4 “Must-Knows” Before Taking on a Distressed Property

by | BiggerPockets.com

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?

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.

Related: 6 Ways to Locate Distressed Properties Online

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 up—and 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.

Related: Rehabbers Beware: 5 Big Issues Distressed Properties Hide (& How to Detect Them)

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!

What’s your opinion—do you take on highly distressed properties or are these something you avoid?

Weigh in with a comment!

About Author

Chris Clothier

In 2005, Chris Clothier (G+) began working with passive real estate investors and has since helped more than 1,100 investors purchase over 3,400 investment properties in Memphis, Dallas and Houston through the Memphis Invest family of companies.

20 Comments

      • Chris Clothier

        Steve,

        Thanks for reading the article and taking some time to comment. Just as a side note, and don’t take this as a cut, I just found it an interesting place to make this comment. Our company has recently undertaken the task to replace the word tenant with resident everywhere we can. We are not perfect yet, but we are working to change the culture within our company.

        The word resident just brings a different understanding of who it is occupying our properties and really changes the dynamic of how they view us and how our team views them. It really has had startling effects so far.

        best to you –

        Chris

    • Chris Clothier

      Hey David – I love reading comments and appreciate your reading the article. That being said, would love clarification on exactly what you mean. I think a lot of readers would love for you to expand on that and understand even why this article was the one you chose to leave it on.

      Best – Chris

  1. tim boehm

    Excellent article Chris! It’s like monopoly in many cases. I do remodels but have all the skills and all the tools, about 250k’s worth. It’s simple for me to see the value and the costs before I start. the one thing I didn’t see in the one I doing now was the crime factor we’ve been robbed twice, actually caught two buglers in the act!! Even though we won’t lose money on this one, we will get far less than I had planned because of this.

    • Chris Clothier

      Tim,

      that is a great pointed a really good factor for readers to keep in mind. You never know where the hole in your renovation budget may occur, but the likelihood is raised significant when you undertake a project that hs been under major distress. Sometimes that distress comes from the area it is in and not so much the house itself. And at other times it can be a combination of both.

      Thanks again for the great comments.

  2. Mohammad (Asad) Asaduddin

    I am currently buying an old wood frame house on pier and beam. I am relying on my contractor to make ready for rental for a few years because Population is growing in that direction. Since I am not a nuts and bolts guy, what could I be missing on not so obvious problems of age and neglect? I am eager to learn. Thanks.

    • Chris Clothier

      Hi Mohammad and thanks for taking time to read and post your questions.

      First, I would say that purchasing an aging property for a buy & held scenario brings a unique set of challenges. Add in that it is a pier & beam constructed house and you get even more problems. I thin one of the factors I would be looking for without knowing anything else about location is permitting and the amount of time that process may take. Houses like this need to be thoroughly inspected by a 3rd party. Do not cut corners and do not let your contractor perform work without all of the proper permits. That could be one area where you will find yourself spending a few more dollars and losing a few more days than you may have initially anticipated.

      best of luck on this project! Chris

  3. Lucas Mills

    So, what does this say about the BRRRR strategy? Does that strategy involve exactly this – buying and renovating distressed properties?

    Can you speak to buy and hold investors then? What should they be looking for? How is “quality” defined?

    • Chris Clothier

      Lucas,

      Great question and thanks for taking the time to ask. Yes, this is the BRRR strategy and no it does not necessarily effect it. It is hard to qualify in such a short amount of space in the article, but highly distressed homes are those, for the purpose of the article, are in need of major repair due to a heavy burden of disrepair, neglect or even calamity.

      In a sense, every property bought through an auction, bought at discount, purchased as an REO is a distressed property. But my point was to avoid the properties where only the experienced investors go to play. The ones who have major budgets, buy at crazy discounts because of the extent of the problems and are prepared for surprises. The average BRRR strategy involves minor cosmetic work and replacement items, not necessarily structural work.

      As for quality, like I noted above, only use contractors that are willing to pull permits and use contractors that share the opinion that there are only two ways to do a task…the right way and again. You should want to eliminate deferred maintenance on the front end as much as possible and do not cut corners. It pays off in the end. For every one dollar you spend on the front end doing work the right way, you can save yourself two dollars down the line.

      Chris

    • Chris Clothier

      Andrew,

      Thank you for taking time to read and leave your comments. You guys have been at this for a while so you know your way around the field pretty good. I too take on large projects but only after having my backside handed to me a few times learning.

      Again, thanks for reading. Best to you – Chris

  4. jay hinrichs

    flipping highly distressed properties is an advanced strategy… it seems to be over glorified on the TV shows.

    having done my fair share we have our success stories and we have our bummers.. the key is we can take on a bummer .. where as those just starting out if they hit a bummer out of the gate they could be sunk for years.

    Nice article Chris !

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