Today, we continue our series on the “10 Commandments of Foreclosure“. (See Part One Here) (See Part Two Here). Not written in stone, but you ignore these rules at your peril:
- Know thy Process
- Know thy Property
- Know thy Title
- Know thy Parties
- Know thy Occupant
- Know thy Judge
- Know thy Repairs
- Know thy Exit Strategy
- Know thy Buyer
- Know thy Closer
We covered #1-#3 in Part One.
#4-#6 was addressed In Part Two.
Part Three (this post), covers #7-#10 (Repairs, Exit Strategy, Buyer and Closing).
When we are done with this series, you should be fully prepared to bid at a foreclosure sale… or you should be too scared to bother.
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PART THREE
#7- Know thy Repairs
Estimating repairs is the single most important profit factor… and helps determine your maximum acquisition price.
How to Estimate Repairs
First, be honest about the extent of repairs needed to flip or rent a home. That is really the most critical step in your estimating process.
Honesty means you are looking at the repairs from your end user’s viewpoint. You never want to leave something undone that turns a buyer off. But on the other hand, you don’t want a bunch of upgrades that won’t increase the value to that buyer. You can’t be an optimist, or your budget gets trashed when reality hits. But a pessimist will never buy a house, because every deal looks bad. You need honest, realistic, end-user based estimates.
Make sure the repairs or improvements you are looking at are justified by the property. I love the patina of hand-scraped wood floors…. but I’d be insane to put them in a rental house. At the same time, upgrading laminate counter-tops to granite might be just the ticket to sell a high-end house. Again, the key is to focus on the expectations of your end-user. NOT what you would want if you lived there (CLASSIC rookie mistake)– but rather what your buyer or tenant wants to see.
Add for Contingencies
What are contingencies? The unexpected things. The hot water heater that doesn’t heat. The pool pump that craps out the day of closing. The mold the last owner painted over. The amateur wiring up in the attic. The surprise things that pop up, despite your best efforts to put together a realistic budget.
The other contingency to budget for is the basic tendency of contractors to over-promise. It always seems to cost more and take longer than they originally thought. Especially when they realize you are new to the game. But even with the most honest contractor, every job is going to contain a few hidden surprises.
When we estimate repairs, we automatically tack on an extra 10% for contingencies on new construction (less than 10 years old) and about 25% for older homes. This covers most of the surprises that were lurking beneath the surface, provided we did a good job of being honest about what repairs went into our initial budget.
Contractors vs DIY
Until you have been doing this a while, you will pay at least 25% more for contractors and laborers than someone who does this full time…. AND it will take twice as long. When we call our AC guy, we are asking him to put in three new units this week. Our electrical contractor is going to one of our job sites every week. So whose call is the electrician returning first? A first time customer asking about a price quote… or the guy who is making his boat payment? The best price is always going to the loyal, proven repeat customer.
Contractors are expensive. So lots of investors are tempted to do it themselves. But doing it yourself can be even more expensive that hiring a pro. Sure, there are some things where a little sweat equity might pay off… painting or putting out mulch. And for your first few houses, doing all the work can be a source of pride and accomplishment. But even if you are experienced AND competent, is it really the best use of your time? Or would you be more productive hiring someone else to paint so you can concentrate your time and energy on finding the next house you want to buy? If you enjoy doing rehabs, then by all means, knock yourself out. But time is money too.
Also consider the impact of permits, insurance, compliance with code… all things your pro will take care of for you. And consider the liability… the waiting lawsuit… if something isn’t done right.
Repairs determine acquisition price
When I am bidding on a foreclosure house, I pretty much know exactly how much the house is going to sell for once it is fixed up… and so do all the other experienced investors (we are all likely within 3% of each other).
And of course I know my minimum required return to be involved in a deal.
So that leaves just one variable: repairs.
If I plan on rehabbing and flipping a house, I’m going to base my maximum foreclosure sale bid price on what I think I can sell the house for once I’ve fixed it, less any expenses I plan on incurring, less my required profit. Easy math.
So if we are bidding against each other and we have the same notion of value and repairs, and we both plan on rehabbing and flipping, we are really just bidding to see who is willing to take less profit on the deal.
That repair number is really the most important factor in the equation, and even experienced investors will have wildly different estimates on repair bills. I’m not often wrong on the value of the home, but my repair number is often way off base. Sometimes too high… sometimes too low. And errors either way cause problems. If I overestimate the repair costs, then another investor is buying that house at the sale. If I underestimate repairs, I make less than I needed.
Extras
Years ago, I read an article by lawyer/investor William Bronchick that he now calls “10 Easy Ways to Spruce Up your Rental or Rehab“. Great read. We swear by this list…. we always look at each of these as possible extras when doing a rehab. These are things that rarely NEED to be done, so they are easy to overlook when estimating repairs. But the money spent on these extras always pays dividends when your first buyer or tenant walks into the house.
- Replace electrical plates
- New six-panel interior doors
- New door handles
- Paint trim
- New front door
- Tile Foyer Entry
- New Shower Curtains
- Paint kitchen cabinets/New faucet
- Add shutters
- New mailbox
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#8- Know thy Exit Strategy
Begin with the end in mind. Always good advice. So what are you looking to do with this house you are buying at the foreclosure sale?
Once you buy the foreclosure for cash, what is your exit strategy… your end use? Different investors might specialize, or you may be open to multiple end uses, such as:
- Flipping Wholesale
- Flipping Retail
- Renting
- Lease Option
- Contract for Deed
- Owner Finance
It’s a good idea to know what other investors are primarily interested in doing with the homes they buy. You may find a bargain outside the sale that is perfect for the foreclosure investor who likes rentals. More importantly, it helps explain why someone bidding against you thought the property was worth a lot more than you did… they may have a different end use.
I have four different exit strategies when buying foreclosures, which give us a fair amount of flexibility (especially when bidding against other investors interested only in a quick flip):
- flipping to other investors who want to do the rehab (wholesaling),
- rehabbing and flipping to an end user
- rehabbing and renting
- rehabbing and selling to a buyer who needs owner financing.
Obviously, the exit strategy for a specific property depends on the age, condition, neighborhood, needed repairs, etc. But we always know our exit strategy BEFORE we bid on the house.
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#9- Know thy Buyer
Who is going to buy or rent your house? What are they looking for?
Take the time to picture your typical buyer or tenant for a particular house, preferably before you buy it, but at the very least, before you start working on it.
- What repairs, improvements, upgrades or extras will they expect?
- Do they care about local schools, nearby shopping, public transportation?
- Will your buyer shop on their own or through a realtor?
- How does your buyer make the decision to buy?
- How are they financing (Conventional, USDA, FHA, owner financing)?
- What concessions or costs will they need?
Obviously, you are not going to discriminate against someone other than your typical buyer. You aren’t going to exclude anyone. But by targeting your rehab and marketing to your intended audience, you stand a much better chance of making them happy.
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#10- Know thy Closer
Most people refer to the person at a title company or law firm who handles the contract closing paperwork as the “Closer” or “Closing Agent.”
But my definition of a “Closer” is anyone who can make or break a deal. Here are a few of the people involved in the sale or leasing of your rehabbed property:
- Listing Agent
- Selling Agent
- Home Inspector
- Appraiser
- Mortgage Broker
- Mortgage Lender
- Mortgage Underwriter/Guarantor
- Title Underwriter
- Title Agent or Lawyer
Any one of these people can scuttle your deal… or help make it go through. As an investor, you need to know what each of these people are looking for in the process.
A closing has many working parts, and getting everyone involved to work together ultimately falls on the shoulders of the person selling the home. After all… you don’t get paid if just one thing goes wrong.
So get to know ALL the closers, anticipate what they need, and make sure they have what they need to move your deal on to the next step.
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To be more specific, the FHA “second-appraisal-on-flips” requirement sucks.
We’ve decided not to accept FHA contracts for now. They are just too much of a pain in the ass. It means we won’t have as much competition for our homes (since the vast majority of borrowers are going FHA), and that probably means a haircut on our prices. Which means we are helping to keep the real estate recovery at bay.
