Care to talk me out of a bad business idea?
June 21, 2016 6:31 PM   Subscribe

The quick and dirty: I'm selling my house and downsizing. I'm using VA loan for my new primary residence so my proceeds can go directly to a down payment for an investment property. I did almost the same thing about 20 years ago and it worked well for me...this time I'm thinking about spreading the wealth a little bit by starting an LLC or something similar in which I can include co-investors and also invest in the names of my kids to purchase and manage properties for the sake of accumulating a little wealth. (more inside)

If I'm not talked out of this, it won't be a DIY scenario. I'll have an appropriate attorney and property management company employed. I had to bail from my last endeavor only because I over extended myself while trying to manage property and raise kids.

My theory is that with some investors our mortgage payments will be much less that what we can charge for rent. Therefore we can better build an escrow account for maintenance and build more equity and purchase more property with that equity.

This is a military town, so renting out property is fairly easy and less risky than usual. Also, FWIW, about 70% of the available (fore sale) properties here are in foreclosure or set for auction. That makes them unavailable to most families trying to purchase a primary residence unless the have huge amounts of capitol. (I would love to put the "flippers" out of business too. They are making a mess here.

So, is this idea dumb, foolish or ill-advised? Any reason to toss this idea entirely? Should I consult with an attorney and make this happen? Is and LLC not the right tool for the job?

I do have investors in the wings. They all know that this is for the long haul and not a "get rich quick" scheme.

I can't wait to hear your comments. Many thanks!
posted by snsranch to Work & Money (9 answers total) 2 users marked this as a favorite
Sounds reasonable to me, but I have no idea what you are proposing or offering to these other investors. What kind of returns do you expect and what kind of returns are you suggesting your investors get? How many properties will you be buying? Enough to diversify so that if any one sucks it will not kill you?
posted by AugustWest at 6:38 PM on June 21, 2016 [1 favorite]

AugustWest, this sounds like and IS essentially a scheme, but not a scam.

The idea is that if we can maintain and rent one property, to start with, we earn both through rent and equity. Over the long haul we can turn that profit into the purchase of more properties...the return from which would go directly into the principal owed. When the first is payed off, it exists only to make money to pay off the other principals and purchase more property.

The only part I'm worried about is the legitimacy of the business mechanism. I don't know about an LLC and haven't spent any money on an attorney yet.

FWIW, the only time I've heard of anyone losing money is when parties have panicked during a recession or "bubble burst".

Regarding specific investments, the risk and reward would be scaled directly to the level of investment. I wouldn't even consider the idea if it could in any way be construed to be a scam.
posted by snsranch at 7:26 PM on June 21, 2016

What you want to do is called real estate syndication.
posted by Ostara at 7:37 PM on June 21, 2016 [1 favorite]

I worked as a real estate appraiser for a time, though, full disclosure, have no certifications and essentially ghostwrote for someone who did (as is the norm in the industry).

One client was a widow whose husband's death set into play a huge chain of valuations of their commercial properties to figure out the estate. They were all held in trusts, and each trust was set up so that Widow and Husband owned 60% and their (adult) children owned X, Y, and Z percents, totalling 100%.

Real estate is certainly a valid investment, though it comes with its own set of risks. A main barrier to entry for most folks, as you mentioned, is a lack of capital, but by having a stable of investors, you've eliminated that. Besides losing your own investment, I would be concerned about your investors coming after you and your family should things go south, but a lawyer could help you set this up in a way that protects you best.
posted by papayaninja at 7:41 PM on June 21, 2016 [1 favorite]

I am not a lawyer, but if it were me, I would ask my attorney about setting up a separate LLC or entitly for each property so that any one property will not be affected by the other. That is, a lawsuit at one will not affect the others.
posted by AugustWest at 7:56 PM on June 21, 2016 [1 favorite]

There are basically two ways to make money off of rental properties, the first is positive cash flow from rents, the second is the increase in property equity. The upside of 70% of properties being in foreclosure is that they're cheap to buy. The downside is that they're cheap to sell. I don't know if you're going to make significant equity gains in the scenario you're describing which means you better be making enough in rent to make up for it.
posted by bitdamaged at 8:14 PM on June 21, 2016

If you want to go forward with this, do an individual LLC for each property.

The additional cost is minimal, and can be rolled into operating expenses.

The primary advantage is that, should something happen with one of your properties, the incident won't cascade to take out your other properties.
posted by yesster at 9:07 PM on June 21, 2016

If you haven't already, you need to build a basic economic DCF (discounted cashflow) model that predicts whether this is a profitable business idea, taking into consideration your cost of capital, investment risk, cost of investment (like sales tax), inflation, maintenance, upfront spend in making rental properties profitable, assumptions about house price increases, assumptions about rental increase, etc. I'm not a real estate agent but I do work in a finance capacity.

It really shocks me when so many people, looking to purchase real estate as an investment, have zero clue about what their final numbers are after taking into account all costs. They use vague rules of thumb, like the rent covers the mortgage therefore it's profitable (???!!!!). Or, the rent doesn't cover the mortgage, but hey! house prices will go up (but how much does it go up??? What portion of your mortgage will cover the capital and what portion for interest??)

Please, for you and for everyone else, put some educated numbers into researching your investment.
posted by moiraine at 1:17 AM on June 22, 2016 [3 favorites]

in which I can include co-investors and also invest in the names of my kids to purchase

As a theoretical co-investor, I would want nothing to do with a business that was structured so that anything was legally in the name of kids. First, people can get really weird about things when "it's their children's money." And second, at some point, the child would gain legal rights over that part of the company, and now I'm doing business with a partner who may not have the aptitude for or interest in real estate or whose goals may be contrary to the stability of a long term company.

You would also need to understand the implications to your kids ability to get things like scholarships and grants if on paper they have significant assets.

There's nothing wrong with funding the children's education with the proceeds from the company or bringing them on board as owners once they've reached maturity, just don't do anything legal while they're still in their teens.

As far as the overall risk, is there any chance the military base will be shut down a decade down the line? If 70% of the real estate is in foreclosure, if the base goes away, it sounds like the town will pretty much die, and you'll be left with a lot of money tied up in real estate that will be impossible to sell. It is always risky to invest in multiple properties in a single geographic location, especially if it's one that you live in as well. If you're planning on using a management company anyway, you're well advised to diversify into different markets.

My theory is that with some investors our mortgage payments will be much less that what we can charge for rent.

If you mean that by increasing the down payment above 20% you can bring down the mortgage payment, thus making renting more "profitable," I second moiraine's statement above that you're not considering the full costs of the investment, because you're losing the ability to make money on that down payment by investing elsewhere. If you put down $100K on a $200K property, your mortgage will be cheap, but you're walking away from roughly $8-10K of yearly gains that you could be making investing that money in the stock market.
posted by Candleman at 5:13 AM on June 22, 2016 [1 favorite]

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