Last week I wrote about the slippery slope that is rehab over-improvement. This week I would like to share a story of how I recently over-improved a home and in so doing, gave away about $30,000. Over spending on your flip projects is so easy to do that I liken it to a disease such as an addiction. It’s a situation were so many factors can converge to cloud your judgment. Often the folly is only recognized after the damage is done. If you don’t make it a point to regularly step back, reassess the situation and refocus, then the siren’s song just might lead you to disaster.
A little background
Last May, a wonderful project was dropped right in my lap. It was a large split level home in a very desirable neighborhood in Fairfax, Virginia. The seller had inherited the home and just wanted a quick out. He didn’t want to hassle with the normal selling process of dealing with Realtors, mortgage brokers, and home inspections, so I made him an offer that worked for both of us.
My initial assessment of the project told me that the home would resale for $550,000 after about $75,000 of updating. It turns out that my initial assessment was exactly correct. Had I remained anchored to the true reality of my initial numbers I might have a different story to tell you now. However, I was led off course by the allure of rehabbing, and in the end I spent over $100,000 and sold the home for $554,000.
The Many Factors of this Siren’s Song
It’s rarely just one thing that over takes you on a rehab, and those factors can be different on every deal. Here are the factors that led me astray on this particular deal that I now recognize in hindsight.
- My lender on this project was pretty skittish at this point in time; many private and hard money lenders had taken a beating over the past year, and were very worried about being stuck with a home they couldn’t sell. My lender urged me to go all out on this place; in fact she wanted me to tear out walls and redesign the floor plan. Luckily I resisted her requests at first but her pressure was a factor for me.
- The property next door was listed for sale by an agent that lived just a couple houses down the street. I sought his advice on the project and he was very optimistic. He told me that I should list my home for $625,000. He was firmly in the camp of making the home a trophy home. This Realtor’s credibility was only elevated in my mind, when several of the other neighbors told me that he was the neighborhood Realtor that everyone used. Looking at the comps myself, I saw nothing to justify that price and I made an effort to steady my expectations. However, as factors added up I lost sight of the comps and numbers.
Keep in Mind: Realtors do not have unbiased opinions. They have an incentive to convince you that they can sell your home for a lot of money. Neighbors like to hear that their property is worth lots of money as well. Seek advice from local Realtors and neighbors, but verify with solid facts, any information (good or bad) that they give you. Sometimes neighbors will give you bad information; I had a case where the neighbor was trying to buy the property and was telling everyone who looked at it very false and negative stories about the place.
- In this particular deal I brought in a cash partner. This was his first deal. He got very excited by the local Realtor’s assessment. He also has a propensity to be a bit of a populist who likes to criticize wealthy people and big businesses. I have to remind him that he is a wealthy person by most standards. This populist streak in so many people makes it hard for them to ask full value for their product or service. They don’t want to seem greedy. They tell themselves they’re not in it just for the money. They are improving the community. The combination of the Realtor’s lofty assessment and his populist streak made him very quick to say yes to most any upgrade or improvement.
- Sales activity in the area was picking up significantly at the time. There were far more buyers out than there had been in recent months. All of my colleagues were reporting that they were very busy. All the homes in the neighborhood were selling very quickly. This led me to believe we were in an upward trending market (we were.) By the time the rehab was nearly complete, I was convinced that we should be able to get $575,000 for the home, even though the comps weren’t there to support it yet. I thought they were coming. I did get two offers on this place for over $575,000 but I neglected to take into account the tight appraisal rules that are dominating the market. The appraisal came in at $540,000.
- The price of the home itself was a factor as well. Because we would be selling the home for well over a half a million dollars I started letting the people around me take too much control. I allowed myself to be convinced that a home selling for this price is a luxury home. However, in this area, this particular home was only one step up from entry level. The majority of its value came from its location. The real goal here should have been to provide our buyer with affordable quality, not price them out of the neighborhood with luxury.
- I wanted to do the best job possible. This innate desire to do the very best job possible is something you must always keep in balance with costs. Many of us have this desire. You have to modify that desire into doing the very best possible job for a predetermined amount of money. That is the key to bringing value. However, on this job the other factors forced my internal equation to get out of balance.
- This deal had very large margins. That cushion made me far too relaxed and passive. Again, when a choice came up to improve or not to improve, this “extra padding” was another factor that helped push me towards spending money, because I knew we could afford it.
- Finally, sheer laziness was a factor. This project was in full swing during the summer months. My partner on this deal was eager to make the trips to Home Depot and visit the site with the contractor. I should have been a little more proactive but I was happy to let my partner make decisions that I should have scrutinized a little closer.
I did not have a loss on this project. I made money; however, I made about $30,000 less than what I could have made if I had just resold the home without making any extra improvements to it. In this business you have to make your money when and where you can. Your next deal might really punish you and the profit from your last deal just may be your savior. I wouldn’t be crying about $5,000 or $10,000, but $30,000 is simply too much to give away.
I’m not crying crocodile tears here. I knew what I was risking. I knew I was giving my partner a lot of slack. Working with partners can be very delicate. I really like this partner; he gave me hundreds of thousands of dollars. I didn’t want to just tell him “no” all of the time. I let him run around and have ownership of the process. It cost us some money but we learned together. I just brought him in on another deal and I believe I have another very good go-to source of funds in him when I need it. However, I could have been much better at managing and teaching a new partner.
The Moral of the Story
If there is any lesson to take from this, it’s that rehabbing is a balancing act. The weights on both sides of the scale are different on every deal. The factors that push you to over-improve can be like feathers that add up on one side of a scale. You don’t worry or take much notice to the effect of one more feather but if enough are piled on it will tip the scale. Make sure you are judicious about identifying and properly weighting the different factors on both sides of the scale on each and every deal.
Coming Next Week:
Next week, we’ll go through the numbers on this house and show you the unnecessary improvements and their associated costs, and compare and contrast it with another rehab home just around the corner.