Underestimating the Cost of Repairs
65If you’ve done any rehab work, then you know that no matter how good you think you are at getting the cost of repairs correct, the odds are against you. You either have a pretty house, you get lucky, or you already know the secret to making good estimates.
Underestimating the cost of repairs is absolutely one of the worst mistakes I see new real estate investors making. Most investors make their money through purchasing, rehabbing, and reselling a property on a retail basis. Others choose to rent the property after fixing it up. How do you minimize the risk of making a mistake on the repair estimates?
I once had three repair estimates on a house, all around $10,000 to $13,000. Then the boiler in the basement caught fire one Thanksgiving Day morning. My total cost of repair easily doubled the initial estimates. There are just some things you can’t predict.
What happens when your repair estimates are off by $15,000? What happens if that house you purchase for $100,000 below its after-repair-value (ARV) can’t be sold because the market tanked during rehab, and you end up holding it for 14 months until you ultimately sell it, rehabbed, for just over the initial purchase price?
You know what happens. Your profit goes down the drain, doesn’t it?
The risks are higher for those who do complete rehabs and sell their properties at retail prices. If you are doing full rehabs, you need to be conservative and build in additional dollars for all the things that may go wrong during the project.
If you’re buying properties to rent, you still have many of the same issues involving repair costs and market valuation; however, you have an additional variable - the tenant. That tenant isn’t responsible for making ongoing repairs. As the property owner, you are.
Most investors pull money out of their rehabbed houses once the repairs have been made. The equity is used to cover current business expenses while they begin new projects. The belief is that even though the house is near to being over-leveraged, over time real estate always increases in value, right?
Well, sort of. If we have learned anything from the past few years, we learned that this isn’t always true.
Here’s the good news: If you learn how to conduct back-to-back transactions for short sales you will limit your exposure to these type of incidents. The most rehab you will do will be minor paint and carpet – just enough to make the house presentable. Total expenses should be no more than $3,000 to $5000. Remember, you are buying a property well below market value, and selling it well below market value. Sometimes you need to leave a little fat on the bone for the end buyer. If you do, you’ll have no problem selling your properties.
When you set up a short sale transaction, repair estimates are a key portion of your negotiation process. The short sale package with your initial offer to the bank should include a detailed list with each repair’s estimated cost. Counteroffers should also include the repair estimates as a reminder of why you continue to offer a lower amount than the bank.
Next, when you’re meeting the BPO agent, you should have that written summary of the repair estimates with you, along with the comps and the market forecast for that neighborhood. By now you should have moved past any extra-low offers you made just to open the case. Validating your counteroffer with evidence like this not only increases your chances of helping the BPO come in at a reasonable number, it increases your credibility.
Estimating repairs means being conservative before you even purchase the property. Here’s a good calculation that is sure to help you buy smart.
a. Take the after-repaired value.
b. Subtract the amount of repairs needed.
c. Multiply the result by 70 percent. This should be your maximum offer.
Your initial offer on the property would be less than this - maybe 60 to 67 percent of the AS-IS value.
Here’s an example. A house is worth $200,000 once it’s fixed up. It needs $20,000 in repairs, including kitchen and bathroom updates, a new roof, a new furnace, carpet, paint, and landscaping. All told, it adds up to $20,000, including labor. So the AS-IS value equals $180,000 ($200,000 – $20,000 in repairs). Multiply $180,000 times 70 percent (0.7) to get $126,000, which would be your maximum buy price.
Calculate the repairs on your next property like this, and you will create that cushion you need to save the profit just in case something terrible happens. And, if everything goes well, you could end up with more profit than you expected! That’s a scenario we can all live with.
