First, you probably know you must determine whether it is legally possible to make the changes. Older homes can be historic, built over setback lines, be too dense on the site, be located too close to a creek or have other challenges that motivate the local municipality to deliver the dreaded “Stop Work Order.” Invest time to understand the general zoning issues in your area and how the rules are applied for renovations versus new construction. Talk to local building department officials and have them review their process with you.
Second, you must determine at what point an extensive renovation crosses the line and becomes unprofitable or results in such a high cost that it would have been easier to tear down the entire structure. The big-ticket items (roof, mechanical systems, foundations, window placement/replacement, etc.) can add up on large-scale projects. If your project is going to involve repairing or replacing the majority of the house, you need to consider building new as an alternative to renovating, or you should acquire the property for land value so any incremental value of the structure is a bonus. Don’t overbuild the project; spend the money where the buyers will pay you for your efforts.
In addition, prior to acquiring the property, consider using a home inspector to look at the house. Your inspector may notice a deficiency that is going to impede the project from being sold. Almost all buyers these days will have a home inspector, so it is unlikely the buyers’ inspector will miss the problem. Let the inspector know your general plan for the home, so he or she can determine whether the home will need further upgrades. For example, electrical service that is adequate for a two-bedroom home may be undersized to handle a master-suite addition.
Step 4: Create a Budget
Create a budget and stick to it. Unanticipated costs will come up and when they do, you need to try to win back some of the overage by saving on other line items. Always have a contingency plan, but try not to use it. Increasing the scope during construction is easy to do because it seems to make sense to add one more thing that would be nice or you would like if you lived there. Don’t fall into the scope-creep trap. This is not the home you are going to live in, so don’t treat it that way.
As a successful new real-estate investor you must remember why you bought the project and what your stated plan was for the property. Manage the budget to that plan. Don’t forget to add the cost of interest carry and sales commission to the budget.
For example, let’s assume you need a total of $200,000 for the physical construction. You expect it will take nine months to renovate and sell the home. With 10 percent interest carry, 6 percent real-estate commission, 3 1/2 percent seller-paid closing costs and annual taxes of $3,000, you should assume the average funds outstanding are about 75 percent of the total of $200,000 hard costs. See the table on this page for a sample budget.
Unexpected costs can always arise. We once purchased a ranch home that was in very rough condition. The budget was large because we decided to do a whole-house remodel. The prior owner had kept dogs in the home and did not let them out to relieve themselves. There was an extreme pet-odor issue, but we had budgeted chemical treatments. However, the situation was so severe the odor could not be remediated after multiple attempts. Ultimately, the only “guaranteed” solution was to gut the hardwood flooring and subflooring in the house. The budget included the replacement of most of the hardwoods, but the subflooring replacement and additional labor were not anticipated.
The positive was the home had all new hardwood floors. The negative was the new subflooring cannot be seen by buyers and likely does not yield a higher sale price. To “pay” for this without going over budget, we had to gain some concessions from our Sheetrock, trim and painting crews on the cost of their labor. We also made some adjustments in the tile and lighting selections by spending more time hunting for closeouts that allowed the quality to remain high but at a lower cost. The project came in on budget. It had multiple offers and actually sold after just three days on the market.
If a cost overrun happens early, you have a better chance to recover by spreading the overage across multiple remaining categories. You always want to save your budgeted “contingency” line item for the end of the project because if the surprise happens toward the end, there are limited ways to adjust.