year. 

Net Rent, according to the investor, will be $21,000 a year.  Assumes he will pay only $7,800 a year on taxes, expenses, repair, and management fees.  Maybe but I doubt it.  Lesson 4--expenses are always higher than expected.  Plus, he is not budgeting for time not rented.  Units always take longer than expected to rent.  Or to rent to people that will pay the rent and not destroy the property.

Return on Investment is 14% calculated as Net Rent of $21,000 divided by investment of $150,000.

Sounds great.  BUT where is the financing cost?  Lesson 5-Say he borrowed the whole amount of $150,000 at 9% for 30 years.  He would be paying $14,483 in mortgage costs so his CASH FLOW is now reduced to $6,517.  The rapidly shrinking rent.

(An interesting financial quirk just happened here.  His ROI if infinite in this example.  Since we make the assumption that he borrowed the whole amount his investment is zero for analysis purposes.  The value of the house offsets the bank loan leaving no investment and thus no ROI.  BUT his cash flow is cut in half.  Actually more than half.)

But, you say, maybe he had the cash and paid cash so his cash flow is not cut in half.  Lesson 7-Ok, I'll give you that one but by paying cash, he has lost the opportunity to invest in other assets and thus has incurred an opportunity cost.  The return on the lost opportunity has to be deducted from the the return on the house.

We're getting a bit far afield here but the real lesson is that real estate is not as easy as it appears.  Fortunes have been made, and lost, in real estate.  The real lesson is that real estate is hard work and takes some pretty hefty up-front expenses.  Do your homework.

There is one caveat-the guy is from California.  God must look out for Californians and real estate.  I don't know how they do it but they seem to make money no matter what.  If you are not from California, work even harder.