I’m so glad I learned about parallelograms instead of how to do taxes. It’s really handy this parallelogram season.
My wife heard somewhere that HGTV was great to put on the TV to entertain our dog when we are away, because it doesn’t have sudden loud sounds (um…how is the destruction of cabinets and drywall not loud?).
I have no idea if this is urban myth or not. But, to keep my wife and our dog happy, we turn on HGTV whenever we’re leaving the apartment for any noteworthy period of time so that the dog doesn’t feel abandoned.
Let me confess: I have a pretty heavy fascination with Lottery Dream Home. Everyone has their vice, right?
One day, we were preparing to leave, so I turned on HGTV. I believe the show that was on is called Home Town. The premise is that a couple finds, renovates, and sells homes in their home town of Laurel, Mississippi. In each episode, they find a house, estimate the costs, and then estimate the sales price, and thus is born a show.
We’d turned it on right as they were showing the math of their latest fixer-upper.
It took a minute for the math to dawn on me, and I rewound the Hulu to take a picture.
On the surface, perhaps this is a good deal.
- Purchase price: $35,000
- Renovation cost: $120,000
- Total investment: $155,000
- Sale price: $175,000
- Potential profit: $20-25,000
Don’t you like how they just fabricated $5,000 of profit out of thin air? Nothing like making your profit margin jump by 25% just by waving a hand.
So, let’s stick with their numbers and talk about some of the things that they might have forgotten to include in their magic math.
- Selling commission. Unless they’re licensed real estate brokers themselves, they’re going to pay 6% to Realtors for the sell and buy side commissions. Sure, they might be able to do this through private parties, but chances are fairly high that they’re going to have to use a Realtor to get top dollar for the property. So, if they sell for $175,000, there goes $10,500 of their $20,000 profit (I’m not including the magically arrived upon $25,000).
- Other closing costs. When I sell a house, I have to give a concession for pro rated property taxes, since the new buyer will be on the hook for property taxes. Jones County, Mississippi, where this show is filmed, has a 1.0474% property tax rate. Since we don’t know when they sell, let’s assume a half year. Annual property taxes on an unrehabbed $35,000 home are $366.59. They’ll owe $183.30 at the close in buyer’s credits. We find our costs at close approximate 10% of the sale price, but our property taxes are about 1% higher than theirs. So, let’s call it 9%. 6% of that is Realtor commissions, so we pay about 3% in other closing costs. For this deal, that would be $5,250. Even before any other costs are added in, their profit is down to $4,250.
- Cost overruns. They have their own crews and do a lot of the work themselves, so, for the hosts, this might not be an issue. For ordinary real estate investors, we generally have to trust our contractors. As mine likes to say, “I never really know the price until I’m inside the drywall.” I tend to assume a 20% cost overrun in my modeling to account for the unknown. If you’re a mere mortal real estate investor who sometimes faces a 20% cost overrun, then you’re looking at another potential $24,000 in cost. Profit vaporized.
- Mortgage carrying costs. While we do not use debt to purchase our rental properties, a lot of investors are either a) unable to achieve that goal, or b) willing to take the financial risk to get leverage and improve ROI on their own cash. Let’s assume you work with a conservative bank who requires 30% of total cost down and charges 8% interest with 1% closing costs. Let’s further assume you have a 15 year mortgage and that it takes 3 months to do this type of rehab, and you closed as soon as rehab was done. You’d need $46,500 as a down payment and a mortgage of $108,500. Closing costs would be $1,085. You’d pay 2 mortgage payments (assuming a 30 day grace period) of $1,036.88 each. That’s another $3,158.77 out of pocket, of which you’d pay down $629.19 in your mortgage, leaving you at a net position of a $2,529.58 of costs.
While most real estate investors cannot control the first two costs, they can potentially control the second two costs.
So, let’s just assume that they were dead right about their numbers, minus the magic $5,000 that came out of thin air, but they also, while making a magic $5,000 appear out of nowhere, conveniently forgot to account for the first two costs in their analysis that came up on the screen.
$4,250 profit off of $155,000 investment. That’s a 2.74% ROI. Annualized, it’s a 11.4% ROI, assuming you can sequentially line up 4 projects of the same scope and nail the timing.
Without an exorbitantly high rental rate (for this, it would have to be at least $2,583.33/month), I’d never make this investment.
What would we do? Check out my real estate investing guide, “Getting People Who Live in Houses to Pay You” and see for yourself.
Would you invest in that property? Let’s talk about it in the comments below!