Adding Value with Rehab Costs - a conundrum
As I continue to evaluate flipping homes I am perplexed by this question:
How is it possible to add market resale value at a cost that is less than the market value you add?
If a house is currently worth $50K and a contractor estimates it will take $25K to rehab - why would the market value the home at something greater than $75K?
It seems to defy economics. I can see if you yourself are a contractor and can get the work done "at cost" that you yourself will have created value and realize it through the sale of the property. If an investor who does no work pays someone to do the work ( the cost of the work, plus the profit they require to do the work) how will there be any profit left over when the investor intends to sell. Why wouldn't a prospective home buyer, instead of an inventor, purchase the house and perform the rehab costs himself at a cost of $25K and live in it for $75K instead of buying from an investor who will look for profit of the $75K?
I know there are flaws in my thinking, that is why I am hoping experienced investors can shed some light on this for me.
If I think of it in terms of another product the problem becomes more clear (I'm hoping the solutions do as well). Let's say there are two separate companies: an oil drilling company and an oil refining company. It costs an oil drilling company $50K to drill and gather unrefined oil. He sells that unrefined oil to a refinery who refines it into gasoline for a cost plus profit that in total equals $25K. Why would the market pay more than $75K for the gasoline?
The only reason why I believe the market would value the home at greater than $75K are as follows:
1. Supply is so great for contractors services as compared to demand for housing that there is a disparity that creates inefficiencies in the market. In other words - there are too many contractors compared to work needed. This drives down prices for contractors services. At the same time, demand for finished homes is high enough to keep the market viable. I think a really smart economist could elaborate on this. Frankly, I'm not smart enough to hash out the details - but hopefully someone here can. Furthermore, profiting from this inefficiency sounds like arbitrage which is scary. When arbitrage occurs and investors have the ability to capitalize on inefficiencies they eventually eliminate the profit opportunities as the market corrects itself.
2. Sometimes the market simply does not value the home for more than $75K. In other words the investor paid retail prices for contracting work and he cannot add value for greater than the cost to add it - thus he makes no money.
3. To answer the question regarding the oil - "why would the market pay more than $75K for the gasoline?" The market (customers) does not have the ability to refine oil so it must pay someone to do it - at a profit.
In the case of real estate flipping - our buyers do not have the ability to purchase the home and rehab it at the same cost you can. What ability are they lacking? The only thing I can think is money. They can't get a loan on a distressed property. They don't have cash to pay for rehab costs. Thus the market is paying us to do something that our customers cannot or are unwilling to do. This leads me to believe that there is more profit in deals where you can raise the barriers of entry higher than your customers ability to enter the market. For example - if we were trying to sell a $185,000 house to a millionaire they would have the resources to do exactly what we are trying to do. They would simply buy a house, higher a contractor, and pay the money to fix it up and live in it, but because we are selling a $185,000 home to a customer that can barely get approved for a conventional FHA loan they will not have the resources to get approved for a distressed property and pay an additional $25,000 cash for rehab. In other words, the buyer doesn't have the ability to "refine the oil". So it must pay someone to refine the oil, or in this case the house, at a profit.
These are just a few thoughts that I have, but would like to hear how it plays out in real life. Can anyone shed light on how it is possible to add market value to a home at a cost lower than the value you added?
Thank You
T.