Should I spend about $6,000-$8,000 in renovations to update a rental property that I inherited after the passing of my father?
I am 28 years old and I recently acquired a duplex in the Minneapolis, MN area (father passed away). This duplex has two units. A one-bed and a two-bed, both with one bath. The mortgage payoff amount is $90,000 and is valued at about $160,000 to $180,000. The one-bed duplex is rented already at $600 and I intend to rent the two bed for $900. The mortgage monthly payment is $970. The principle amount on the $970 is $350 a month. I currently make $62,000 per year and have no debts and I pay $1,250 in rent. I have $8,000 in an emergency fund and $3,500 in an investment account.
Is it smart for me to keep this rental property and rent both units considering I will have to put about $6,000 to $8,000 in renovation costs before the two-bed is ready to be rented?
Hello Friend and thank you for asking this question.
Also, sorry for the loss of your Father. I also want to compliment you on having no debts.
There are a few arguments that you can make for keeping or selling. At the end of the day, I want you to be able to sleep at night and be ok with your choice.
On one hand, you have a nice little cash cow (on the surface at least). For a $100,000 investment your annual return on that is $18,000 or 18% once you have this paid off. I believe that Duplexes are a good opportunity to create wealth and most Real Estate Property is "just" 4 walls, a roof, Plumbing, Electricity, and a foundation. If you can handle managing that your half way there. What can be very difficulty is managing the people. If you are comfortable with both of these issues, you are golden. If either brings you great anxiety, then you may not be suited for being a landlord.
On the other hand, selling could be your better move. To start, you receive a full step up in basis. What this means is that if you sell the property for Fair Market Value (at date of death of the owner) you pocket the money tax free. For example, if your father paid $100k for the property, and you inherited it now at $180k. The $80K gain is tax free to you in essence. You could invest this money in and argue that the growth will far exceed that of the rental with little to no hassle.
I have more questions. I am looking at the terms of the loan and it seams that your interest rate is quite high? Well I can not see what it actually is, but at a glance $350 to principle does not resonate with a low interest rate. At any rate, you might consider refinancing and cashing out funds to repair the property. Again, if you enjoy getting your hands dirty, this might sound like a fun project.
At the end of the day, it depends on you, the condition of the home, and what your overall goals are. I hope that my perspective supplies you with some ideas and direction on how to move forward.
Best of Luck!
With love and regards,
Jose Sanchez, CFP®
P.S. here are a few good links in favor of rental property:
First, my condolences on the loss of your father.
Regarding this situation, I think you need to ask yourself if you really want to be a landlord and deal with a myriad of tenant issues. Because you are renting yourself, I also wonder if you are familiar with general home ownership issues and all things that can go wrong. A house is essentially a small machine with working parts, plumbing, heating/cooling, electrical, walls that breath, sometime varmints in them that breath, etc. It is a real learn-as-you-go experience.
Beyond that, there are the finances. You will need to refinance the mortgage when you take title from the estate, so the current mortgage payment is irrelevant. Since you do not have the extra funds to renovate the second unit, I suggest taking cash out of the house in the refinance. That means you will have a mortgage for about $100,000 (remember closing costs). The principal and interest payment for that at 5.5% interest for 30 years fixed rate is about $568 with only $109 going towards principal. I used a little bit higher interest rate because this will be an investment property rather than owner occupied. You still need to factor in property taxes and insurance for your area. If they total $300 per month, that puts you at about $900 per month total, with only $109 towards principal. At this rate, it would take a very long time to reduce the principal by the $10,000 it cost just to do this before you collect the first month's rent. Even if you cleared $600 per month ($1,500 from rents, less $900 mortgage, tax, insurance), you would need to build up an emergency fund for the property of about $5,500 before you could begin to use rent proceeds for your personal purposes. Add to that, professional real estate investors indicate that they allow for an avreage of 1 month per year for vacancies and expenses are required after every tenant. The average tenant will remain for two years, after which you need one month to clean, and another to show and allow new tenant to give notice at thier current place, carpets need to be changed after every two tenants, etc. They have this down to a science. You also need to consider if you would be able and willing to do minor repairs yourself or have to pay top dollar for others to do it. More hidden costs: water if there is only one meter, trash collection, general maintenance equal to 2% of the value of the house. $180,000(.02)=$3,600 per year or $300 per month.
Bottom line math on this: $1,500 rents, less $568 principal and interest, less $300 taxes and insurance, less $125 vacancy allowance, less $300 maintenance, leaves $207 per month. That's $2,484 annual return on your $100,000 investment. There are much easier ways to make 2.5% on your money. This leads me to suggest that you would be better off selling the property, net the $90,000 equity, somewhat less after selling costs, and invest it wisely with the help of a fee-only fiduciary financial advisor.
If you would consider living in the second unit, this could change things. You would get a better mortgage rate, the value to you on the second unit would be the $1,250 you save on rent, rather than the $900 you plan to charge. You would know that at least part of your investment was cared for as you personally would do, and only part was at risk by tenant behavior.
Hope this is helpful and I wish you the best.
First, sorry to hear about your dad.
Second, I think this sounds like a good candidate for the BRRR stategy made famous by Brandon Turner at Bigger Pockets. This stands for Buy, Renovate, Refinance.
You don't have to buy it--it's already yours and it comes with 70 - 90k equity. This strategy would entail the following:
- Complete all necessary renovations to not only get the two bed ready to rent, but also improve the entire property to command as much rent as possible. This might require you to take out a HELOC or seek outside financing, but it will be worth it.
- Once renovated and rented at higher rates, you can go to a bank to refinance the property at higher appraised value and 75% loan to value (LTV). So long as the rent covers mortgage and expenses, you're ok, and now you've pulled a bunch of cash out to invest elsewhere.
Just doing quick math...assume you spend $8k renovating this property. At that point you can refinance at an appraised value of $180k at 75% LTV for a total new mortgage of $135k. After paying off the current loan of 90k, that would be a cashout of $45k (or $37k after subtracting your $8k reno cost). You would still have "equity" of 25% of the duplex of about $45k.
Having higher mortgage debt isn't necessarily a bad thing--it's fixed, long term, low rate debt and interest is tax deductible. You will have tax benefits of deprecitation as well. The biggest issue with this strategy is whether the property will cash flow above the new increased mortgage payment.
Here's a an example of what I'm saying:
|Before Reno||After Refinance|
|Cash on Hand||$8,000||$37,000|
|Total Cash + Equity||$78,000||$82,000|
This is somewhat of a bold strategy, but just google BRRR bigger pockets and see how many folks have had success with it, especiallly younger investors with smaller properties.