Estimating Rehab Costs: Things NOT to Do

Investing in real estate is a fantastic way to build long-term wealth or to supplement your current income. Like with every other business, though, you’ve got to keep your eyes on the profit. When estimating rehab costs, you need to account for three major components: the price you’ve paid, the costs you’ve incurred during the renovation process, and the sales price your property can fetch on the market once it is renovated. Our previous blog installment highlighted common pitfalls in evaluating the after-repair value of the property. Today’s article focuses on significant mistakes in assessing the costs of owning and rehabbing your investment property.

NOT BUDGETING FOR THE CARRYING COSTS OF YOUR PROPERTY

The costs you are about to incur have two major components. The first one is obvious—it is the amount you are planning to spend renovating your property. There are other types of costs, however. One of the most common mistakes we see investors make when estimating rehab costs is forgetting to budget for them. I am specifically talking about carrying costs or costs associated with owning an investment property.

Carrying costs include property taxes, homeowner’s / condo association dues, property insurance, payments on your loan, utilities, and basic property maintenance such as landscaping upkeep. Remember the joke that there are only two things in life that are certain: death and taxes? If you are in the rehab business, there is a third: carrying costs. These costs can sneak in on you and slowly but surely nibble your profits away, especially if you are making these mistakes:

NOT HAVING RESERVES

There is no way to avoid carrying costs, so you should be prepared to cover them. This is why it’s important not to spend your last dime on paying for renovations. When estimating your rehab costs, you must have enough money set aside to pay for the carrying costs expenses as they occur.

The money set aside to cover both expected and unexpected costs is called reserves. If you are working with a hard money lender, chances are that this hard money lender will require you to have some reserves. At New Funding Resources, we are not prescriptive of exactly how much in reserves you must have. Instead, we use common sense. For a medium-sized project, we might be satisfied to see $7K to $10K in reserves. For more ambitious renovations, you might need closer to $20K.

WASTING TIME

Not working with a sense of urgency is one of the main mistakes a rehabber can make. Each rehab has many components, which might depend on several vendors and decision-makers. To say that managing them is like herding cats is an understatement. You’ve got to keep pushing to avoid your time being sucked into a black hole. Any delay literally costs you money and cuts into your profit.

ESTIMATING YOUR REHAB COSTS BASED ON THE BEST CASE SCENARIO

Almost all of our borrowers have ambitious goals of finishing their rehabs in record time. “It will take me three to four weeks!” they tell us. It’s great to have this sense of urgency – you need to push yourself to finish your project as fast as you can. However, few rehabbers can meet such an aggressive goal. It always takes a couple of months more than you’ve planned.

The same is true when estimating rehab costs. It feels that almost always it costs more than you’ve expected. It’s OK. It’s the nature of the business. Where you run into trouble is when your rehab only makes sense under the ideal circumstances. I’ve seen new investors cutting their previous rehab estimates down ten to fifteen thousand dollars to inflate their expected profits artificially. Of course, at this point, profit is “on paper only” and has very little to do with the reality you are about to face.

Unexpected costs will happen. To avoid working for nothing, plan for them. Do your best to avoid them, but make sure your deal has enough margin to be profitable even if it takes you extra months to finish or if you must fix something that you haven’t planned to fix before.

New Funding Resources is a private mortgage lender that operates exclusively in Maryland, Washington, DC, and Virginia. For over 18 years, we have worked closely with DC area rehabbers to help them make money and manage their risk.