Accurately estimating the costs of a potential rehab is a vital part of a real estate investor’s job. Not being able to do so will affect your cashflow and your bottom line. This is because most real estate investors, myself included, generally need to borrow rehab funds along with those needed to purchase. Since we have to pay those funds back, the increased payments affect your bottom line for years to come. An example of how rehab costs affect cashflow will help to demonstrate my point.
Before I get started, I am assuming you know what cashflow is and how it is calculated. If not or if you need a refresher, I discussed cashflow and how to determine it here.
The Best Deals Need Rehab
Many of the properties that you will purchase as a real estate investor will need significant amounts of rehab. Yes, every once in a while you may find a cream puff that is in almost perfect condition, but these cream puffs are few and far between. More often, we investors find properties that are outdated, functionally obsolete or just plain run down. It is with these types of properties that we often make the best deals
Accurately estimating how much it is going to take to get these properties functional is thus a big part of our job (see here and here for tips on estimating a rehab). Underestimating the costs will likely lead you to pay too much, while over estimating the costs will cause you to potentially lose out on the deal since another investor will offer the seller a better offer. Messing up the rehab amounts will either cost you money or cost you potential deals.
How Cashflow Is Affected
You find a listing for a four-plex offered at $200,000. In our example here, let’s assume each of the four units rent for $650 per month or a total of $2,600. Let’s further assume that property taxes average $300 per month, while insurance costs $100 per month. Finally, let’s assume further that 90% of the purchase price can be borrowed at a fixed rate of 6% and aromtized over 30 years (Google “mortgage calculator” to find and play with the payment amount).
Let’s put all of that together and look at the initial cash flow numbers.
Monthly Income $2,600
Monthly Expenses
Principal and Interest Payment $1,079
Property Taxes $300
Insurance $100
Repairs and Maintenance $260
Vacancy Credit $260
Reserves $260
Total Monthly Expenses $2,259
Monthly Cash Flow $341
Not a bad but not a great cashflow either. There is a potential deal here with a bit of negotiation. However, this example assumes that there is no rehab needed and no rehab costs are included. While such a scenario is possible, the more likely scenario is that there is a significant amount of rehab needed. In fact, it is often the case that some of the units may be vacant due to lack of repairs.
Adding In Rehab Costs
So let’s re-examine our example and assume there is $50,000 in rehab needed. $50,000 you say! That seems like a lot. Well, it is not really. Sprucing up kitchens and bathrooms, painting walls and installing new flooring does not come cheap. It is easy to spend $10,000 to $15,000 when rehabbing a dwelling unit (I have not even gotten into systems like HVAC and electrical). These numbers are entirely plausible. So let’s add these rehab costs to the amount you need to borrow. You will note that the principal and interest payment has increased.
Monthly Income $2,600
Monthly Expenses
Principal and Interest Payment $1,349
Property Taxes $300
Insurance $100
Repairs and Maintenance $260
Vacancy Credit $260
Reserves $260
Total Monthly Expenses $2,529
Monthly Cash Flow $71
There is still positive cash flow, but it significantly reduced due to the increased amount financed. To me, the cashflow is just not enough to take on the deal. There has to be more cashflow as the margin is just too tight.
Reduce The Price
The best way to increase the amount of cashflow is to reduce the principle and interest payment. There are a number of ways to do that, including seller financing or putting more money down. But, the logical step however is to negotiate with the seller and reduce the price you pay. A $20,000 reduction in price and the amount financed will increase the cashflow over $100 per month.
New real estate investors have to learn how to calculate cashflow and estimate rehab costs. This example demonstrates why it is so important to do so. It all directly affects our bottom line.
