Investing in Detroit. Things to worry about

2013-05-06 20.07.07
One of 18 in the offer

Following the general theme of lemons into lemonade, let’s discuss investing in Detroit. What I am going to say will be pretty specific to Detroit. The general principals will apply for investments in just about any USA city as it is all about due diligence and understanding the local market.

Detroit is the poster child for a failed American city. Not so much because someone got it wrong. More as an example that when the economic reason for the city ends, the natural trend is for people to move on to greener pastures. Unless the community finds a new purpose, the population will continue to drain away and that creates a self-reinforcing spiral. Call it a city in a death spiral.

Specific facts and figures are going to be used to highlight certain points. I am not making this an full on academic research paper so lots of details will be glossed over. It is the broad trends and the impact the trends have which matter for this discussion.

As a general rule, a real estate investor makes their money from an individual deal. They do not buy a city or larger economic area. That means you can make money or lose money even if the larger trends around you are heading in the opposite direction. As a buy and hold, long term investor, the broader community trends have a bigger impact as time passes.

One investor I know says that the market defines about 50% of the total value. The property (asset) management contributes about 30% to the end result. The actual deal mechanics represent only about 20% of the total. In other words, all the creative techniques will only have a minor impact to the total result. More so for the buy and hold investor.

2013-05-07 13.22.56
Another one of 18 in the offer

To make this a slightly more lively discussion and to ground things in real facts, I will use an example. On a well known website, someone posted an offer to sell 18 residential properties all in one area of Detroit. They are being sold as a package and the properties are priced at $4,000 each. Some might think this is a bargain price. The devil is in the detail.

I replied by email that I was interested in finding out more. I received a reply the same day. The person who replied gets points for being prompt.

Included in the reply were pictures of the properties, a spreadsheet with the addresses and the same numbers already reported. It was stated that the properties are free of any water liens. In Detroit, past due water / sewer bills attach to the title of the property. There are back taxes owed. The period is almost 10 months. The back taxes need to be added to the sale price. Each property needs work. A crude estimate is $6,000 to $10,000 per property. 150% of the purchase price to 250% of the purchase price plus the back taxes. No idea who determined the estimated repair costs. A quick check of one website puts the property taxes at $2,600 a year. So, $4,000 + $10,000 + $2,600 (last year) plus +2,600 (this year) equals $19,200. Throw in some misc. legal costs plus an agents fee to get the place rented and you are looking at close to $20,000. Maybe some slight double counting and some time needed before a property could be rented. At this stage the estimate is close enough.

Somehow $4,000 looks attractive for a detached home while $20,000 is much less interesting.

The offer indicated that the property would be transferred using a quit claim. For those who are not used to the term, all this means is the person ‘selling’ is documenting that they are waiving any and all interest in the property going forward. They are not making any claim about even having a past interest in the property. The ‘seller’ signs a document and then the ‘new owner’ needs to prefect the title before the ownership is clear. This impacts the ability to sell on the property and the ability to secure a loan with the property. Quit claim deeds do serve a purpose. You just need to recognize how little legal standing they have if your objective is to know you really own the target property.

In this case, you can work with a local title company who will tell you want needs to be done before they would issue a title insurance policy. Such a policy is standard and required with a conventional sale and / or when there is a lender involved. I would budget a couple of thousand to clean up the title. This should cover most situations though it is not the upper limit of what it can cost. If you are not sure that the property you are buying will ever become your property, would you gamble or pass on the transaction?

As this is Detroit, the crumbling infrastructure has to make you wonder if it makes any sense to go through all the work and hassle to secure bargain deals like the one above. If you are going to invest in Detroit, you want to focus on specific areas or streets where the opportunities are more in your favor. If you are a cash flow investor, focus on earning your money back from rents with the view that when the property is no longer worth owning, it will be scrapped. Similar to a factory owner who buys a machine to produce a product and then sells off the machines when they are no longer fit for purpose. While I am not suggesting that you literally bulldoze the property at the end of its economic life, you should focus on earning your investment back plus a return rather than assume you will make up the short term losses through capital appreciation.

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