# What's the best way to decide whether a home purchase for gut rehab makes sense?

Asked by Keith Free Ellis, 60622 Mon Aug 4, 2008

How far below current market would you think the home purchase and construction costs should be to make it worthwhile - factoring in a desire for resale in 3-5 years.

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Keith- the Prices are right for purchasing, however they are also NOT right for selling. Good rull of thumb- Purchase price plus cost to rehab should net you 20% in a quick sale. Selling is tough right now, so if you can purchase plus rehab costs at 20% below and wait 3 years to sell you should be fine as long as you can rent it to cover the monthly costs It will be a good investment.
I like Tino's formula. Here's one used by investors. Note: Investors are looking for immediate profits. Not that they're greedy, but no one knows what'll happen in 3-5 years. So, rather than guessing or speculating, they do their calculations based on today's costs and today's expenses. Note, too, that this formula builds in the Realtor's commission (always negotiable) when selling. And it assumes expensive "hard money" to purchase. Your costs would be less to purchase.

MAO (maximum allowable offer) = (After repair value * 0.70) - Repairs.

So you determine the after repair value of the property--what would it be worth today fixed up? Multiply that by 0.7. Take the result and subtract the rehab costs.

In some areas of Baltimore (an area I know a bit about), where a rowhouse gut costs maybe \$80,000, the formula would look like this:

\$60,000=(\$200,000 * 0.7)-\$80,000

So, on a property that, fixed up, would be worth \$200,000 and that requires \$80,000 in rehab, the most an investor would pay would be \$60,000.

That formula results in a number pretty close to Tino's--so you can get a sense of what numbers you should be looking at.

Hope that helps.
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Since your question states 'home purchase' I'll assume you plan on living in the building and making it a home for a few years. Here are a few points to consider.
- Do YOU want to live in this home or location? If yes, then others will probably also find it desirable. If No, then why would you expect others to want to buy it. Don't get into a deal just because the price is low.
- Why a gut rehab? Is the place that outdated? Don't over build for the location or type of home
- What are homes in finished condition going for in the neighborhood? Assuming 5 years out with old school modest price increases can you get back what you put into it?
- What quality work are you planning on.? Low grade flipper quality works if selling the place immediately. Everything will be new and shiny. Buyers won't know the difference. If selling 3-5 years down the road you have to use quality products now. Quality work and products will still look good in 5 years. Cheap stuff will look like the place needs rehab, again.
- Code compliant or garbage work. Buyer inspections have gotten far better. Skimping now can cost you later.
- When rehabbing for resale, consider what others like and trends, not just what you like. Make it nice, not eccentric. Your eccentric might not be the same as other peoples and turn buyers off.
- Don't go will low ball estimates for work. That usually only spells trouble.
- Consider having an inspection and cost analysis done for the project.
Hope that helps
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Keith,

All the answers here were great. The one thing missing is "cost of capital". Where is the money coming from to do this rehab? Are you liquidating a 401k rollover or other retirement account or selling stock to fund this project? If you are, it may not be the best time either. As with any economic cycle, there's a "better" time and a "worse" time to buy or sell assets. It might not hurt to run through some numbers (based on the tax liability for certain transactions) and cost of capital for that time (or loss of profit depending on what you might sell).

What this boils down to is that it may be better to do a rehab or construction loan (rates are especially attractive if it's owner occupied) now with rates being where they are as the cost of your capital could increase dramatically over the next year or two depending on where you got it from or you could have significant unrealized gains for taking funds from the wrong source. With the tax advantages of having the rehab funds in your mortgage, the numbers can get very muddy fast (hence the spreadsheet).

If you want to go into this in further detail, we should meet up. I have an engineering background (I.E. analytical) and this is probably best done with actual numbers and a spreadsheet vs this medium)

You can reach me at 847.404.7006 or by clicking on my profile and reaching me that way.
Web Reference: http://robweber.com
Let us know how this advice worked for you Keith...
Hi Keith-
While these are all great answers, they are old school investor answers. Investors in todays market, begin negotiations sometimes at 30-40% on the dollar. Now, it depends on whether or not you can do a lot of the work yourself or whether or not you will have to hire someone to do the work for you. Looks like you intend on hiring someone (construction costs) And, you must keep costs low, which means even if you intend to live there, you must not outprice your market. You MUST BE AWARE of your numbers at all times! AND, in negotiations, you must remove all emotion! If it's a total gut rehab, in other words down to the studs, replacing electrical and plumbing, you never know what you will encounter. So, once you get to the finish work, you may not always have a lot left over. ALWAYS PLAN FOR WORST CASE SCENARIO.

Hope that helps!
It sounds as though you intend to owner occupy, which makes more loan programs & lower down payment available however, you need to really assess the price point for your location. In rehabs, there is a tendancy to over improve properties buyers intend to occupy. When you buy something already up to date, it may be easer to assess it's value relative to surrounding properties. Good luck with your decision.