Guide to Buying a Fixer-Upper as an Investment Property
Renters Warehouse Blog
In a housing market where home prices continue to increase, fixer-uppers are a bright spark of hope for investors looking to get more from their investments.
But transforming a run-down bungalow into a cozy single-family rental involves more than putting on new curtains and a fresh coat of paint. Depending on the property’s condition, you might face substantial costs, either in the form of capital or sweat equity as you make the necessary repairs.
Renovating a fixer-upper and renting it out can be a profitable strategy, but only if you know what you’re working with. Are you in the market for a fixer-upper? Here’s how to tell if you have a good deal or a headache on your hands.
Why Get a Fixer-Upper for an Investment Property?
A fixer-upper is a property that requires significant repairs or improvements to bring it up to a livable or marketable condition. These properties often come with a lower initial cost than move-in-ready homes. This makes them an attractive option for landlords willing to invest time, effort, and money into improving the property.
Aside from the lower purchase price, a fixer-upper has other advantages, such as:
Equity Potential: The value of a fixer-upper can be substantially increased through renovations. As you enhance the property’s features, from addressing structural issues to improving overall aesthetics, investors can build equity that goes beyond the initial investment.
Adaptability to Market Trends: Real estate market trends and renters’ preferences continue to evolve. With a fixer-upper, investors can incorporate modern amenities, energy-efficient features, or technological upgrades to align with current buyer or tenant expectations. The property remains competitive, and the modern touches can enhance the property’s market value. Addressing common tenant issues and providing what they want may also justify your charging a higher rental price.
Potential for Sweat Equity: ‘’Sweat equity’’ refers to the increased value a property gains through the owner’s efforts, particularly in do-it-yourself (DIY) renovations. Investors with the skills and willingness to put in the work can save on labor costs and realize a higher return on investment.
Tax Advantages: When it comes to fixer-uppers, the potential for higher tax depreciation often comes from big renovations made to the property. Depreciation can be claimed on both the building structure and eligible improvements, such as flooring or HVAC systems. The higher the cost of improvements, the more significant the potential tax deductions over time.
Portfolio Diversification: Balancing a portfolio with different types of properties, including those needing renovation, can provide investors with a range of investment opportunities and risk mitigation.
10 Things to Look For When Buying a Fixer-Upper
If you plan on adding a fixer-upper to your portfolio, here’s what you should look at during your search:
A Discounted Purchase Price
Securing a property below its market value provides immediate equity, creating a financial cushion to absorb renovation costs. This discount can result from several things, such as the property’s condition, motivated sellers, or strategic negotiation. Look into recent sales in the area and compare the prices of renovated properties with those in their original condition. Acquiring the property below market price improves your chances of achieving a better return on investment when the property is renovated and brought to market.
An easy benchmark for a good price for a fixer-upper is typically based on the property’s after-repair value (ARV) and the 70% rule. According to this rule, an investor aims to acquire a fixer-upper for 70% or less of its estimated ARV, accounting for both the purchase price and anticipated renovation costs.
So, if the estimated ARV of a property is $200,000, the maximum allowable acquisition cost would be $140,000 (70% of $200,000). Note that when using this benchmark, landlords should also consider other factors such as location and market conditions.
Knowing how much you’ll spend on repairs also helps you properly gauge the potential return on investment, so be sure to set a realistic budget for renovations. Begin by identifying the necessary repairs, upgrades, and cosmetic changes needed to bring the property up to standard. Factor in a contingency budget for unforeseen issues that may arise during the renovation.
Before you get carried away by the allure of a potential fixer-upper, take a close look at its structural integrity. While minor cosmetic issues are expected in a fixer-upper, major structural problems can quickly turn your investment dream into a financial nightmare. Assess the foundation, roofing, and overall structural soundness. Hiring a professional inspector to evaluate the property can provide invaluable insights into potential challenges and help you make an informed decision.
Location and Rental Demand
High rental demand indicates a fixer-upper’s potential profitability. Properties in desirable areas with strong demand for rentals will offer a consistent income stream and quicker returns on investment. Factors contributing to high rental demand include locations with proximity to amenities, schools, and employment centers. Understanding the preferences of the local tenant demographic and tailoring renovations to meet those preferences can also enhance the property’s appeal, ensuring a steady influx of potential renters.
Don’t forget to do a market analysis before buying a property. Learn how to do it with How to Conduct a Market Analysis for Your Rental Property.
Zoning and Regulations
Before buying a fixer-upper, check the local zoning laws. They control how you can use the property and might limit specific renovations. For example, if there are strict historical preservation rules, you might be restricted from making changes to the exterior, affecting your renovation plans and potential profits. A property with fewer zoning restrictions gives you more freedom for renovations and flexibility for its future use, boosting its overall value.
Rental Income Potential
Rental income potential is one of the most important considerations on whether a property is worth it. Analyze the local rental market to see the demand for properties similar to the one you’re considering. Assess the property’s size, layout, and features to ensure it aligns with the preferences of your target tenant demographic. While optimism is great, realistic income estimates help set accurate expectations for potential earnings and ensure better financial planning.
Read more about setting the right rental rates here: A Guide to Setting Rental Prices.
Size of the Home
The size of the property directly impacts renovation costs, as larger spaces generally require more materials and labor. Square footage also influences potential rental income or resale value. A larger property may offer greater profit potential, but it may also require a larger upfront investment and increased renovation expenses. Striking a balance between square footage, renovation budget, and market demand will help maximize your returns and ensure a successful fixer-upper investment.
Age of the Property
The age of a house can influence the extent and nature of required renovations. Older homes may have outdated systems, materials, or design elements that demand comprehensive updates to meet modern standards. Taking account of the home’s age helps you anticipate potential issues with electrical or plumbing systems, structural wear, and compliance with current building codes. Older homes may have a unique charm, but investors must weigh the meticulous renovation costs against the property’s historical or aesthetic appeal.
Longer renovations could mean that you’re looking at months with zero rental income. Consider the duration of the renovation process, from securing permits to completing the actual work. A realistic timeline allows you to plan for income loss, keeping your cash flow disruptions to a minimum.
Explore various financing options to determine the most cost-effective solution for your fixer-upper investment. Traditional mortgages, renovation loans, or financing from private lenders may all be viable options depending on your financial situation and investment goals. Carefully evaluate the interest rates, terms, and conditions associated with each financing option to choose the one that aligns with your investment strategy.
When to Say No to a Fixer-Upper
It’s tempting to rise to the challenge of turning a low-cost, neglected property into a money-making gem. However, there are instances when passing up a seemingly good deal saves you time and money in the long run. Here are some circumstances where a fixer-upper might not be the right fit for landlords and rental property investors.
Unmanageable Renovation Costs
Overextending your budget can jeopardize the profitability of your investment and lead to financial strain. Home Guide estimates that it can cost anywhere between $15 and $60 per square foot to renovate a house; that’s $20,000 to $100,000 on average for an entire house remodeling.
Here are some more recent estimates of home renovation expenses:
An outdated electrical system can cost around $20,000 in a 2,000-square-foot home.
Asbestos removal costs around $1,200 to $3,100, depending on the damage.
Mold remediation ranges from $1,125 to $3,439.
Foundation repairs typically cost $2,000- $7,500.
Square footage matters a lot when it comes to renovation costs. If you’re dealing with a large home that needs extensive work, it might be wise to reconsider the purchase.
Severe Structural Issues
A house with poor structural integrity is unsafe for occupants due to the potential collapse of crumbling structures. The foundation, walls, and framework also set the stage for all other renovations and improvements, so problems with these structures require much work that may surpass the rewards of the investment. These issues can be financially draining and time-consuming to rectify.
Lack of Expertise
Taking on projects beyond your skill set can lead to subpar workmanship and may diminish the property’s overall value. Take stock of your strengths and limitations, and seek professional help when needed. Passing on a work-intensive fixer-upper might be a safer choice if you lack the expertise required for the renovations. Alternatively, you could outsource the work to reputable contractors, but this will take a bigger percentage out of your profits, so you’ll need to factor these additional costs in when running the numbers.
Legal entanglements can be red flags. Issues such as unresolved property disputes, zoning violations, or undisclosed liens can result in prolonged legal battles and unexpected expenses.
Discovering hidden environmental hazards, such as toxic mold or asbestos, could be a dealbreaker. Mitigating these hazards can be both hazardous to health and financially burdensome. Environmental concerns should not be taken lightly; a professional should thoroughly assess potential risks.
Excessive Time Constraints
If you’re working within tight time constraints, a fixer-upper might not be the ideal investment. Renovations often take longer than anticipated, and unexpected challenges can further delay the project. Assess whether your timeline aligns with the property’s renovation needs before committing.
Low Cash Flow Potential
Ultimately, if the numbers don’t add up, it’s best to let go of a fixer-upper. If the property’s potential return on investment doesn’t justify the upfront costs, renovation expenses, and market risks, reconsidering the investment would be a prudent move.
A bargain basement price doesn’t always mean you’re getting a good deal, but fixer uppers can be a sound investment strategy if you know what you’re doing. Consider working with experienced professionals, including inspectors, contractors, and real estate attorneys, to evaluate the property’s condition and its legal standing before you buy. Uncovering potential issues early in the process can save you from costly surprises and help you negotiate a fair purchase price.
Ultimately, this is your investment, so the decision is yours alone to make. Conducting extensive research before you make a purchasing decision could assist you in ensuring you’re buying something that will help your investment portfolio, and not a money pit.
Thinking of adding a rental unit to your portfolio? Take a look at available investment properties in your area, many of them ready to rent, some complete with tenants. And if you want to learn more about being a landlord, we have an Education Center packed with free resources on the ins and outs of rental property investing.
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