You’re Making a Mistake if You Are Not Adding Contingencies to Your Rehab Budgets

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I’ve been investing in real estate since 2005, and to this day, I have yet to hear any other investor say, write or even hint at anything that resembles the following,

“You know, I have this problem where I’m just budgeting too much for rehabs. I end up borrowing more than I need, and I’m probably missing out on deals because my rehab budgets are too large. I just always seem to come in under budget.”

I’ve gotten better and better at hitting budgets since I started, but I still go over more often than I’d like to admit, and very rarely do I come in under. So, from what I’ve experienced (and heard about), mistakes are not made evenly in both directions when it comes to rehab budgets. We are biased heavily toward under-budgeting for rehab expenses.

Indeed, we are biased toward under-budgeting in general.

Why Rehab Budgets are Generally Too Low

There are a large number of things that often go unaccounted for—particularly by newbies but also by more seasoned investors—when estimating a rehab budget.

One of the big ones is holding costs. If they are even remembered in the first place, investors often assume that the project will go along speedily and there won’t be any delays. Unfortunately, that is often not the case. 

Perhaps the contractor can’t start on time or is slower than expected, or maybe you even need to replace them midway through the job. Or maybe there’s a permit issue, and the city holds up construction. (There is one issue on a duplex that took us nine months to resolve.) Or there are supply chain issues causing back orders on parts. On a small commercial property, we have been waiting for a 1000-amp meter bank for almost a year now due to supply chain issues. This has become more common of late, particularly with electrical equipment.

We’ve also had situations where we have prioritized smaller projects we could finish quicker and left large ones sitting for far longer than originally anticipated. Properties also sometimes take longer to sell or lease than expected. (The multiple offers on day one that flippers got used to in 2021 are no longer here.) Therefore, any investor using financing will have substantially more debt payments. And then there are taxes, insurance, utilities, etc.

The next problem is that we often underestimate the cost by using old numbers. With higher inflation these days, it’s not uncommon for investors to use wildly outdated estimates when putting together an estimate. This has been particularly true for HVAC. For example, as Samantha Lile notes regarding HVAC last year, “Some [HVAC manufacturers] have announced increases as much as 38%, while it’s not unusual to see increases ranging from 3% to 20% higher than 2020 levels.” 

Next up are the “punchout” items that are almost always undercounted. This can include things like trim, blinds, screens, outlet covers, light bulbs, doorknobs, closet poles and shelves, cabinet pulls, splash blocks, bark mulch, etc., as well as a deep clean. Throwing $1,000 for all that often seems sufficient, but it usually costs more. 

The big ones, however, are unforeseen items. Oftentimes, various parts of a house function when tested but will fail under a load, i.e., with consistent use. We find this often with HVAC and supply lines and, from time to time, with appliances.

Then there are things you cannot see. The sewer line being broken or hopelessly filled with roots and offsets is a common one. Pro tip: Scoping your sewer line during due diligence is highly recommended. 

Once you open up a wall, there’s always a potential for problems. There could also be galvanized plumbing or knob and tube wiring in the walls that need replacing. Or there could be termite damage or rot that was missed because it was behind a wall or under a floorboard. You could also find you’re dealing with lath and plaster instead of drywall (common in older homes), and much more time intensive to repair.

Every seasoned investor has stories of rehab budgets that have been wrecked they would be unhappy to tell. I wrote an article a while back about a project of ours that went sideways, which is a good illustration of what can be missed for those interested. I missed that the cabinets were garbage, the electrical in the finished basement didn’t work, and I falsely believed the HVAC had life in it, amongst other things. I had budgeted $34,800. The total price came in at $57,498. 

And I’ve heard of even worse than that.

Of course, many of these problems can be found beforehand with thorough due diligence. But you must assume that you are likely going to miss something. And there’s also a tradeoff. Due diligence takes time and energy, of which you only have so much. Doing infinite due diligence is not advisable. It should be thorough but within reason.

For more on budgeting rehab expenses, I highly recommend Jason Scott’s book: The Book on Estimating Rehab Costs.

A Few Noteworthy Examples of This Phenomenon

If that wasn’t convincing enough, it might be helpful to zoom out a little and look at some illustrative examples to make this point. There is a litany of historical instances of budgets not simply being exceeded but being completely blown apart. A few include,

• The famous Sydney Opera House was budgeted to cost $7 million and take a few years to build. It ended up taking 14 years and costing a cool $102 million, just over budget by a barely noticeable 1357%.
• The Scottish Parliament building was budgeted at £50 million in 1998 before climbing to £190, then £260, then £375, and finally settling in at £414.4 million in 2007.
• The 1963 film Cleopatra was originally budgeted at $2 million. By the time it was all said and done, the cost came in at $44 million and almost bankrupted 20th Century Fox despite being the highest-grossing picture of that year.
• The Sochi Olympics were budgeted at $7 billion but came in at $52 billion, although it should probably be noted that a large amount of that cost came in the form of “kickbacks and embezzlements.”
• In 1966, the House Ways and Means Committee estimated that by 1990, Medicare would cost $12 billion (adjusted for inflation). Instead, it cost $107 billion. 

The James Webb Space Telescope is an incredible achievement, but as its Wikipedia entry shows, in both time and money, it went waaaaaayyyyyy over budget.

And this goes for just about everything, not just the really big projects. Daniel Kahneman quotes two studies in his great book Thinking Fast and Slow that are pretty emblematic of this phenomenon,

“A 2005 study of rail projects concluded that, on average, planners overestimated the number of people who would use the new rail system by 106% and underestimated the cost to build by 45%.”

“…A survey of American homeowners who had remodeled their kitchens found that the average person expected to pay just over $18,000 but ended up spending over $38,000. (Thinking Fast and Slow)

Now sure, there are examples of coming in “on time and under budget.” (Although not as many as you might think, one study from KPMG found that only one-third of building contractors’ projects came within 10% of their budget.) But moreover, there are virtually no examples in the opposite direction. For example, here’s what I got when I searched Google for “projects that came in most under budget.”

Yeah, this is a one-way problem. 

Historically, going over budget is a much more common problem than budgeting too much. Indeed, being overly optimistic is a historical norm. Many on both sides of World War I thought “the war would be over by Christmas,” and commentator Bill Kristol, like many others, infamously predicted the Iraq War would be just a “two-month war.” 

Rosy predictions are par for the course. Realism ain’t. 

When it Comes to Real Estate Investing

There are three big tips to make when it comes to real estate investing, but the first is simply to embrace the undeniable reality that there is a systemic bias in favor of underestimating rehab budgets. Please accept the fact that you will likely spend more on rehab than you originally anticipated. 

You need to accept that truth to be able to address this problem and accurately analyze deals.

Once you have accepted that, there are three things you should do:

1) Make due diligence a priority 

Sure, don’t go overboard, but thorough due diligence will catch many of the “unanticipated costs” that tend to blow up rehab budgets.

2) Add a contingency

We put in a 20% contingency for “unexpected expenses,” which could range from a furnace failing to a delay in getting the project started. You may put in less or more, but I would always add a contingency to any budget.

3) Review each project

It’s often tempting to just move on to the next thing once a job is done. This is even more true when it comes to projects that go badly. We really don’t want to think about such things. It’s important to fight this temptation.

Analyzing how far off your budget was from the actual expenses and, even more importantly, why you were off is essential to improving your ability to estimate rehab projects accurately. Indeed, in Thinking Fast and Slow, Daniel Kahneman found that the best way to estimate a project’s costs is by looking at similar projects in the past and using them as a guidepost.

With proper due diligence and a contingency, you should be able to stay in the ballpark of your budget. And if you hone your budgets over time by comparing them to the actuals, you should get pretty close to that “on time and under budget” goal we all strive for. 

But don’t ever get complacent. It’s easy to fall back into the habit of underestimating rehab costs. Because, if nothing else, you’re almost certainly not going to overestimate them.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.