In this episode, I reveal a cost associated with rehabbing that many real estate investors fail to plan for. It will probably not ruin the deal, but many investors have been burned by it. I am going to help you avoid this one!
I have talked many times on this podcast about various costs that you have to account for when doing flips, or buy-and-hold renovations. I have interviewed several very successful real estate investors who have also discussed the costs that they calculate when evaluating a deal. If you’ve been listening to this podcast for any length of time, you should have a pretty good idea of the major components of calculating whether or not a deal is going to be profitable by now. Just in case this is the first show you listen to, I will run through them quickly one more time:
- The purchase price of the house – This is the price that you pay for the property when you buy it. Usually, this number is the output of all of the other financial factors when evaluating a deal.
- The cost of rehab – This is the cost of fully renovating the property inside and out.
- Holding costs – This is basically the cost of money, plus any other fees that you will pay while you’re renovating the property, such as utilities, water bills, trash collection, etc. The cost of money is what the financing institution or private lender is charging you to use their money. It could be a fixed interest rate, a percentage of net profits, or a number of other possibilities.
- Fees associated with selling the property – For example, realtor fees. These usually average around 6% of the sale price of the property, transfer tax, land taxes, etc.
- After Repair Value (ARV) – This is the price of the property after it has been fully renovated by you. Most flippers use this value as the starting point in their calculation.
However, we have not talked much about the cost that you can incur when you’re about to sell a house and the buyer’s inspector does his inspections. A lot of real estate investors may tell you that, if you do a good job on your rehab, the buyer’s inspector won’t have anything to cite. While that may happen occasionally, the buyer’s inspector usually comes back with a list of things that “need” to be addressed. (And yes, for the purpose of an audio podcast I need to let you know that I did air quotes around the word need.) Just like I talked about in my interview with Eric Tomei and his case study yesterday, inspectors are paid to do one thing – find problems with property.
I have literally gutted an entire house and replaced the plumbing, electrical, HVAC, most of the walls, roof, all the windows, and still inspectors managed to find something wrong. Now, if you do a really good job, the violations that they list will often be very superficial. They probably won’t cost you more than a couple hundred bucks to send your contractor back in and take care of. Every once in a while however, you will get an inspector who will list so much stuff it’ll make your head spin. That’s not to say that you didn’t do a good rehab, but like I said, it is their job to find problems. So just be aware that once in a while you may have a very tough inspector who creates a list that will end up costing you a couple of thousand dollars or more. Usually, you are not required to make these corrections; it’s more of a bargaining piece that the buyer will use to either lower the price, or force you to take care of it in order to close the deal. If you’ve done a good job with your numbers and you’ve built in plenty of profit, usually these corrections will not make a good deal unprofitable. But if there is something in the deal that could potentially cost you one, two, or maybe even up to five thousand, you should be aware of it and at the very least have it in the back of your mind.
The inspector surprise costs are another reason why you should always create a little cushion in your rehab estimates. Maybe an additional 8% to 12% on top of your calculated rehab would be appropriate. The exact way that you account for this is completely up to you. You can totally ignore my advice on this, but be aware that it still may end up being an issue.