At one point or another, an investment property will need to undergo some repairs. If you do flips or if you rehab properties before renting them out, these repairs could occur right after the purchase. If you rent the properties – short term or long term – you will likely have to do some repairs due to normal wear and tear or due to tenant negligence. There’s also the possibility of some unforeseen event, such as a hurricane or a water leak, that would require you to make an urgent repair. In all these cases, it’s always worth understanding the true costs of repairs and their financial impact on your investment.
In this article, we explain the math behind the financial implications of repairs and renovations for investment properties. We also provide a few tips on how to go about estimating some of the financial impact of the job you’re considering.
Avoid the common pitfall
Before we dive into the details, let’s look at an example of a repair project. You find a distressed house in a reasonably nice area listed for $100K. The house has “good bones” (i.e. can be repaired rather than replaced) and you estimate that you can bring it back to its glory days for around $30K. You start looking around the area and you find that similar houses in better shape sell for around $150K. You get excited at the possibility of making $20K on this project in equity, if you repair and keep the house, or in cash, if you flip the house. A nice 15% return, right? Can you tell what’s wrong with this math?
This is a very common trap that both beginner and expert investors fall into. It’s often referred to as “TV math”, alluding to some fun-to-watch real estate projects that are not so mathematically accurate. The math above is missing a few impactful costs that could make or break this deal. For example, this project might take you 6 months to complete. During that time, the property is vacant, but you might still be paying your property taxes, loan interest, insurance, and utilities. If those come up to $10K, your investment return is now around 7% and you’re better off just keeping your money in a stock index. If the repairs drag on due to additional unforeseen issues like additional water damage in the foundation, the repairs might completely eat into your profit. So how do you estimate the full financial impact of property repairs?
There are 3 major components to this exercise:
- Estimate the repair costs
- Estimate the holding costs
- Estimate the after-repair value of your property
We will talk about each of them in more detail below.
Repair costs are the estimates for the labor, materials, and any potential permits or miscellaneous costs to make the planned improvements. The first step in estimating repair costs is to come up with a list of the repairs that are needed and at what quality level they need to be made. For example, if you’re redoing the kitchen, do you plan on replacing the counter tops with fancy granite or with an inexpensive laminate? As you draw up your list of repairs, you will invariably have to decide on the level of quality most suitable for the style of the property, the area where the property is located and the type of residents it will attract. Spending some time thinking about your strategy for the improvements will help you prevent runaway costs and avoid delivering updates that are not worth the investment.
Holding costs & foregone rent
As we discussed above, there are costs like property taxes or loan interest that you likely pay even before the property is rented or sold. These are called holding costs. They are generally comprised of property taxes, insurance, utilities, and loan payments. You may also incur HOA fees or other miscellaneous costs depending on your property’s location and type. Additionally, your property is likely going to be vacant while undergoing major repairs. You will likely forego rent as well during that time.
As mentioned above, it’s important to include holding costs and the foregone rent in your calculations to make sure they don’t unexpectedly eat into your profits. Padvest already factors in most of these into your deal so you don’t end up missing them. Enter the number of days you expect the repairs to take. Padvest will then estimate your holding costs based on your property’s operating expenses and the rent estimates.
After-Repair Value (ARV)
The after-repair value (or ARV, for short) is the value of your property after the improvements are made. The after-repair value of the property is based on comparable property sales (or ‘comps’ in real estate jargon). In other words, if you were to turn around and sell the property after the repairs and improvements are complete, a potential buyer will pay for your property around the same price as other similar properties in your market.
You can reach out to a real estate agent to request them to provide you with comps for your property. You might even hire an appraiser to evaluate the value of your property. However, if you are evaluating tens of deals every month, it might become cost-prohibitive to follow these approaches.
An alternative is to do this analysis yourself. The first step is to gather information about your property such as city and state, zip code, neighborhood, property type, number of bedrooms, size of the property and its associated lot, zoning information, and when it was built. Padvest provide you with all these details directly from public records.
Make sure to note any improvements you’ve made or plan to make to the property that might not be reflected in current records. For example, if you add an extra bedroom or a completely new unit, make sure you factor that in.
Next, go to your favorite real estate listing site and start a new search for the zip code or area where your property is located. You can use Redfin, Zillow, Realtor or any other website you prefer. Depending on your website, make sure to adjust the filters so it shows you recent sales. Here are a few ways to narrow down your search criteria:
- Filter properties based on number of bedrooms and size that is similar to your property. Leave some leeway in the numbers so you don’t end up filtering too much.
- Look for recent sales in the last 2-3 months.
- Limit the search radius to contain it to your area. In more dense areas, it might be sufficient to limit your radius to less than a mile from your property. In more disperse rural areas, you might have to raise this number higher to get enough matches. Many websites allow you to draw a boundary on the map to make this easier.
- Export the results out to a table in a spreadsheet.
Now that you have a nicely tabulated set of results, compare your property to the table and select the properties that most closely match yours. You can then determine the estimated value for your property.
Putting it all together using Padvest
Now that you have the repair costs, holding costs, and ARV at your disposal, you can complete your deal evaluation. Repairs play an important role in your property’s lifecycle and have a significant impact on the overall financial analysis of your investment property.
Padvest makes it a lot quicker to go through this process and see your deal financials quickly:
- Open an existing report or look up a new property address using Padvest
- Scroll to the Cash Flow section of the report and click ‘Edit’ next to the Repairs line item
Note: If you are on a mobile device, you will need to expand the details under Cash Flow to see the repairs line item
- Fill out the form and save
Your report will update to reflect the repairs and their impact on both the cash flow and long term equity. Now you can compare the financials before and after the repairs to determine if you can add value to your investment.