A short-term strategy focused on rehabbing restorative superior homes is often more viable than a simple buy-and-sell strategy. But if you, like most, plan to use a traditional mortgage to buy a home with repairs, you may have trouble getting financing.
What follows are the pros and cons of this strategy, as well as some tips and tricks based on my 20 years of experience.
MAIN BARRIER: GET FINANCING
I have found that traditional lenders do not want to take the perceived risk associated with restorative superior homes or rehab. The main problem is that, at the time of purchase, these properties are generally not habitable, which makes their valuation and appraisal difficult and subjective, two characteristics that traditional lenders do not like.
And there’s not much you can do to avoid this “livability” problem with rehab. There is no point in making repairs before mortgage closing to please the lender, because you never know when a deal will fail. And of course, if that happens, you will lose everything you have put into the property up to that point.
TOP BENEFIT: EXCELLENT CASH KING
That said, once you find a non-bank lender, rehabbing upper fixes that primarily require cosmetic upgrades can be a great long-term investment strategy, because you’re essentially getting a capital buffer for your willingness to coordinate repairs. Many people call this “sweat equity.” After rehab, you can withdraw some cash when you refinance the property into a traditional 30-year fixed mortgage using this built-in equity cushion as a down payment. This basically allows you to refinance without having to pay out of pocket.
For example, I recently purchased and rehabilitated 2 upper repair multi-family homes where this strategy was successfully implemented. Both were foreclosures sold by the REO departments of the respective lending banks through the regular MLS listings. In both cases, I minimized my out-of-pocket expenses by using a private lender to finance both the acquisition costs and the rehab work. In both cases, thanks to my “sweat capital,” I was able to refinance into 30-year fixed loans with no down payment or PMI (private mortgage insurance).
A top repairman was a triplex. My total financed costs were $ 160K ($ 125K to purchase the property and $ 35K in rehab and maintenance costs). The rehab took 3 months to complete, after which it was valued at $ 230,000. Thanks to my $ 70K capital increase, my loan-to-value ratio was just 72% ($ 165K / $ 230K), allowing me to easily refinance on a traditional 30-year fixed-rate $ 165K mortgage to pay off at private lender plus an additional $ 5K in cash to finance my closing costs.
Thanks to the power of leverage and credit, my total out-of-pocket cost on this investment property was just $ 2,500. In 12 years when I sell, thanks to the additional monthly payments I make for the beginning each and every month, my mortgage payment should be approximately $ 96,000. I expect to sell the property for $ 300,000, which will generate a profit of $ 161,000 after subtracting selling expenses and capital gains taxes. This equates to a cash on cash ROI of over 6,400%!
The other recent example involved a duplex that I bought for $ 150K, put in $ 20K, and priced it at $ 217K 3 months later. The resulting capital gain of $ 47K again allowed me to easily refinance. In 12 years I expect this investment property to sell for $ 250K, which I estimate will provide a profit of $ 109,382. My initial out-of-pocket cost was $ 3,200, which equates to a cash-on-cash ROI of 3,400%.
TIPS AND TIDBITS
So clearly, rehabbing superior restorative homes is an excellent strategy, especially from a long-term perspective. You can do it! Just tread carefully and pay attention to the following:
- Keep in mind that this is a more “advanced” strategy because you will first need to build your network and find a private lender you can trust (because again, traditional bank financing is difficult in this scenario).
- Like any other investment property, you must conduct a real estate analysis. Your main concern here will be the price, which should reflect an approximate 20-30% discount relative to an equivalent “superior no-repair” property.
- If price is the n. 1, so your rehab costs are close to No. 2. You should go through a full walkthrough and inventory as many repair items as possible. Calculate the repair costs and add the total amount to the purchase price to get your actual cost basis.
- Beware of structural deficiencies. Appreciate cosmetic deficiencies.
- In some cases, it may be in your best interest to do as much of the rehab work yourself as possible; If you fall into this category, remember to avoid focusing on rehabilitations that are in a state of total disrepair.
- Rehab requires a greater short-term time commitment than other investment strategies, so make sure you have time to commit.
- Remember that your private lender will probably want to have a first bond holder position on the property until they are paid. It is not a problem, just something to keep in mind.
- It’s probably not a good idea if you have a weak stomach.
CONCLUSION
Rehabilitating top fixers is a great strategy, but it’s not for novice investors or the faint of heart. But when you have the experience and access to capital to do just that, it can be an extremely effective, low-risk, long-term strategy for building substantial wealth.