I see a lot of inexperienced investors and retail buyers overpaying for fixer-upper homes. Fixer-upper homes can be particularly dangerous even for the professional. The siren song of instant equity can lead the home buyer into the cold hard rocks of financial and market realities, and by the time you realize it there’s no way out unscathed.
Whether you’re buying a home to live in or as an investment, the incentive for buying a home that needs a lot of work is to have equity in the deal when the work is done. The work is both expensive financially and taxing on your mind, body and relationships. If there’s not a financial payoff in the end, then there is no reason to go through the agony of home renovation.
No matter how much you want a deal, don’t bend the numbers to match your dreams, and know when to walk away when the numbers aren’t adding up. I’ve said it before: If you aren’t going to have at least 10 percent equity in a home after you pay for the renovations, then save yourself the hassle and buy a home that is already renovated or that has been maintained.
Last winter I looked at a home that needed a lot of work. It was absolutely disgusting. It needed everything: carpet, paint, windows, kitchen, baths and heating and cooling system. It also had a very nasty crack in the foundation. Some cracks in foundations are not a problem. An engineer once told me that there are two types of concrete: cracked concrete and concrete that is going to crack.
This foundation, however, was cement brick that had cracked from top to bottom through some of the bricks, and the wall was pushed inward. The crack was also under the portion of the house that was covered on the outside by a fully enclosed back porch. In other words, the home was perfect for me.
The covered porch made the foundation issue even harder to resolve and to estimate costs. Typically, in a situation like this the contractor would dig out the soil on the outside of the foundation to relieve pressure on the foundation and replace and possibly reinforce the block to prevent future problems. The porch would need to be removed or the foundation would have to be dug by hand in very tight quarters.
But I wanted the house. One of the main reasons I wanted the home was because it backed to a busy street. That location made the home perfect for advertising. I could place a big sign in the back yard while I conducted the renovations. and that one home might bring me one or two more profitable deals. I even considered keeping it at a possible loss as a rental to continue to reap the advertising benefits.
Because of the location, I was willing to pay much more for the home than I would on a usual deal. I put my numbers together and prepared to come in with a very strong offer. I was willing to make no profit on this deal, and I made an offer that would have put me at about break even and could very possibly push me into the red when all was said and done.
Here are the numbers:
The home was listed on the market for $135,000. Based on my market evaluation, I felt the home would be worth about $265,000 after I fixed it up. I estimated that the home would need about $75,000 in upgrades and renovations. However, the foundation was a big question mark. I estimated it could cost $3,000 to $12,000. I was thinking it would be closer to the high end, but there was no way to know for sure, and there was not time to have it properly evaluated. I would have about 8 percent costs from just buying, reselling and holding the house, which came in at about $21,000, and I would have about $18,000 in capital expenses.
Initial evaluation cost breakdown:
$265,000 — value after the repair
minus $21,200 — 8 percent buy/sell/holding costs
minus $18,000 — capital costs
minus $75,000 — renovations expense
equals $150,800 — break even purchase price
The home had not been on the market long and I knew it wouldn’t last. The listing agent told me that they already had a couple of offers. I offered $148,000 for the home, which only would give me an estimated $2,800 profit on the deal. Renovations typically run five to 10 percent higher than budget in construction and old houses almost always hide some surprises.
My bid was $13,000 over the asking price, and I felt very confident that I would be victorious. The listing agent, however, informed me that an offer came in even higher than mine. I walked away right then and there.
But many investors and home seekers alike will start to second-guess their numbers and consider raising their bid. First, they’ll start thinking about how they can get renovation costs down, or they’ll get much more optimistic about the comparable sales in the area and convince themselves that the home will be worth more than they first estimated after a high-end renovation. If you’re not very familiar with construction material and labor costs, then it is very easy to start second-guessing your budget and start trimming down costs.
You have to let a deal be what it’s going to be. Don’t try to make a deal what you want it to be.
When I was beat out, I figured it was by a homeowner who had probably planned to do renovations themselves. A homeowner can pay at least 10 percent more for a deal than I can and still come out just as well because their holding costs are lower, their housing needs are being met, and their cost of capital is less. I also suspected that it could be a shady flipper who planned to do minimal cut-rate renovations and probably bury the foundation problem under drywall and insulation.
When the deal closed, I saw that the home was purchased by another real estate investor who paid over $22,000 more than what I had bid. Immediately, I suspected the shady flipper scenario.
When the home hit the market, it looked like the flipper actually did a pretty good job on the renovations. However, they initially listed the home close to $300,000, which was $35,000 over what I valued the house, or 13 percent over my opinion of market value.
They have since reduced the price to $280,000, and it’s been sitting on the market for more than 100 days.
If I had to guess, the flipper probably looked at the comparable sales in the neighborhood and got very optimistic to try to make the deal work.
I think they’re still a little overpriced on the home, and they’re not even getting the advertising benefit that I was seeking. In a situation like this, a flipper has a tough choice. The investor should just reduce the home price to market value and get it sold, even if it means taking a loss. It’s never going to get better, and in the meantime, holding costs start piling up, and investors, lenders or both start getting angry, which jeopardizes your future deals.
Many investors and homeowners cling to the hope and dream that someone will swoop in and pay an above-market price. It rarely happens, and the seller eventually has to accept reality. By that time, they’ve usually piled up thousands in holding costs and thousands more in opportunity costs.
Once you’ve found yourself in the cold hard rocks of real estate and market realities, your only real choice is to get out as fast as you can. Take the loss, get it over with and free up your resources to make money on the next deal. The longer you sit there, the more damage you’ll sustain.
Justin Pierce is a real estate investor and real estate agent who regularly writes about his experiences buying, renovating and selling houses in the Washington area.