Purchase Price vs. Rehab Cost
A frequent question we get is whether it is better to buy a property that needs more rehab at a lower price or spend more for a property that needs little rehab. A great question but one (as usual) without a simple answer. Note that this article is focused on financed properties because if it is a cash purchase and the rehab risk is very low, it is a simple spreadsheet decision. Financed purchases are more complex which is the focus of this article.
Before I talk about rehab cost vs. purchase price I want to talk about rehab risk. Every time we rehab a property there are always unexpected costs. Because we are very careful to only choose properties that have low risk items, the "unexpected costs" rarely exceed $500. And, when we do discover a possible high risk rehab item (usually during the inspection), we either get the seller to repair the item before close of escrow or we cancel the purchase. What are some high risk rehab items? Mold, Chinese dry wall, structural damage, foundation issues, non-permitted additions, water damage, older properties, Kitec plumbing come to mind. Low risk items include paint, carpet, tile, appliances, window treatments and landscaping.
The real challenge with many high risk rehab items is that they are not usually visible on a walkthrough. This is why the property inspector is a critical team member. For example, a few years ago our property inspector discovered that the floor around a toilet on the second floor of a property we had under contract was spongy, indicating water damage. The seller wished to credit us $500 at close of escrow in lieu of repairing the item but I refused, I required the seller to repair the damage. They agreed "knowing" that the repair was minor. However, once they removed the toilet and the vinyl flooring, they discovered the water damage went under the shower stall. The shower stall was old and could not be removed intact so they had to purchase a replacement. Once they got the shower out, they saw that the water damaged not only the sub flooring but the ceiling of the room below. To make a long story short, the cost to repair the "minor" water damage was over $3,000, not the $500 that they planned.
Another significant rehab risk is the contractors/handyman doing the work. We've used many different contractors and handymen over the years. The most common problems we have with such workers are poor quality work, not showing up, showing up drunk or on drugs, etc. The current handyman service is the best we have had and has rehabbed 30 or 40 properties for our clients. Still, I have to go on site every day or the workers will take short cuts, do poor work, etc. Managing the rehab is a part of our service (all of our services are free to buyers including rehab overwatch) and unless you have someone available and knowledgeable enough to manage rehabs, even the simplest rehab items can become high risk due to the workers themselves.
Never forget that risk is an integral part of every rehab and that is why you want to be very careful about any high risk rehab elements and the workers you use. However, for the rest of this article I will ignore rehab risk.
Depending on the current market, properties that need significant rehab may be available at a large discount or there may be almost no discount. In Las Vegas, the discount due to property condition is small compared to what it was a few years ago. If you are in a market where there is a large discount, then such properties may be the way to go.
Rehab Cost vs. Purchase Price
Suppose you have the option of purchasing a property that needs very little rehab for $170,000 or a similar property for $150,000 that requires $10,000 in rehab. Which is the better buy? Below are the assumptions I will use in the following example:
- Purchase price: $150,000
- Rehab: $10,000
- Purchase price: $170,000
- Rehab: $0
- Financing: 30 year, fixed rate of 4.5%, with 20% down
- Hold period: 10 years
- Monthly rent: $1,100/Mo
Note that I am ignoring property closing costs, property tax, rent, insurance, management, time value of money and other real world factors so I can focus only on rehab cost vs. purchase price. Below is a table showing the acquisition cost for both properties:
|Property 1||Property 2|
|Total Acquisition Cost||40000||34000|
As you can see, the total acquisition cost for Property 1 is $6,000 more than the acquisition cost for Property 2. However, Property 1 does have a lower debt service so at some point in time the debt service savings will equal the higher acquisition cost. Below is a simplistic calculation showing that you will have $81/Mo. higher cash flow due to the lower payment of Property 1. (Note: The negative sign indicates cash out.)
|Property 1||Property 2|
|Debt Service (Mo)||-608||-689|
|Cash Flow Difference||81||-|
How long will you have to hold the property in order for the $81/Mo. increased cash flow to recover the $6,000 higher acquisition cost of Property 1?
($40,000 - $34,000) / $81/Mo. = 74 Months or about 6 years.
Note, the cost recovery time calculation shown above is overly simplistic and true cost recovery time will be longer.
What if the cost difference between the two properties is $16,000 and the rehab remains the same?
|Property 1||Property 2|
|Debt Service (Mo)||-624||-689|
|Cash Flow Difference||65||-|
In this case, the time to break even is:
($40,800 - $34,000) / $65/Mo. = 104 Months or about 8.7 years.
As you would expect, the smaller the cost difference between properties in almost market ready condition and properties that need rehab, the longer the time to break even; i.e. the better off to buy properties in almost market ready condition. Also, do not forget rehab risk. Major unplanned rehab items can be devastating.
You need to consider all the factors when you consider buying a property which needs significant rehab including:
- Rehab risk
- Payback time
- Total acquisition
- Worker reliability
- Your availability and ability to overwatch the rehab to ensure quality work and timely completion of the work.
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