You acquire a property that as a renovation/rehab play, not necessarily just for the units themselves, but also improvements to be made to building systems and exterior . . . Let's say you already know the approximate $ figures of the costs of the renovations you plan to make to the property. I usually just add this amount to the cash invested equity portion. But I am curious to see how others might be incorporating renovation/rehab costs in their financial model, especially if these changes are done over time, a period of a few years perhaps. Also, where you are adding these costs to - to the equity portion? taking additional debt? seller concession? How do you typically account for these renovations costs in your financial model?
Are you talking about a SFH or an apartment? My answer would be different between a SFH rehab and an apartment value play where you're building equity by increasing cash-flow.
In general though, there are two options:
1. Assume all rehab costs are laid out upfront as part of your purchase costs. If you plan to hold the property for a while, this will skew your annual cash-on-cash return numbers as well as your IRR, but it's easier than trying to forecast when your expenses may come if you don't know. Also, this is a conservative approach, which is never bad.
2. You can try to forecast your future outlays, and use your income and outlays to build a model that predicts your IRR at various points in time, depending on when you ultimately decide to sell. This will give you a more realistic assessment of your return, but is obviously dependent on your being able to forecast your rehab expenditures.
That is a pretty broad question Michael. JScott's answers are terrific, as usual.
For certain projects the precision of the cash outlays won't really matter much. For other projects slippage in dates matters a great deal if you are using measurements that account for the time value of money. I like using IRR because it is difficult to determine a cost of capital to use NPV and the measurement still works well on most projects.
How the costs or contributions are modeled depends on the project too. In some instances the seller will give concessions that can reduce your initial cash outlay if the lender agrees to it. For most projects the improvements will be coupled with cash outlays that would need to be approximated over time using your judgment. For multi-year projects lumping approximate outlays into months each year to go with potential rent collection will generally suffice.
So the answer is that "it depends." Sorry...it just does depending on the circumstances of the project. That is why people build their own custom models instead of using Argus or other packages with canned functionality.
Thank you both very much for your insight.
J Scott: I am referring to a multi-family property, not a SFH. I like the conservative approach of laying the total figure out in the front of the model as part of the purchase price, with the hope being that the seller is more flexible on the price due to the renovations that need to be made. However, lumping in a large number upfront can also decrease the COC return, which many investors are looking for in the first year or two (of course until your improvements increase the property's top line numbers)
Bryan: I certainly see the validity in approximating the cash outlays over time on a monthly basis against the property's revenue as another approach.
At the end of the day, financial modeling is in many ways an art just as much as it is a science. I guess I will need to tinker with my models using both of your approaches to see the various returns that each approach yields, and perhaps take some sort of average of the two!
For Apartments --depending on type of rehab-
you always buy at lower price --however--if you plan to get financing --you do projections and add cost -- to purchase price --lender can include the rehab costs --
However, renovations to building or structral repairs --called Improvements --such that it will increas value of property and of course higher rent -- than it is different --it is deffered maintenance - and have to consider based on components -- you also need to talk to an accountnt --for depreciation consideration --you need to buy a soft ware to anlayze -- using what if senerios -- for different assumptions -- IRR is the best -- always leverage and refinance to maximum available at the time --after rehab or major renovations are done and rent increases or cash flow increases --
I have done this for several Hotel loans ---similar principal apply --I use simple spread sheet to do five year proforma projections and improvements are added to loan --Lender keep money in escrow- called reserve for improvemnets -- fixed amount based on Recommendation in an Engineering Report. The engineering report identifies major components and remainig life- then estimated cost to replace in year one, two, three--like that -- you have to plan for that and set aside some money every year --for future repairs.
Hope this will help you --
What size apartment complex is it ??
Also --if it is too old --may have Asbestose and Lead Based Paint issues --- very expensive ---
A poster named John is actually building what seems like a decent tool to automate some of this. I sent him some of our non-proprietary models to give him a sense of the way we model things. I am happy to forward those to you if you want to dig through them.
Modeling all of the rehab cash outlay at the beginning of the project certainly is conservative. I would argue it is too conservative, especially if you are trying to attract equity funding via LPs.
Personally, I like to do my analysis in two steps:
1. I use my models to determine what my monthly and annual cash-flows will look like given a stabilized investment, and then...
2. I manually take those monthly or annual cash-flows from my model and create a list of cash-flows. I modify those cash-flows manually with my presumed rehab costs, and then run an IRR on it.
Here's an example (see attached spreadsheet)...
Let's say I want to model an empty apartment building that I'm rehabbing over the course of a couple years. I purchase it for $200K, and I have to immediately (over the first two months) put in $100K to start getting it rented. In the first twelve months after rehab, my model indicates a monthly cash-flow of $2500/month.
Then, after twelve months of cash-flow, I plan to sink another $100K into more renovations (which takes 2 more months), and for the next twelve months, my model indicates that I can expect a cash-flow of $6000/month.
At this point, I plan to sell the building for $500K.
Given that example, I take my monthly cash flows projected by my two models, and augment them based on my purchase/sale/rehab expenses, and run an IRR to get my expected return (in this case, about 25%).
If you want to see what this looks like for this example, see the attached spreadsheet...
Hope this helps!
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