It was supposed to be a simple transaction. Invest in property, rent it, and have the tenant pay the mortgage. The young couple had allocated $52,000 of their savings to buy a detached single family house as their first investment rental property. The couple's goal was to renovate the house, rent it with the help of a property manager, and then refinance so they could recoup their initial cash investment while keeping the house. They were not into flipping property.
Their real estate consultant from a property investment company told them that the After Repair Value (ARV) was around $65,000, which they verified after speaking with a local agent. A local property manager told the couple that the market rent was about $700 per month.
The couple agreed to pay $27,500 for the house. They hired a certified home inspector. They solicited renovation estimates, one for $19,900 and one for $23,500. They selected the contractor with the lower bid. Factoring in closing and carrying costs, they figured their total initial cash investment would fall within their $52,000 budget. With an ARV of $65,000, they estimated that they would receive $48,750 back from their mortgage lender via a 75 percent loan-to-value refinance. At that loan amount, their positive monthly cash flow would be about $141. And they would have over $16,000 worth of equity.
The couple thought that they had found the perfect residential investment property. And they were right. Until they fell in love with the house. Then they strayed from their initial strategy.
Real estate investors, particularly novices, make a number of good moves but often ruin a deal by making just one wrong move in the midst of all the good ones. These are some of the costly missteps made by investors:
- Offering too much for the property.
- Overestimating the After Repair Value.
- Underestimating the renovation costs.
- Underestimating the time it will take to renovate.
- Overestimating what the property will rent for.
- Over-improving the property.
- Changing the exit strategy in the middle of the project.
Instead of spending $19,900 on the renovation, the couple ended up spending $36,000. They spent hours at the hardware store selecting beautiful light fixtures, faucets, and doorknobs. They instructed the contractor to build an extra, unnecessary bathroom in the kitchen. They demolished the kitchen and installed top-of-the-line cabinets and counters. They unnecessarily replaced windows and doors. They renovated the house to a condition similar to their own home, instead of in line with similar rental properties on the market.
Upon realizing that they had spent more on the property than the $65,000 ARV, the couple decided that they shouldn't rent out such a nice home. They decided that it should instead be sold. Unfortunately, their mortgage broker told them that without a tenant, they would not be able to refinance the property. When a real estate agent told them that it was unlikely that they would recoup all their money if they listed the property in the current market, the couple became dejected. They decided to curtail their dream of becoming wealthy through real estate.
And their over-improved house is still on the market.
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About the Author: Tai A. DeSa is Chief Executive Officer of Significa Corporation, a professional real estate investment company based in Pennsylvania (www.significacorp.com, www.significashortsales.com, and www.significadeals.com). DeSa is a graduate of The Wharton School at the University of Pennsylvania. Prior to entering the real estate business, he served as an officer in the U.S. Navy. He is the oldest in a family of 11 children and was valedictorian of his high school class. DeSa is also an Associate Broker with Keller Williams Real Estate (www.thetaidesateam.com). He is an organizer of the Lehigh Valley Real Estate Investors Group (www.lvrig.com) and an Area Director with Business Network International (www.bnidvr.com).
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