Having bought, owned, flipped, and sold hundreds of properties since 2002, I can usually estimate renovation costs within about 30 minutes of walking through a property.

In this case, I estimated approximately $50,000 in repairs.

The roof was shot. The HVAC system was gone. The windows were rotted and allowing water to penetrate the interior. All of the siding needed to be replaced. The electrical system was a mess and needed a complete re-wiring. The kitchen and bathrooms were outdated and needed to be upgraded.

I told the seller that I thought the asking price was too high given the amount of work required. They still wanted to test the market.

And test it we did.

We had more than 15 showings during the first two weeks.

Why?

The after-repair value, or ARV, was approximately $250,000.

On paper, the property looked like a great deal to many retail buyers. But once their agents brought them through the house, reality set in.

With the condition of the property, it was highly unlikely to qualify for conventional financing without significant repairs being completed first.

The buyer was not going to do this. It was being sold as is.

Realistically, the buyer pool was going to be heavily weighted toward investors and other cash or hard-money buyers.

Then the Investors Showed Up

About six weeks into the listing, the investors started knocking.

Once the property had been on the market for more than 30 days, the question became:

“Let’s make a deal.”

Offers began pouring in from investors in the $85,000 to $110,000 range.

As an investor myself, my maximum offer would have been about $115,000.

Here’s how I would have looked at the numbers:

• $250,000 ARV
• $175,000 maximum loan at 70% LTV
• -$50,000 for repairs and contingency
• $125,000 maximum purchase price

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I would actually have targeted a purchase price closer to $115,000, or about 46% of the ARV, because I like having a larger cushion for unforeseen expenses.

And on a property this rough, there will almost always be unforeseen expenses.

Then We Got a $165,000 Offer

By the end of July, another real estate agent brought us an offer of $165,000 from his buyer.

The buyer planned to use hard-money financing, which required an inspection and appraisal.

After the inspection, the buyer requested only one concession: a $7,000 credit toward replacing the roof.

I told the seller that, in my opinion, they absolutely should agree to it.

They did.

We adjusted the purchase price to $158,000 and sent the addendum over for signatures.

I also called the buyer’s agent to let him know the seller had agreed.

While we were talking, I asked the question I always like to ask:

“What’s your client’s exit strategy?”

If the buyer intended to flip the property, I estimated that the purchase price, renovations, financing costs, holding costs, and selling expenses would put his total investment somewhere around $225,000.

That would leave only about a $25,000 gross spread against a $250,000 ARV.

And that’s assuming everything went perfectly.

• No major surprises.
• No construction delays.
• No additional repairs.
• No cost overruns.
• No problems with the resale.

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Anyone who has flipped enough houses knows how often everything goes perfectly.

That is very tight profit margin considering the amount of money being invested.

So I asked the agent what his client planned to do.

You know what he said?

“He’s going to keep it as a rental. He’s fine breaking even for the next few years because his focus is building equity.”

Really?

That got my attention.

Let’s Look at the Rental Numbers

Rents in that area are approximately $1,650 per month at the high end.

Now let’s assume the investor completes the renovation, the property appraises at $250,000, and he eventually refinances at 75% LTV.

That would give him:

• $250,000 appraised value
• 75% LTV
• $187,500 maximum refinance loan

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At 7% interest on a 30-year fixed mortgage, the principal-and-interest payment would be approximately $1,247.44 per month.

That leaves:

$1,650 rent – $1,247.44 mortgage payment = $402.56

Not bad if the buyer is self managing a maintenance free property but the buyer is out of state.

But that is not cash flow.

That’s simply the amount left after principal and interest.

We haven’t accounted for:

• Property tax hikes
• Insurance premiums rising
• Property management fees
• Maintenance reserves
• Capital expenditures
• Vacancy reserves
• Turnover costs
• Leasing costs

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Once those expenses are included, the actual cash flow could easily be close to zero—or negative.

And there’s another problem.

The Refinance Doesn’t Magically Create Equity

The investor bought the property for $158,000 and spends $30,000 on a light renovation.

He’s now into the property for approximately:

$158,000 + $30,000 = $188,000

If the property appraises at $250,000 and the lender allows a maximum of 75% LTV on the refi, the maximum loan would be:

$187,500

So even before accounting for the closing costs associated with the refinance, he has essentially no cash to pull out.

In fact, he would likely have to bring money to the closing table to cover some or all of the refinance costs.

And this is where the strategy starts to concern me.

The investor is paying a relatively high price for the property, putting additional money into renovations, and then relying on future appreciation and loan amortization to create his return.

That’s not investing based on cash flow.

That’s speculation on future equity.

The Problem With “I’ll Break Even”

There is nothing inherently wrong with buying a property for long-term appreciation.

But if your primary justification for buying a rental is:

“I’m fine breaking even because I’m building equity,”

you need to understand exactly what you’re betting on.

• What happens if you can’t achieve your target rent?
• What happens if the property sits vacant for two months?
• What happens if the HVAC system fails?
• What happens if you have a $10,000 plumbing or foundation problem?
• What happens if property taxes or insurance increase?
• What happens if the market declines?
• What happens if the property doesn’t appraise for $250,000?
• What happens if your renovation costs $40,000 instead of $30,000?

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Every one of those scenarios requires additional cash.

And that’s the problem with a thin-margin rental.

There isn’t much room for error.

The “Lipstick on a Pig” Strategy

My guess is that this investor will do what I call a “lipstick on a pig” rehab.

Instead of spending the $40,000 or more that I believe the property really needs, he may try to get the renovation done for around $30,000 or less.

That might work.

Or it might not.

The problem is that cutting $10,000 from the renovation budget doesn’t necessarily save $10,000.

Sometimes it simply moves the expense from today to tomorrow.

And once the tenant moves in, those deferred repairs become much more difficult and expensive to address.

Stabilization Takes Time

One thing many new rental investors underestimate is the time it takes to stabilize a property.

Stabilization isn’t simply putting a tenant in the house.

For us, stabilization means getting the property occupied and then going through a period of time without significant maintenance requests or other problems.

Even when we completely renovate a property and deliver what we believe is a maintenance-free rental, the first few months of occupancy almost always reveal something.

• The septic backs up.
• A plumbing issue develops.
• Water pressure isn’t what it should be.
• A drain backs up.
• An appliance fails.

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There may be an issue with the septic system.

On a fully renovated property, it typically takes us about three months to feel like the property has truly stabilized.

On a property that received a light renovation, I would expect the potential for even more problems.

Everyone Has Their Own Strategy

Maybe this investor will prove me wrong.

Maybe he’ll get the renovation done for $30,000.

Maybe the property will appraise for $250,000.

Maybe he’ll get $1,650 per month in rent.

Maybe he’ll have a great tenant who never calls.

Maybe nothing major will break.

Maybe the market will appreciate.

If all of that happens, his strategy could work.

But that’s a lot of “maybes.”

As investors, our job isn’t to make the numbers work when everything goes right.

Our job is to structure the deal so that it still works when things go wrong.

That’s the difference between buying a property because you hope it will build equity and buying one because the numbers make sense from day one.

This investor has his strategy.

I have mine.

Who am I to stand in his way?