4 Must-Knows Before Taking on a Distressed Property
Have you ever looked at a distressed property—a truly distressed property—and been thrilled with the idea of buying it, renovating it, and renting it?
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It can be an appealing notion, especially if you’re an investor with an imagination.
With so many areas undergoing revitalization, the idea of taking a cheaper distressed property and making it something valuable in an up-and-coming market seems attractive.
But is it actually worth it?
To really answer the question, we have to first get on the same page about exactly what is a distressed property and what makes it different than, say, a regular fixer-upper.
Think of it this way. Your average, everyday fixer-upper is a property where an investor can see some subtle changes and improvements in their mind’s eye and know that those improvements will increase the value. This would include basics like quality paint, new flooring, maybe removing a wall or moving some rooms to change the flow of the house. An investor can see minor changes that are relatively small-dollar improvements and know that those changes will help them meet their ROI.
Whether an investor intends to hold for long-term or to try for a quick turnaround sale, these types of properties are ideal because of forced appreciation. If an investor can perform the right renovations and do them inexpensively, then the return comes from the forced increase in value. This allows them to pay more and consider more properties with lower discounts.
On the other hand, a distressed property, for the sake of this discussion anyway, is one that has a few more warts than your average ole fixer-upper. Those warts could be fire damage, water damage, foundation issues, and years or even decades of neglect and vacancy. A distressed property comes with its own set of issues, and they are truly unique.
Those issues are often enough to scare even experienced renovation investors away from a deal. They are simply too big, there are too many unknowns, and they come with increased risk. So, why the appeal?
Along with risk, they often promise an even bigger reward. It takes nerves of steel to walk into a distressed property in need of a complete overhaul and smile like you know this is going to be a home run.
With all of the unknowns, the questions and the risks, these highly distressed properties hold a promise that is very enticing. So what does an investor need to know before embarking on a challenge like this? We’ll start here and see where this list takes us.
4 “Must-Knows” Before Taking on a Distressed Property
1. Low market price doesn’t mean low-cost.
New investors often make the mistake of buying the cheapest properties on the market, thinking that they’re going to make the best investments. It’s not bad logic: Reduce your costs by saving on the property, and you’ll earn more, right? Not so fast!
A low-cost price tag for a property does not always mean the property isn’t as valuable. You can rightly assume the quality isn’t there, at least when you buy it as-is. You can assume the property is discounted due to the condition and work needed. But that does not mean that you ignore basic investing 101.
An investor still needs to know the basics of how they are going to earn a return on a property. A cheap property in a bad area is still going to demand the same low rent no matter how nice you make it. Therefore, you cash flow won’t be as good. Ask me how I know this!
Obviously, a distressed property has that nice low price tag because it has some problems. Those problems have to be fixed. Even if that initial price tag looks nice, you have to know that you’re about to need to go through the costs of getting it to a place where it pays off. And you have to be open to the fact that the payoff simply may not happen with that property, no matter how low-cost and attractive the price may be.
Maybe you aren't going to go through the full lengths a flipper would, but it still adds upâand you don't necessarily have the advantage of leveraging a bank loan to pay for your renovation costs. It's an investment in and of itself to fix it up!
So make sure on the front end that you know exactly how you are going to make the numbers work. Are you holding for a long-term rent or are you planning to sell the property quickly? Either way, know your numbers on the front end and understand how every dollar you spend will effect your final ROI.
Never forget that highly distressed properties hold secrets. You have to budget and account for them. This is not some arbitrary number. You really need to go through and consider what major costs may be hidden due to age of the property, amount of time it has been sitting distressed, and what special distresses that property holds. Each of those factors can increase your hidden costs and makes what looks like a sound, quality investment turn into a money pit.
2. They take much more direct investment.
Speaking of the renovation costs, handling a distressed property does take much more investment and involvement than a traditional investment property. Distressed properties don’t need sprucing up. They need major overhauls that often take long renovation timelines—you might be completely overhauling the sub-flooring, foundation, roof, plumbing, electric, and flooring. You might need to create new spaces or redo the layout.
There are any number of big-ticket items that could come into play on a distressed renovation. Those big overhauls can be very, very costly. Sometimes they can cost as much as you paid for the property itself. Not only that, but it’s not necessarily something you want to be hands-off with. Honestly, distressed real estate can be a little unpredictable.
3. Unanticipated risks abound.
Whether it was old or neglected, distressed rental properties can be chock full of hidden risks. Inspections may not save you here when you’re calculating costs. There are the property issues you could run into, such as mold, septic issues, asbestos, foundation problems, and any number of costly problems.
But there are other things that we don’t always consider: an unclean title, unforeseen issues with the bank, issues with neighbors, and even zoning issues.
It can get tricky. It can turn into a massive headache and can consume much more of your time than you budget for on the front end. And it really isn’t for the faint of heart! These types of projects have the ability to suck the passion out of an investor, so you have to be strong-minded on the front-end.
There will be issues—be prepared to deal with them or don’t bother in the first place!
4. It’s a flipper’s game.
Buy and hold investors typically aren’t the ones who go after these highly distressed properties. One of the reasons is this: When a flipper takes on a distressed property, they have a few advantages when they flip it versus trying to rehab it as a rental. One, they’re looking at the short term. They don’t have to worry about future market fluctuations to wonder if their current investment is going to pay off down the line.
They pretty much know what they’re going to get out of it in the end, and they understand the risks associated with the unknown.
Two, experienced quick turnaround investors have this down to a fine art at this point. Experienced investors know how to handle the unexpected horrors of distressed real estate. Inexperience can kill you when it comes to these types of properties, but knowing how to handle them can reap big rewards.
They have a shorter runway from purchase to return and therefore they are able to calculate a slightly different risk tolerance. A buy and hold investor who needs a property to hit a very particular number on the bottom line in order to be profitable may find themselves either cutting corners or pushing the rental market to make a deal work for the long haul.
Again, in this scenario, an experienced buy and hold investor who targets these types of projects may already know on the front end that they can break even with a rental for a short period of time (usually two years or less) and then sell the property for a more modest return when the market allows.
Bottom line: Experience rules the day, and having a very open mind and clear understanding of risk usually only comes with experience.
If You’re a Buy and Hold Investor, Know This…
You don’t need to rely on capital appreciation to succeed.
Renovating cheap properties and renting them out isn’t going to bring you success. It might work for you as a strategy, but there is so much risk involved! You can invest successfully without so much leg work and risk.
If you want to flip, by all means, buy all the distressed properties that you want. But if you’re looking for long-term real estate investment, you don’t need to look for cheap properties to be profitable. What you need is quality.
I will save the argument of DIY real estate versus passive real estate for another day, but the idea of finishing with quality plays an important role when deciding whether or not to buy highly distressed properties and what your ultimate strategy will be.
As for the original question of “are they worth it?”
As a very experienced real estate investor and entrepreneur, I can attest to one recurring theme: Highly distressed properties work best for investors who have a lot of experience, capital, and talented teams at their disposal. Regardless of long-term buy and hold or quick turnaround, the key is experience. If you have that, they are definitely worth the effort!
We’re republishing this article to help out our newer readers.
What’s your opinion—do you take on highly distressed properties or are these something you avoid?
Weigh in with a comment!