Division Street:

A case study in finding an investment property and

working with various players to bring the transaction together
Copyright 2013 by Josh Fuhrer. All rights reserved.

Executive Summary:
New to real estate investing, Julie Metro is hoping to take her passion for real
estate, a newly minted accounting degree, and a small amount of money she
received as a wedding gift, and turn them into the first of many investment
properties. This case study explores her experience navigating the process of
finding and analyzing her first property: a four-unit craftsman-style apartment
house just off of SE Division Street in Portland, Oregon.

Discussion questions:
1. How did Julie approach the tasks of finding and evaluating this property?
2. Who helped her in the process, and what role did they play in navigating
that process?
3. What challenges does the renovation present?
4. Should Julie pursue this investment? If so, how?
Note: If you need help with the math, use the Sample Proforma provided in
Lesson 3 to follow the calculations given in the material.

Note: This case study has been prepared to facilitate a discussion on the
process of finding and analyzing a transaction, not to illustrate all of the various
possible outcomes or exit strategies a transaction may include.
1

Introduction
It was early summer, 2004. Julie and her new husband, Jonny, recently
graduated from Portland State University, Julie with a degree in accounting, and
Jonny with a degree in theater arts. The college sweethearts were married in a
simple ceremony among friends and family only a few weeks earlier. Instead of a
big expensive wedding and honeymoon, they opted to take the money they
would have spent on those experiences and use it instead to invest in their future
together by acquiring real estate.
When they were still in school, Jonny and Julie struggled to find a rental house or
apartment available within a short bike ride of the university. They ended up
renting an old 1920s bungalow on the east side of Portland, across the river from
Portland State.
When Jonny was a student, he worked part time in the student housing office. He
saw firsthand how difficult it was for students to find on-campus housingover
90% of the universitys students lived off-campus, and on-campus housing had a
two-year waiting list. Jonny and Julie saw renting to university students as an
opportunity to build wealth for themselves, while renovating run-down houses
and providing much needed housing to students.
Jonny now worked as a theater technician, using his carpentry skills to build sets
for Portland Center Stage, a local theater company. He and Julie had no real
estate experience, but they determined that they would combine their other skills
on their new real estate venture. Julies mind for numbers would come in handy
with getting a mortgage, managing budgets, and forecasting profit. Jonnys
carpentry skills would allow them to self-manage their building renovations,
saving them money by not paying a general contractor.
Hawthorne Blvd.
Julie and her friends liked to hang out at the vintage clothing stores on trendy
Hawthorne Blvd. on the east side. This corridor is home to a number of
restaurants, boutiques, cafes, and pubs, and the homes in the area were in high
demand. The real estate market in Portland in 2004 was booming, and
Hawthorne was one of Portlands most desirable neighborhoods.
When not working as a junior accountant for a local brewery, Julie spent her
evenings and weekends learning everything she could about the area. She liked
the walkable, pedestrian-friendly nature of the street, with storefronts that came
right to the sidewalk, lots of interesting street retail, and easy window-shopping.
Young unmarried singles living together as roommates, and young families with
and without kids, occupied the homes in the area. These homes were located

within four blocks north or south of Hawthorne Blvd., and most were built in the
1920s, during the boom years that preceded the Great Depression. Many were
well cared-for, while others were in need of renovation. Julie thought some of
these homes would make good candidates for investment as value-add
renovation opportunities.
She spent time researching recent home sale prices on PortlandMaps.com, the
citys property information website. She also picked up for sale and for rent flyers
from vacant homes as she walked the neighborhood. Finally, she hopped on
Craigslist.org and compiled the sale and rent asking prices for homes in the
neighborhood. Using this data, she was able to determine that the average home
could be purchased for $300 per square foot, and rented to a tenant for
approximately $1.25 per square foot, per month. She would use these figures
later when it came time to evaluate a specific property.
Julie determined that she would need to enlist the help of a real estate agent to
search for the right property. She called a number of brokers who had home
listings in the neighborhood or advertisements on bus stop benches nearby. She
wanted to get an idea of the market and what the opportunities were before she
began looking for a property.
The Realtors Julie met with wanted to know what kind of property she was
looking for, how much she had to invest, and whether she and Jonny would live
in the building. The listings the brokers showed her looked good on paper, but
when she visited the properties, they were quite disappointing. She had
budgeted $250,000 for their first investment, but that amount didnt buy much in
the Hawthorne neighborhood. One rather run-down house she looked at was for
sale for $225,000 and offered an 18% return on equity, but that didnt include
costs for a much-needed renovation. After adding in another $50,000 for
upgrades, it brought her profit down to just 4%barely more than the rate of
inflation.
The houses she could afford were not only dilapidated, but were also too small to
generate enough rent to cover the mortgage. She would need roughly double her
budget to buy a house big enough for four rental units, but even then, that high
price relative to the market rents would make positive cash flow very difficult.
Another property looked like it might work when a Realtor showed her an income
projection, but Julie felt like the rent assumption of $1,000 per month for a onebedroom apartment was a bit high for the neighborhood. She decided to visit the
property anyway, and while chatting with Tony Cooper, a young man who lived in
the building, she learned that the current landlord offered tenants a rental rate of
$1,000 per month with a one-year lease, and two months free rent.
I took the two months free rent and applied it over the length of the entire lease,
paying $833 per month for 12 months, Tony explained. Most tenants in the

building do the same thing. This allowed the landlord to show higher rents of
$1,000 after the initial two free months to prospective buyers, making the
property look more profitable than it really was.
Julie was becoming disheartened. Prices were too high relative to rents to
provide positive cash flow unless she had a much larger down payment than the
$25,000 she and Jonny had saved up. Even small fixer-uppers were beyond her
budget. The Realtors she spoke with also owned rental properties, and she
wondered if they were holding back the most desirable properties for themselves,
in effect competing with her and other customers for the best opportunities. Even
if they werent, the market was so hot that to make a commission, agents had to
find buyers within hours of a property hitting the market. That meant they
presented the best deals to their favorite cash-rich investors who didnt have to
wait for bank financing. Furthermore, the properties they showed Julie either had
little room to increase rents or lower operating expenses, or already had the
benefits of a renovation built into the sales price. These were retail opportunities,
and Julie was a value-add investor.
Factors Affecting Value
The great shops and restaurants along Hawthorne had attracted a wide variety of
people to the areaeveryone from students, musicians, and artists, to
professionals working in the nonprofit, healthcare, technology, and education
fields. Many of the more established residents were eager to own real estate,
and as a result, property values had more than doubled in the past 10 years.
The neighborhood is also well served by transit, with several convenient bus
lines providing service to all parts of the city. In addition, the neighborhood has a
number of car-sharing vehicle stations, and multiple bike lanes and bike parking
stalls course through its arterials and side streets.
The area had undergone dramatic improvement in recent years. Portlands inner
east side neighborhoods had transformed from chronically blighted areas in the
1980s and 1990s, into some of the most in-demand addresses in the entire city.
The area consists primarily of retail businesses, market rate apartments, singlefamily homes, and row homes. There are hundreds of businesses in the
neighborhood, including ethnic restaurants, brewpubs, bookstores, theatres,
cinemas, vintage clothing stores, bicycle repair shops, bank branches, frozen
yogurt shops, cafes, concert venues, specialty foods grocery stores, and natural
medicine clinics. They are densely packed, in a walkable urban environment that
makes the strip on Hawthorne a regional shopping destination.
Local zoning ordinances limit the building height and density of new development
in the area. This means that a newly constructed building would not add so much
new supply of housing to the market that it would saturate the market. This
protected the investors who owned existing buildings from having a sudden drop

in demand for space. Further, the historic nature of the existing building stock,
coupled with an active neighborhood association that routinely worked to block
new development that they felt was incompatible with existing buildings, limited
new supply. An investment in this neighborhood would enjoy low vacancy and
healthy annual rent increases.
This all added up to a relatively safe investment for Julie, if only she could find a
building at a price that would provide positive cash flow. That had turned into a
much bigger challenge than she and Jonny had anticipated. Hawthorne was
quickly moving from a transitioning to a mature neighborhood, and home prices
were too high relative to rents to produce positive cash flow unless they had a
much bigger down payment. Either they needed to buy, renovate, and flip
properties (if they could find them) in the hot Hawthorne market, or they needed
to look in neighborhoods with lower prices and a higher likelihood of positive
cash flow.
Division Street
Jonny suggested that what they should do instead was look to buy in the next
Hawthorne neighborhoodin other words, look for a neighborhood with similar
characteristics that was a few years behind Hawthorne in its life cycle. They
needed to find a walkable neighborhood that was early in the transitioning phase,
instead of late transitioning/early mature like Hawthorne was.
In early September, Julie got a call from Claire Barnes, a friendly Realtor she had
met, who had a listing she thought Julie might find interesting. It had just hit the
MLS that morning, and if Julie acted quickly, she might be able to get the
property under contract before other interested buyers submitted offers. The
property was a four-unit apartment building just off of Division Street, not far from
the Hawthorne neighborhood. Julie made arrangements to visit the property on
her lunch break that afternoon.
The Division Street corridor ran parallel to Hawthorne, about a half-mile to the
south. With one lane of traffic in each direction, storefronts that met the sidewalk,
and lots of street trees, the area was very walkable, just like Hawthorne. The
neighborhood has good bones, Julie thought to herself.
In fact, it had advantages Hawthorne didntthe speed limit was 25 mph
(Hawthorne was 35 mph), and it was only two lanes, compared to Hawthornes
four. From a pedestrian perspective, it was even more walkable than Hawthorne.
In addition, the area was improving, with new shops and restaurants moving in,
but it was far from peaking. While the hipsters and artists were building a
presence, it wasnt yet a destination for the general public. Property prices and
rents had begun to creep up in the last year, but the neighborhood was still early
in its transitioning phase.

The property sat on a side street, about a block south of Division. It was a fourunit apartment building built in the 1950s that had suffered partial damage from a
fire. As Julie walked up, she could see that some repairs were underway to fix
the roof and an exterior wall. Peering in the windows, she could see that much of
the interior had been gutted, including one units kitchen. This was probably a
good thing, since a 1950s kitchen wouldve been obsolete and in need of a total
upgrade anyway.
As she was walking the site, Claire the Realtor pulled up in her car and met Julie
in the front yard. Claire explained that the seller had inherited the property from
his uncle, an architect who was renovating the property when he died
unexpectedly. The architect had already removed the damaged portions of the
structure, designed the renovation, secured the necessary permits from the city,
and begun the renovation work when he passed away. The nephew who now
owned the property lived out of state and wanted nothing to do with the project,
so he put the property up for sale.
Claire went on to say that the architect had put about $100,000 into the building,
which needed another $50,000 to complete. The structure had been repaired,
and the plumbing and electrical work was nearly done, but the interior needed to
be finished. The asking price of $250,000 for the 4,000 sf building was just
$62.50 per square footfar lower than the $300 psf typical on Hawthorne. Of
course, that was a bit of an apples-to-oranges comparison, given that this
building had no interior, but even after the $50,000 of improvements Julie and
Jonny would have to make, it would still be just $75 psf. Plus, there was value in
the drawings and permits that she wouldnt have to pay extra for.
Julie finally felt like she had found a viable deal. It was in a walkable, transitioning
neighborhood adjacent to the trendy Hawthorne area. The property was small
enough to manage, but big enough to be worthwhile. Much of the challenging
structural work had already been completed, the remaining work was mostly
cosmetic, and kitchens and baths offered the highest return on investment
compared to structural improvements. And most importantly, the seller was
motivated and priced the property low enough to leave enough upside for her.
Julie would need to move quickly if she and Jonny were to get this property
under contract. She gave him a call and within a few minutes, he met her at the
property. Jonny was pleased with what he saw, particularly since most of the
remaining work was carpentry and painthis strengths. They decided right then
to submit an offer, contingent upon finding acceptable financing and confirming
the cost of renovations with an experienced contractor.
That night, Julie called her uncle Brian, an experienced investor, and together
they started putting some numbers on paper. She began building a simple backof-the-envelope proforma using the best guesses she could with the information
she had. She knew the asking price was low and firm at $250,000, and that the

property would probably need another $50,000 to finish, for a total project cost of
roughly $300,000.
Are you sure about that renovation figure? Brian asked. Based on what youve
told me about the condition of the property, that number seems a bit low.
Thats what the Realtor said the owner thought would be needed to complete
the project, Julie responded.
Id have an experienced contractor walk through it with you first before you get
too far along. Brian pulled out his phone and called a contractor friend of his that
he had hired to do a number of renovation projects for him over the years, and
made arrangements to have him meet with Jonny and Julie at the property the
next day. Eric Wilson is a very reputable contractorhell help you understand
what youre dealing with. Even with the best intentions, Realtors dont often
understand what it costs to renovate a propertytheyre looking to make a sale.
You have to determine your costs independently.
While she would later confirm that estimate with Eric, $50,000 was the number
shed use for now. She was reasonably confident that she could get a loan to buy
and renovate the property at 80% loan-to-value (LTV), which would be $240,000.
At 5% interest, her monthly mortgage payment equaled $1,403. She would
therefore need about $60,000 as a down payment to make the deal work
($300,000 - $240,000 loan = $60,000).
Julie also assumed that she could rent out each of the four one-bedroom units for
about $800 per month. That would give her a monthly gross income of $3,200.
To be on the safe side, Julie assumed $0.50 per square foot for operating
expenses, multiplied by a total of 2,400 sf, for a total of $1,200 per month. Her
monthly gross revenue of $3,200 minus operating expenses of $1,200 left her
with a net operating income (NOI) of $2,000 before debt service.
After paying the monthly mortgage payment of $1,403, she would have positive
cash flow of $597. This was good, but was it good enough to get it financed?
Julie did one last quick calculation to find out: She knew a lender would want to
see a debt coverage ratio (DCR) of at least 1.2 or higher. She took her NOI of
$2,000, and divided it by the mortgage payment of $1,403, for a DCR of 1.43.
That would work.
Julie knew that these numbers would need adjusting, that her repair estimate
would need to be further fleshed out, and that there would be other costs, such
as due diligence inspections and closing costs, to account for. But for now, with
these rough numbers and the cushion between the 1.2 DCR required by the
bank and the 1.43 DCR she roughly calculated, the deal worked and was worth
moving forward on.

Brian also pointed out that she would need to include carrying costs in her
budget. Youll need to add costs for taxes and insurance, utilities, and mortgage
interest during the renovation before you get tenants in there paying rent. Brian
explained that the bank would probably allow Julie to pay interest-only payments
during renovation to keep costs low, and then switch to principal and interest
payments once the property was leased out. Also, add $1,500 each for an
inspection and an appraisal. You can probably negotiate the other closing costs
to be paid by the seller since you made a full price offer.
When Julie got home that night, she told Jonny she would start talking to lenders
the next day, and she asked him to arrange a time to walk through the property
with Eric, the contractor, to start estimating repair costs as soon as possible.
Mortgage Financing
Julie asked Claire if the owners bank would consider letting her assume the
mortgage. She figured that taking over the deceased architects loan would be
cheaper and quicker than applying for new financing. Claire said that she would
check, but that most banks these days dont allow mortgages to be assumed
anymore, because then they dont earn as much in origination fees.
Julie also asked Claire if the seller would consider taking back a second
mortgage for a portion of the purchase price. Julies back-of-the-envelope
analysis showed that she needed at least $60,000 for a down payment, but she
only had $25,000 in cash. If the seller was willing to give her a loan for the
$35,000 difference for one year, that would give her and Jonny time to finish the
renovation and lease the units. (Julie figured that since she didnt haggle on the
price, she had room to negotiate terms). Once the property was leased up at
market rents, the value of the property would be higher, and they could borrow
against that added value in the form of a line of credit, and use that credit line to
pay off the loan to the seller. This creative deal structure would allow the seller to
get full asking price and allow her to get the property financed without having to
come up with more cash out of pocket.
Just in case the sellers lender wouldnt let her assume the existing mortgage,
Julie called Nancy Bennett, a mortgage broker she recently met at a local real
estate investing club. That afternoon, Julie met Nancy in her office and showed
her the listing, walked her through the income and expense projections she put
together, and explained her renovation plans.
Nancy questioned whether the renovations could be completed for only $50,000.
We usually assume $30,000 per door for renovations like this. You only have
$12,500. If Nancy was correct, that would mean a renovation budget of
$120,000, not the $50,000 she and Jonny had hoped for. About that time, Julies
cell phone rang. It was Jonnyhe had walked Eric the contractor through the
building, and he said they were looking at a renovation cost of approximately

$37,500 per door, or a total of $150,000. That was much higher than Julie had
imagined.
Furthermore, Nancy said she would only be able to lend 70% loan-to-value on
the property, not the 80% Julie had assumed. This would mean that Julie would
need to come up with an even bigger down payment, and she doubted that the
seller would offer to finance an even bigger chunk of the transaction than she
had already asked for. Julies heart sank.
But dont worry, Nancy interjected, I think we can still get this deal financed.
How? Julie wondered aloud. The purchase price was $250,000, and she
needed another $150,000 to complete the renovation. Thats $400,000, and she
could only get a loan for 70% of that amount, or $280,000. That meant she
needed a $120,000 down payment, and she only had $25,000 in cash. Even with
the seller lending her the $35,000 she asked for as owner financing, she was
$60,000 short.
When you buy a single family home, Nancy began, we determine the market
value by how much other similar nearby homes sold for. But when you buy an
apartment building, we typically determine the value based on the rental income
generated by the property, not the replacement cost or what other nearby
properties are selling for.
Nancy explained that most apartments in the market were selling with annual
rental incomes that equaled 7% of the sales price. This is known as a
capitalization rate, or cap rate. Julies assumption was $800 per month per unit,
which equaled $38,400 in annual income. That number divided by a 7% cap rate
equaled a value of $549,000. A loan of 70% LTV on $549,000 equaled $384,000.
That was pretty close to the $400,000 she needed to buy the property and
complete the renovation, and under this scenario, her $25,000 in cash was more
than she needed for her down payment. Also, the $1,637 mortgage payment on
this loan still gave her a debt coverage ratio of 1.27. This deal worked!
Nancy said there were two conditions banks might require before giving them a
loan. Because Julie and Jonny had no experience managing an extensive
renovation project like this, the lender would probably require them to hire an
experienced general contractor to manage the project for them. There were
complicated construction issues to contend with, as well as managing
contractors, and getting permits. Nancy said that it was great that Jonny had
experience in carpentry, but that in order for the lender to feel comfortable that
the work was done properly and up to code, they might ask Julie and Jonny to
hire an experienced project manager. While this would add approximately
$10,000 to the costs, this would be a good way for Julie and Jonny to learn how
to do a renovation without the risk of making costly mistakes. If they chose not to

hire someone, they may not get the loan, or it might come with a higher interest
rate or more fees.
The second condition was that Julie and Jonny would be required to personally
guarantee the loan as an additional protection for the bank against default. That
meant that if the project failed, the bank could come after Julie and Jonnys other
assets.
Julie asked why this would be necessary, especially since there was ample value
in the property. She knew of other investors who had been able to secure
financing without personally guaranteeing their loans. Nancy explained that this
was the policy of virtually every lender who makes mortgage loans on smaller
properties, especially when the LTV was over 50%. If Julie wanted to avoid
personal liability, she would need to come up with enough cash to reduce her
loan-to-value to 50% or less of the value of the property. Nancy reassured her
that each year she pays down her loan principal, her liability would be reduced.
That night, Julie and Jonny discussed what they had learned. Julie wondered if
they should get another opinion on the renovation costs, beyond the estimate
they received from Eric. Jonny felt like after walking through the property with
him, he had a much better sense of the scope of the work needed, and that the
costs were indeed higher than originally anticipated. But by how much, he
couldnt be sure.
Jonny and Julie were both concerned about personally guaranteeing the loan.
They were just starting their lives together, and if things didnt work out with the
project, they didnt want to be completely broke and depending on family for
basic needs. Jonny suggested they run this past Jonnys dads longtime attorney.
Legal Advice
The next day, Jonny met with Bill Handler, an attorney who had handled many of
the business contracts for Jonnys dad over the past 20 years. Jonny explained
what he and his new wife were trying to do with the investment property, and how
the mortgage broker they spoke with indicated that they would be required to
personally guarantee the loan. Jonny explained their concerns about this,
including how it could cause them to lose what little they had if things didnt turn
out as planned.
Bill told him that he didnt want to play down the risk, but that it was standard
practice for banks to require a personal guarantee on small investment property.
In fact, even after investing in much larger properties himself for nearly two
decades, he still had to personally guarantee his own investment loans on nearly
all of his deals.

10

Bill told him not to worry, and that he and Julie were doing a number of things
that would lower their risk, such as buying in an improving neighborhood, adding
value through renovation, and working with an experienced contractor. Even in a
worst-case scenario where the project failed and they would lose everything, they
didn't have many assets beyond the $25,000 in cash they were already putting
into the deal, their two cars, and some personal property such as bikes, furniture,
and assorted wedding gifts. In other words, they didnt have much to lose, so why
not personally guarantee the loan? They were young enough that they could
easily replace whatever they might lose in short order.
Just then, Jonnys phone rang. It was Julie, saying that the seller had agreed to
extend them $35,000 in owner financing, at 10% interest. This was a pretty high
interest rate compared to the 5% interest they could get on the senior loan.
Jonny initially was reluctant to accept, but Bill reminded him that 10% interest on
$35,000 was only $3,500 a year, and that was a small price to pay to have an
extra bit of capital to use as a cushion against cost overruns.
Bill asked Jonny why they were planning to hold the units as long-term rentals
instead of selling them as condominiums. Julie and Jonny should be able to sell
them as condo units for $150,000 per unit, for a total of $600,000. After
subtracting the $400,000 for acquisition and renovation costs, that would leave
them with a $200,000 profit. A $600,000 valuation was also higher than the
$549,000 valuation that Nancy had showed was possible by using the income
from rents as the basis for value. Jonny said that he and Julie hadnt really
considered selling the units as condosthey were interested in long-term cash
flow and building a nest egg for their future, and believed that the neighborhood
would continue to improve and rents would continue to increase for the
foreseeable future. He conceded, however, that maybe they should consider all
options before making a decision on their exit strategy.
Bill suggested that if they were going to hold the property long-term, they should
probably hold it in an LLC. However, if they planned to sell it as a quick flip or as
condos, that either an LLC or an S-Corp would work. Both would provide asset
protection, but for properties held for less than a year, an S-Corp could provide
tax advantages.
Finally, Bill wondered how Julie and Jonny were accounting for the value of their
time in the project. He said that projects like this often look good on paper, but
new investors frequently forget to weigh the demands of a renovation project with
the demands of their full-time jobs. In addition, they would need to consider how
it would impact their new marriage and relationship dynamic, and how they could
further reduce their risk. He closed by telling him that they had a good
opportunity in front of them, but that it would take a significant commitment to
make it successful. It wouldn't be easy, but they would learn a lot in the process.
Summary

11

Julie and Jonny would need to decide the following:

Should they buy the property? Yes or no?

Should they get additional estimates on the renovation cost?

Should they hire a contractor to manage the project for them?

Should they accept the sellers offer to finance a second mortgage of

$35,000, due in a year?

Should they hold the property long-term, or sell the units as condos?
Should they take the financing offer with the requirement of a personal
guarantee, or pursue non-traditional financing like hard money that might
cost more to borrow, but not carry the requirement of a personal
guarantee?

How much of the work could and should they do themselves?

Please consider how you would proceed if you were in this scenario by
answering the four questions on page 1 of this assignment. Good luck!

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