Should you REhab or PREhab? Most real estate investors have heard about (and many have participated in) a REhab. Made famous by reality TV shows, a REhab is when a real estate investor renovates a dilapidated property into a sparkling home, so it can be sold to a retail buyer.
Far less known and rarely executed by real estate investors is the PREhab. Rather than selling to an owner occupant, with a PREhab the goal is to sell to a special type of investor-buyer.
First, you clean the property, remove junk, and perhaps do some light cosmetic work. Then, you get an appraisal and an inspection. Finally, you bring in contractors to put together bids.
Although similar to wholesaling/flipping, what makes the PREhab unique is the preparation prior to selling to an investor. This prep work allows the PREhab investor to “flip” or “wholesale” the property at the very top price of the investor-buyer market.
To REhab or PREhab, That is the Question…
The answer to this important quandry was revealed to me through the school of hard knocks. It started out as a hunch after buying and selling houses to retail and investor-buyers for years myself. Then, it became more clear to me after coaching and mentoring others from all over North America.
Unlike most real estate investors, I have had the distinct advantage of being able to review thousands of investment deals over the past decade because of my position as a real estate coach and mentor.
An unmistakeable pattern emerged after evaluating hundreds of real world deals from all types of areas, in all types of markets, from all types of real estate investors. It went against what so many others teach and for sure what you see on HGTV.
It is rarely, if ever, talked about at local real estate investment club meetings and almost no investors do it. For creative real estate investors, it could be the missing link.
So, What Is It, Phil?
Before I reveal this real estate investing breakthrough to you, let’s take a walk through of the typical REhab deal. The following is a real deal…
- A property in need of significant repair is for sale for $65,000 in a decent neighborhood of Chicago. An enterprising real estate investor connects with his power team, and his general contractor tells him that there is no way it will cost more than $28,000 in order to bring it up to a level that he could sell it for top market price to a retail buyer. His Realtor shows him numerous comparable sales to support a conservative sales price of $150,000.
- The profit looks incredible, and the investor can’t believe his good fortune! He conservatively estimates it will take two months to complete the work, even though his contractor swears it will be much faster than that. He adds another two months to sell it. His best funding source is a hard money loan because it doesn’t require a credit check or down payment, and it will fund the fix up costs. The hard money will cost 5% interest plus 15% per year.
- He negotiates the seller down to $60,000 and after closing costs, he is in the deal at $64,000. So far, he is the happiest real estate investor around. He is bragging to his friends and family how awesome he is–buying a home that will sell for $150,000 for $64,000 without using any of his own cash or credit. He’s on top of the world.
- The repair work starts off great, but soon, delays begin to creep in. Some of the subcontractors fall behind, and that throws off the schedule of upcoming subs which creates more delays. The real estate investor overlooked a few details and that adds to the cost of the renovation. Week after week, month after month, the investor drives to the property to inspect progress and seems to find more and more problems. It feels like a never ending saga. Rather than two months, it takes four months to complete the work. Rather than $28,000, it costs $34,000.
- The now-exhausted soon-to-be real estate tycoon puts the property on the market for $150,000 and after two months, he has no bites. His Realtor says he should drop the price and offer to pay the buyer’s closing costs.
- After three months on the market, he finally gets an offer of $140,000. He accepts the offer, but during the inspection, the new buyer finds several problems that must be fixed prior to closing. Another $2,000 in repair work later, the new retail buyer is happy and they go to closing.
- Mr. No-Longer-Happiest-Investor-Around looks at his final profits in absolute shock:
$140,000 Sales Price
– $64,000 Total Purchase Amount
– $8,400 Realtor Commissions
– $4.200 Buyer’s Closing Costs
– $1,400 Seller Closing Costs
– $36,000 Renovation Work ($28,000 estimate + $6,000
unexpected + $2,000 to appease the new buyer)
– $15,000 (5% plus 8 months at 15% per year, or 15% of the
$11,000 Net Profit to the Investor
This is a true story. In fact, it happened last week. And it happens every day of the week all across North America. I’ve seen it a hundred times (literally).
What Went Wrong?
How did the real estate investor only make $11,000 when he bought a $150,000 property for $60,000?
Some people will take a magnifying glass to each major expense and assess the problem as “rookie mistakes.” Such as:
- Estimated Value: Maybe you’re thinking, it wasn’t a $150,000 property, it was a $140,000 property! OK. You’re correct. In fact, most people overestimate how much a property will sell for when they first buy it. Whatever you think it will sell for after pouring over all the comparable sales, reduce it by 8% and you’ll be more accurate.
- Cost of Funding: Maybe you think he paid too much to the hard money lender. Perhaps, but he didn’t have to use his own cash or credit, and all of his renovation costs were paid for by the loan. His bigger issue with the money was that he paid it off after 8 months, rather than 4 months.
- Too Long to Renovate and Bad Cost Estimation: His renovation took double the estimated time and $8,000 more. Perhaps that is where he went wrong? I would argue that such an outcome is quite normal. Even the best contractors miss the mark sometimes, and there are always things you didn’t expect. I have seen over and over and over again that renovation expenses can run about 25% more than budgeted, and the project can extend several months. In other words, it always takes longer and costs more than you anticipate, even when you are a seasoned pro with years of renovations under your belt.
- Hidden Costs: REhabs have hidden costs that are rarely calculated. The time to drive back and forth to the property to track progress. The mental energy to think through all the unexpected problems. The extra phone calls from the contractor and the subsequent decisions you have to make. And let’s not forget the extra “little” trips to Home Depot. This all adds up.
Is the Problem the Process… or the Model?
Herein lies the answer to this game changing question. The REhab model is fraught with pitfalls and places where costs can greatly expand. The problem is the model.
Rather than close on a property, renovate it, and resell it to a retail buyer (aka REhab), instead PREhab it. This deal could easily have been flipped to a special type of investor-buyer for $70,000, perhaps even $80,000. Then, the profit would have been $10,000-$20,000 for less than one month’s work.
The special type of investor-buyer I am referring to is a contractor investor-buyer. These people are full-time contractors who do one or two REhabs per year. They save a tremendous amount on renovation costs because they are their own contractor. Plus, since the profitability of the project impacts their bank account, they are more efficient, so delays and overruns are minimized.
They are rarely the types who continually educate themselves on real estate investing, so they probably aren’t reading this article. Further, you won’t find them at your local real estate investor club meeting. But they are out there in every community.
So Let’s Compare…
The average REhab ends up earning 10% to 20% of the final sales price and takes six months and tens, if not, hundreds of hours of an investor’s time. The average PREhab earns 5% – 15% in less than two months with twenty hours or less invested. Therefore, it’s more efficient to PREhab. In Tennessee parlance, “A quick nickel beats a slow dime.”
Are there exceptions to this rule? Of course. However, it’s tough to go broke taking a profit. Far more people have fallen victim to the REhab than the PREhab.
Most real estate investors go through several REhab projects before they finally see the light. But you can avoid having to learn this lesson the hard way: PREhab rather than REhab.
What do you think? REhab or PREhab? Post your comments below.