13 Jul Be Careful About Changing Course Mid-stream
It was supposed to be a simple transaction. Invest in a small fixer upper house, renovate it, rent it, and have the tenant pay the mortgage. The young couple had allocated $52,000 of their savings to buy a detached single family house as their first investment rental property. The couple’s goal was to improve the house, rent it with the help of a property manager, and then refinance so they could recoup their initial cash investment while keeping the house. They were not into flipping property.
Their real estate consultant from a property investment company told them that the After Repair Value (ARV) was around $65,000, which they verified after speaking with a local agent. A local property manager told the couple that the market rent was about $700 per month.
The couple agreed to pay $27,500 for the house. They hired a certified home inspector. They solicited renovation estimates, one for $19,900 and one for $23,500. They selected the contractor with the lower bid. Factoring in closing and carrying costs, they figured their total initial cash investment would fall within their $52,000 budget. With an ARV of $65,000, they estimated that they would receive $48,750 back from their mortgage lender via a 75 percent loan-to-value refinance. At that loan amount, their positive monthly cash flow would be about $141. And they would have over $16,000 worth of equity.
The couple thought that they had found the perfect residential investment property. And they were right. Until they fell in love with the house. Then they strayed from their initial strategy.
Real estate investors, not just novices, make a number of good moves yet can ruin a deal by making just one wrong move in the midst of all the good ones. These are some of the costly missteps made by investors:
- Offering too much for the property.
- Overestimating the After Repair Value.
- Underestimating the renovation costs.
- Underestimating the time it will take to renovate.
- Overestimating what the property will rent for.
- Over-improving the property.
- Changing the exit strategy in the middle of the project.
Instead of spending $19,900 on the renovation, the couple ended up spending $36,000. They spent hours at the hardware store selecting beautiful light fixtures, faucets, and doorknobs. They instructed the contractor to build an extra, unnecessary bathroom in the kitchen. They demolished the kitchen and installed top-of-the-line cabinets and counters. They unnecessarily replaced windows and doors. They renovated the house to a condition similar to their own home, instead of in line with similar rental properties on the market.
Upon realizing that they had spent more on the property than the $65,000 ARV, the couple decided that they shouldn’t rent out such a nice home. They decided that it should instead be sold. Unfortunately, their mortgage broker told them that without a tenant, they would not be able to refinance the property. When a real estate agent told them that it was unlikely that they would recoup all their money if they listed the property in the current market, the couple became dejected. They decided to curtail their dream of becoming wealthy through real estate.
There is nothing wrong with being excited about renovating a house. When renovating a rental property, it does not have to be improved to the standard that one would have for their own home. Trying to turn a rental property into a flip project does not always work. It may be prudent not to change course mid-stream.
Tai DeSa is a graduate of The Wharton School of the University of Pennsylvania. He became a full-time real estate investor in 2004 after serving in the U.S. Navy. Tai has made colossal mistakes in investing (and learned some things along the way). He has owned over 200 properties with various investment partners, and he has been involved in over 200 more transactions as a real estate broker in both Pennsylvania and Tennessee. Tai and his wife Amira enjoy hunting for investment properties. Contact Tai if you need some consultation on real estate investing. Tai may be available for coaching and speaking engagements on a variety of real estate topics. Send an email to tai@investandtransform.com. Tai is passionate about helping investors make money and avoid mistakes.
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