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What it really takes to make a profit in real estate rehab

Posted by John T. Reed on

Let’s say you want to buy a duplex and make a $20K profit on rehab. What does that mean you have to do?

You have to pay transaction costs when you buy. Valuepeguin-com says 3% to 5%. Call it 4%.

You also have to pay the rehab costs.

You also have to pay the selling transaction costs. Zillow says 8% to 10%. Call it 9%.

If the property is vacant while you are doing the rehab, you also must pay the carrying costs—mortgage payments and operating expenses like taxes, insurance, etc.

Finally, there is your profit which we already said was $20K.

Okay, so pick the neighborhoods where you want to do this and the price range. Let’s say you want to sell the rehabbed house for $300K. That means you must select neighbor hoods where at least some houses currently sell for $300K.

So you need to pay $300K - $20K profit –seller transaction costs 9% x $300K = $27K – buyer transaction costs – rehab costs – carrying costs or $253 – buy transaction costs – rehab costs- carrying costs.

Let’s try a purchase price of $220K. That gives purchase transaction cost of 4% x $220K = $8.8K. $253K - $8.8K = $244.2K That leaves $24.2K for rehab costs and carrying costs.

The original get-rich-in-real-estate author, William Nickerson, said you should get back $2 in increased building value for every $1 you spend on rehab. In this case, that would mean the rehab cost is $20K, leaving $4.2K for carrying costs.

Now, look at the differences between the $220K and $300K duplexes in the various online real estate data bases. Generally, you will find the differences are square footage and number of bedrooms and garages and lot size assuming they are all in the same neighborhood.

So, the question is can you by rehab that costs $20K increase the size and number of bedrooms in the duplex such that it now matches the descriptions of the $300K duplexes in that neighborhood.

Probably, you will have difficulty even finding a $220K duplex for sale in a neighborhood that also has $300K duplexes. If you do find one, you will probably also find that changing it to match the $300K duplexes costs more than $20K. In most duplexes, such changes require new foundation, roof and exterior walls. Too expensive. You need to get the additional space by decreasing the load factor. That means you have to create the additional rentable space out of existing interior space like finishing an attic or, ugh, maybe turning a basement or garage into living space.

There is a very good chance that what few $220K duplexes that are in that $300K neighborhood have no unfinished attic or basement or garage that can create the match with the $300K houses.

Keep looking.

Now contrast that with what most wannabe flippers are doing. They are paying $255K in that neighborhood and buying a duplex that has nothing in particular wrong with it. They do $30K worth of HGTV updating like replacing a formica counter with granite and making the bathrooms nicer and doing some planting and painting.

Then, three years later, they sell the duplex for $330K—a 17.6% increase—and proclaim themselves geniuses. As you can see from the above numbers, that was absolutely not a profitable rehab. What really happened was they raised the building value maybe about $5K by spending $30K. They lost money.

If they check, they will find that the average sale price per square foot is such that all houses in the neighborhood, most of which were not rehabbed, went up about 17% during the period.

In other words, the rehabber is incorrectly attributing his increased resale price to the rehab when it came almost entirely from marketwide appreciation. In other words, he would have sold it for $325 if he had done nothing to it.

Truly profitable rehab is very difficult to pull off. It is hard to find properties where it is even possible. And it is hard to execute the rehab fast enough and cheaply enough and well enough to achieve the match with the target higher priced properties.

Can the above be rejected as merely my opinion? No way. It is all arithmetic with the sources names.

If this makes rehab far more difficult that you were led to believe, welcome to the NFL, rookie.

Can you learn how to do it? Maybe. Profitable rehab is generally for skilled handymen who can do most of the work themselves thereby collecting the labor portion of the rehab cost. Can a non-skilled handyman successfully go into the rehab business? Generally, no.

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