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Rehab by individual real estate investors almost always loses money

Posted by John Reed on

Rehab is really big among individual real estate investors. It is almost total bulls***. It is almost never profitable, almost always causes a loss on the cost of the rehab.

In the typical case, the investors pays, say, $350,000 for the property then spends another, say, $8,000 fixing it up. Then he sells it two or three years later for $395,000 and says he made $37,000 profit on his $8,000 rehab.

What a financial genius!

In fact, The $45,000 appreciation almost certainly came from inflation and marketwide appreciation. In other words, probably all similar buildings, including those that were not rehabbed at all, that sold for $325,000 to $375,000 when he paid $350,000 saw a very similar increase in their sale price per square foot over the same period.

If the investor had refrained from rehabbing, he would still have sold for $350,000 plus, he would not have wasted the $8,000 and all his time working on the rehab.

How much of the $45,000 increase in price resulted from the $8,000 rehab? Probably, about $1,000 tops. More likely, nothing.

Does any rehab make a profit? Yes. I have done several of them.

I discussed this with John Beck once. He was a famous real estate investment guru. He was legit. Smart. An attorney-CPA. Expert on distress sales. He said the only profitable rehabs he ever did or saw were what I call reducing the load factor.

Full disclosure: Beck became a TV guru, I renounced his behavior in that. The FTC prosecuted him and he was required to pay hundreds of millions in restitution. He declared bankruptcy and disappeared. He is now a fugitive from the federal justice department.

Load factor is generally mid- or high-rise non-residential building terminology. Load factor is indoor space that cannot be rented out. It is expressed as a percentage of total building area. 

Lobbies, stairwells, elevators, public restrooms, hallways, utility rooms, you get the idea.

Are the average rehabbers possibly doing the reducing the load factor thing?

A. They have never heard of the term.

B. Some may have figured out some profitable load-factor reductions without knowing the term.

C. Other than John Beck, I have never heard another individual real estate person talk about this by the name reducing the load factor or any other name. Nonresidential mid-and high-rise building people DO know the phrase and look for such opportunities.

I turned a store room next to a one-bedroom apartment into that apartment’s second bedroom. I turned a larger storeroom in that apartment complex into a studio apartment. I also turned two outdoor balcony dead ends into rented breezeways.

In each case the pay back was perfectly measurable—the rent raises on the apartment and on the two apartments that got the breezeways and the rent on the studio. The payback periods on the cost of these modifications were about one to two years.

I had a three-year payback criterion. If the incremental rent would not pay back the cost in three years or less, I would not do the modification.

Am I saying that adding a second bathroom to a one-bath house does not raise the building value? That probably would add a little value, but not enough to repay the cost of it.

1. In order to add a bathroom to a house, you must take away that much space that is currently something other than a bathroom.

The truth is that most one-bedroom floorplans do not really have a place to put a second bedroom. More modern houses that were designed to have two bathrooms may have more total square footage in order to accomplish that.

Forcing a second bathroom into a one-bathroom house that does not really have a good place for it has a high probability of resulting in an awkward conversion that may actually detract from the overall value.

2. Older buildings often have lousy, wasteful floor plans. Those are the great candidates for cost-effective modifications like adding a second bathroom.

3. A bathroom has five water supply lines—hot and cold to the shower and vanity and cold to the toilet—all of which must be protected from freezing—and three drain lines from the tub, vanity sink, and the shower.

Drain lines have to slope downward from the drain in question to the sewer line in the street. If the house is built on a slab, creating those sloped drain lines is likely to be prohibitively expensive. Drains also have a “chimney” of sorts—called a vent. That is a pipe that starts above the drain and sticks out of the roof. This is needed to get air pressure to help the waste water drain down and into the public sewer pipes. It also carries bad odors out of the bathroom and the house.

The issue for the rehabber is where are you going to put all these five water-supply lines, three drains, and three drain vents. If you just built the plumbing in the yard to see the whole thing, the contraption is probably about 20 feet of pipe height even for a one-story building. So you have to worry about what is above and below the planned bathroom.

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