By Andrew Bang | Boomerang Capital
There is an old fairytale about a group of homebuilders, let us call them real estate investors of the pigskin variety. The first investor threw together a quick project, found an old property he could quickly patch together with a bit of straw and hay, and called it good. The second investor spent a bit more time, money, and effort, and upgraded his building material to some solid 2x4s. His rehabbed home was much sturdier than his neighbors, but there is always room for improvement. Finally, the third pigskin investor remodeled his home with sturdy bricks, tight new insulated doors and windows, in-floor heating, and extensive kitchen remodeling including a fabulous Wolf range. Though more expensive, it was the safest, sturdiest, prettiest house in the neighborhood. Now which one of these three real estate projects do you think was most valuable? In other words, how much is that “happily ever after” worth? Some may be surprised to find that home buyers are willing to pay a bit more up-front for that safe, sturdy, and pretty home, and further that financing the upgrades of the cheaper “good” house may be more difficult down the road.
As our fairytale has alluded to, we’ve found that with the market has swung to favoring buyers, end purchasers (people buying your rehabbed homes) are looking for homes that are completely redone – think insulated doors, windows, and Wolf ranges. This is in contrast to the seller’s market of the recent past where buyers were looking for homes that still needed a bit of work so that they could get a better price (or any house at all). With interest rates higher and the lack of supply, you’d think the same strategy would be employed now to try to buy a home at a discount. But that is not what we are seeing; rather, purchasers are demanding a move-in home. While part of the reason is ‘because they can,’ the other part is that previously home purchasers would have excess cash after their purchase, and with affordability where it is, that is no longer the case. Regardless, the bankers we talk to are unwilling to extend further credit to a new homeowner. Buying that “fixer-upper” now and financing all the improvements later, is becoming a fairytale for some.
At first glance, this might appear to put investors at a disadvantage, as those extra expenses generally come out of the investor’s profit. Surprisingly, we are seeing complete rehabs offering higher margins than partial rehabs. Why is that the case? Let’s look deeper.
The Sum of the Projects is Less Than Adding Up the Individual Expenses
When adding up the expenses it is frequently cheaper to do extensive work than to do piecemeal (on a per-unit basis). The reason is that a comprehensive solution offers a number of advantages. First, there are synergies of scope. For example, if your goal is to replace some light switches, you’d need to rip out and replace drywall in the process. Whereas, if you are re-doing the drywall anyway, there is no marginal expense to replace the light switches along the way. Resource efficiencies also come into play. Tackling the most work with the right resources rather than piecemealing the job, which eats into time, labor, and materials. And you can also factor in greater flexibility with a full rehab job – plumbing supplies on backorder? Attack the kitchen. Rather than putting the entire project at a standstill, waiting for one contractor, or one order of materials, with a full project there’s always work that can be tackled to keep the project moving. To put some numbers behind it: remodeling two bathrooms might cost $10,000; while doing a remodel of a 3 bed/2 bath house including a kitchen might be $50,000. And you’d protest that costs went up – and they did overall – so how does that work?
The payoff comes from the final sales price of a completely redone house versus a partially redone house. Consider two comparable projects we’ve seen recently completed and these are actual numbers. Both were in ‘okay’ shape at acquisition, about 10 years old, and were 3 bed/2 baths in Mesa. The purchase price on the first was $274,000 and it had a total budget of $10,000 to update the bathrooms and a bit of paint. It sold for $335,000 last week, netting a gross profit of $61,000. The other home was purchased for $282,000 and had a rehab plan including full renovations: cleaning and removing trash (it was pretty rough), new flooring and carpet, painting interior and exterior, remodeling bathrooms and kitchen, updating all fixtures, and repairing/replacing/retexturing sheetrock. This had a budget of $50,000. The rehabbed home sold for $411,000, netting a gross profit of $79,000. Certainly, other variables may explain the difference between the two, but this is something we are seeing over and over, and we see about one hundred projects completed each month, so our sample size seems fairly decent.
In the case of the first less-than-complete house, there will still be work that needs to be done, which will require capital, and there is none available. This is what we’re talking about – finding additional capital to make these minor renovations is increasingly difficult. Even if the buyer can handle the higher payments of an additional line, the banks are no longer willing to lend that additional money to buyers like they used to in the form of either 105% financing, a second, or adding a consumer credit line. With the banks unwilling to lend more money, and with rates where they are, smart buyers are choosing to put as large of a down payment as possible, so the buyer has no available cash. This all leads to a buyer needing a home that is move-in ready.
We asked the investor in the second house if they spent more time than they think they otherwise would have, in doing a full rehab vs. some general upgrades, and they reported, “I was there anyway. It was better for my guys to just come ask me and I could go see what they were talking about rather than them calling me and trying to explain it. And I don’t think my total hours on the job site was any different than if I’d have done a smaller job.” In addition, as an added bonus to the investor in the completely remodeled house, it sold 2 weeks faster than the other one.
When evaluating what needs to be done in a project consider a few different scenarios: a light remodel, a comprehensive remodel, and construction. We are seeing that the middle option of a comprehensive remodel is yielding the best investor returns in the current environment.
So, the moral of the story is that the little extra effort, energy, and expense is worth it in the end. The home buyer gets the best home that is move-in ready at a better price than doing it themselves and the real estate investor gets the profit he’s looking for. And they both live happily ever after. The End.