How Much Does That "Free" House Really Cost?

Suppose I just inherited a house that, if fixed up, would sell for about $150,000. Also suppose, that there is a single mortgage on the property with a balance of about $150,000. The house was originally built in 1983. It is in good shape, but it has not been modernized. At the very minimum, paint, flooring, some bathroom, and some kitchen refreshing would be required. The monthly payments are $1,211 per month, including taxes and insurance.

I inquired about putting the property on the market using traditional means, only to discover that closing costs would run about 7-8% of the purchase price, plus I would most likely have to fix up the property and still get "picked-over" by the buyer's home inspector. In my checkbook, I noticed that I didn't have the funds for the extra $1,200 month or the money needed for the fix up.

What are my options?

Of course, the obvious one is to not make the payments and let the house go into foreclosure. Not wanting to do that, I was looking around for other options. And then the real estate investor called me...

After some discussion we decided that I would let the real estate investor take over the payments on the loan, the property taxes, and the insurance. I would also deed them the property. The investor informed me that they wanted it as an investment property, and would fix up the property and rent it out and manage it. We signed a contract putting all our terms in writing and established a closing date.

Prior to closing, the investor sent his contractor to check out the property and estimate the repair cost. Much to the investor surprise, the cheapest estimate for a refresh was $6,200 and to make it look nicer, it would cost $11,347. And those figures only represented fixing up the property to achieve rental condition, versus a full refresh to achieve retail sale condition. The buyer also called a title company to ask them about how much the closing fees would be. The title company said that the fees for the buyer would be about 1.2% of the purchase price and the fees for the seller would be about 1.9% of the purchase price.

I got a call from the investor quoting the title company's estimate on the amount of fees that the seller would have to pay to close the deal. I informed the buyer that I could not pay those fees and the buyer would have to cover those fees for me. I reminded them that I was giving them the house for free.

Looking closer at the numbers the investor realized that this free house would still cost about $6,000 to fix up and about $3,000 to close. Plus they would have to incur costs for marketing, etc., and incur costs for the time it required to fix up the property and find a suitable renter.

So as strange as it may seem, a free house still costs somewhere in the range of $5,000-$10,000.

The bottom line is: Even with a free property, the savvy investor must know all of the out-of-pocket transactional expenses before concluding the deal. After years of doing these deals by hand, my partner and I have developed a software program that gives us an unfair advantage when computing offers on long-term hold rental property. We can actually iterate all of the variables, including interest rate, loan terms, rental repair cost, vacancy factors, monthly rent, desired cash flow, and even first year, pre-tax, cash-on-cash return and you can too.

To Your Success, Tom & Svein

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