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?
You are investing your time, money, and expertise into rehabbing the home. That is valuable beyond just the numbers on a balance sheet. Otherwise, no managers anywhere would ever get paid for anything. What does a manager do - he just makes sure other people do work, right? Well, he comes up with a plan, he oversees the project, he manages people, he coordinates schedules, he makes deals and purchases from vendors, etc. That is valuable.
Also, because rehabbers have time to shop around and because they can buy in bulk or offer repeat business, they can often find materials and contractors for less than the average homeowner. Plus, they tend over time to know more than the average homeowner and are not as likely to get fleeced by contractors. So, it may cost a homeowner $50k to do a renovation, whereas the rehabber can do it in $30k. Therefore, in a sense, the rehabber just added $50k of value by spending only $30k.
I see homeowners buying fixer houses here in SoCal for slightly less than a renovated home thinking they are getting a deal because they will fix the home up themselves, not realizing that they are probably going to spend more on the home than if they bought a fully renovated flip.
Must have missed the Principles of Economics chapter at the beginning of the class.
Land, Labor, Capital and Entrepreneurship.
You have the land, you utilized the capital in your cost of goods, you get paid for your labor and your management of the projects adds value in bringing your product (the property) to market at its market value.
You missed the entrepreneurship required and the profits from labor as well as for your direction of capital.
Class dismissed.... Have a great week! LOL :)
How does Papa John's stay in business when you could buy all the raw ingredients for pizza and make your own at a lower cost?
Same principle applies to rehabbed houses...
The other thing to consider is that the $50K house you used in your example (where you did $25K in rehab) may not have been attainable at $50K by your average homeowner (so, it's not really worth $50K). If the house was distressed, it's very possible lenders wouldn't provide financing to homeowner, so only those with cash could buy it. The $25K you spent didn't just add "prettiness" to the house, it also made it financeable. In essence, that $25K may have taken the value from near $0 to $75K because even if someone wanted to pay $50K in original condition, they wouldn't be able to.
Thank you all for taking time to reply. I know my questions are overly simplified, but it's important for me to understand how its possible to truly add value to a property.
Thank you all for your answers.
The inherent value/equity/profit is determined by what price you pay for it. You don't add $50k in value by doing $25 k worth of work.
In the Central Valley California you could have a house with holes in the wall and no floors and a house just like it in the same neighborhood but completely rehabbed and they would appraise at close to the same price.
I am starting to sell my houses there now and the comps on my house I have for sale now are compared to mostly ugly run down homes at the same price. The only good thing is that my home will sell faster and may get more money from a cash buyer. It will not be able to get financing any higher than the appraised value though. At any rate they have doubled in price since I purchased them.
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