Pssst - Wanna Be a Real Estate Millionaire? (Part 6)

Chapter 6: Estimating repair costs

We’ve just finished discussing the costs to repair a junker house so that it becomes a habitable structure. We didn’t do anything elaborate. We just made the necessary repairs to bring the structure back into serviceable use. I wanted you to do the physical labor and the materials shopping so that you would have a first hand understanding of what’s involved. So many investors avoid really good investments because they don’t understand how inexpensively a property can be repaired. Now that you have a taste of what costs really are, you can successfully hire contractors to do this work while having full confidence that the contractor can’t put one over on you. You know what the costs really are and how much labor it really takes, and you can award repair contracts to the folks who are willing to do the work for a reasonable profit, not a rip-off fee.

My formal education was mechanical engineering. As an engineer, I was trained to examine every detail. When I first started investing in real estate, I spent hours analyzing what the repair costs would be before I even made a purchase offer. Despite all that analysis, not a single one of my estimates ever turned-out to be accurate. Some cost estimates were on the low side and others were on the high side. None were exact. So, what did I accomplish?

Part of the reason I spent all that time analyzing costs was just based on lack of knowledge; lack of experience. After I finished a few buildings, I began to realize that the precise costs are unimportant. Yes, you do need to know the ballpark number, but exact costs are just not knowable. So why bother?

Well, it is important to know before you buy what range of costs you’ll be encountering. I have adopted the attitude that a rehab is either a $5000 cost or a $10,000 cost or a $15,000 cost, and so on. By the way, if we had decided to hire the fix-up of our tax lien house, I would have chosen $10,000 as the rehab cost. I basically doubled the materials cost to allow for installation labor. When I look at a property, I decide what it needs and what is the most efficient way to repair the property without overdoing it for the neighborhood. Let me digress on this point.

One key element you look for in a property is that it is the worst house on the block. For whatever reason, the prior owner has allowed the structure to fall into disrepair. Your objective is to spend as little as possible to repair the structure and bring it up to the neighborhood. Notice I did not say “exceed” the neighborhood. Do not make the mistake of repairing a property in the same way you would improve your own home. This is a business, and we want to provide clean serviceable accommodations without going overboard. We have to be aware of structural problems as well as cosmetic improvements and the costs to rectify both. We do not let structural problems frighten us. Instead, we use those sorts of problems to negotiate a much lower purchase price. A cracked or sinking foundation can probably be fixed for $5000 or less, yet most investors and sellers immediately think in terms of $20,000 to $30,000. Once again, knowledge will be your key to success.

In the tax lien house we just repaired, we considered a complete remodel of the kitchen and bathroom. We could have replaced all the 1952 era windows with the new, double pane thermal insulated versions. We could have replaced the front door with an ornate wood door. We could have landscaped the yard with mature plants and really improved the curb appeal. We didn’t do any of those projects. Why? Because we immediately found a willing tenant/buyer who was happy with much less. There was no monetary justification for doing more than necessary to make the property serviceable. Again, this is a business, not our personal residence.

There will be times when a complete kitchen and bath remodel is called for. So what would we expect to have to pay? I was deadly serious when I told you the entire kitchen could have been remodeled for about $1000. Remember, this is a standard house and only one wall is utilized for cabinets and sink. Home Depot features Mills Pride cabinets which are very attractive and very reasonable. Sink counter tops come prefabricated and ready to install. Attractive flooring is available for $2 per square foot installed regardless of whether you’re using tiles or carpeting. Sure you can pay more, but why? This is a business, not your home. The bathroom can be completely remodeled for $800 to $1200. Many times, it’s cheaper to just rip out all the old materials and fixtures and just start over with new. The reason it’s cheaper is labor costs. It takes time to custom fix and finish old materials. It’s more time efficient to just rip out all the old stuff and start with the new pre-fitted materials available today. You then have new fixtures and facilities for less cost than trying to repair the old.

What about the roof? Yes, $15,000 roofs are available, but not for your properties. Rather a $1500 roof would be most suitable if the roof needs replacing.

What about painting? Once again, you can hire a good, 2-coat paint job inside and out for $1500 including good quality paint.

As you begin to accumulate these individual cost figures for your investment area, you begin to recognize that you can spend just a few minutes looking at a prospective project and very quickly determine whether or not it’s a $5000 job or a $15,000 job, or whatever. That’s as close as it is necessary for you to estimate. Don’t make too much of a project out of estimating what it will cost to repair a structure. It’s only an estimate, after all. It is almost meaningless if you have properly structured the purchase price.

Although the title of this chapter is estimating repair costs, it is closely associated with the price you are willing to pay for the house. Here is how your purchase analysis will tie-in with your repair cost estimate:

We’re looking at a house that really is ugly (as opposed to Ida Mae’s house that was just a little seedy and needed only minor attention). We survey the house looking at all the repairs that will be required. We make a decision as to how much in the way of repairs we will need to do to make the place attractive and yet not exceed the neighborhood standard. That’s where we come-up with the $5000 versus $15,000 rehab cost estimate. Here is the formula we then use to determine how much we are willing to pay.

First we determine what the fair market value (FMV) of the property would be in good condition. For our discussion, let’s say it’s $100,000. Then we reduce (discount) that FMV price by a percentage that we are willing to accept for our efforts and knowledge. This percentage can be whatever you’re willing to accept. I usually use 30% to 40% as the discount factor. If we use 35% as our discount factor, we note that 35% of $100,000 is $35,000. We subtract $35,000 from $100,000 and are left with $65,000. Then we deduct what we estimate it will cost to repair this property; let’s say $10,000. This means that the maximum price we would be willing to pay for this property would be $55,000. Here is how the numbers look:

$100,000 Fair Market Value (FMV) in good condition
35% Our minimum acceptable profit for taking-on this project
$ 35,000 The dollar-denominated minimum acceptable profit we’ll accept

$100,000 FMV

  • 35,000 Deducting our minimum acceptable profit
  • 10,000 Deducting our estimated cost of repairs
    $ 55,000 The maximum price we’d be willing to pay for this property

Of course, we’d try to purchase the property for even less. But why, you ask, would someone be willing to sell us this property for such a discount? Recall that this is not a pretty house; it is a junker that requires a great deal of work to repair. It has terrible curb appeal and most buyers wouldn’t give it a second thought. We know how to repair it at a reasonable cost, but we also insist on being paid for our expertise. The owner of this property also knows it’s a junker and probably just wants to get rid of this headache.

Note again that this “formula” applies only to junker or ugly houses; not to pretty houses that just need minor cosmetic upgrades.

Another benefit we create by properly determining the wholesale value of an ugly property is that we can flip it to another investor that specializes in rehabs. If we’ve correctly identified the proper rehab cost range and have purchased it at a cost sufficiently below retail cost, we can resell the property leaving a significant profit potential for the rehabber and still make a nice profit for ourselves. Think of our talent in this example as being able to find and properly price ugly houses. Meanwhile, the rehabber wants the project but is perhaps not as effective as we are in finding the rehab projects. The bottom line is that we are still in a win-win-win operation: the seller gets rid of a problem property, the rehabber gets a good project at a fair price, and we get paid for our ability to find and correctly price a project property.

NOTE: Stay tuned for Part 7 - Apartments