Why Rent when you can Rehab?

Question

Hello, I'm sure many people here are a big fan of renting properties to obtain wealth and so was I.  But, thinking through this more clearly, I realized it would take so much longer to obtain money by renting out houses.  Put it this way, lets say you have one rental and bought it for 50k.  Now lets say you put in 15k to rehab and plan on renting it for 1,200 a month gross.  It would literally take over a decade just to get your money back on the rehab costs only.  Now think about a rehab.  Lets say you bought it for 50k, put in 30k and resold it for $130.  Net profit is 30k in 3-4 months.  Anyone is a big imbalance here?  I have no idea why anyone would want to rent to see a return on their money years down the road when you could see a return within months.  Many will say because Rehabs require a lot of work, but it really doesn't because once systems are in place you can get a project done with under 10 hours a week.  That's pretty good in my book.  Any opinions?

Steve L. · Answer

Greg, I think this is a good question.  I also feel I am in a good position to answer it as I am both a landlord and buy-sell guy.

I have some comments:

First of all, I don't know how realistic your numbers are.  80k total cost into 130k resale is 61.5%.  That is a very hard number to reach consistently.  But for sake of doing an analysis we can use it.

So let's say, 30k profit.  You have to pay short-term tax on that.  Let's say your effective rate is 40%.  So 12,000 goes to taxes.  You really only end up with 18,000.

If you get 1,200/month rent and assume it is free and clear.  Let's say you self manage it and we will use the 50% rule, less 10% for management.  $720/month in cash-flow.  Let's say the improvements are valued at 75% of the total cost.  65,000 * 75% / 27.5 years you can depreciate sfh = 1,772 / 12 months = $147/month of depreciation.

$573 * 12 months = $6,876 * 60% factor in taxes = $4,125 after tax
$142 * 12 months = $1,704 depreciation add-back, tax free 
After tax benefit 5,829

So it would take just over 3 years to make as much renting it as flipping it.

But you still own the house!  So let's say after 3 years you decide to sell the property.  Assuming the value is the same...

You would make 30,000 again but it would be taxes at the long-term capital gains tax rate (which is 15%).

$30,000 * 85% = $25,500 + 17,487 (5,829 over 3 years) = 42,987 after taxes.

If you can add leverage to the rental property the situation it is a lot better.

The buy-sell business is a job that is great for returning a huge ROI that is highly taxes (contains very few of the benefits of real estate ownership).

Thinking of the end business model I would rather own 10 of the houses free and clear and make 60k after taxes for managing them then have to flip 3 a year for the rest of my life.

I am doing both.  But I think landlording makes sense if you understand it in the terms above.   Especially if you can buy properties at 1/2 or 1/3 of replacement cost.  If they ever need to build a house again I would imagine we are going to see prices go up.

J Scott · Answer

There are a lot of ways to build wealth, and what you lay out above is certainly one way.  But, it's not the only way.  Different people come into this business with different goals, different time constraints, different amounts of money, etc.

For someone with lots of time and a good bit of cash, your plan above is reasonable.  But, doing 20-30 rehabs per year can be expensive and time-consuming.  Personally, I find it difficult to find 20-30 great rehab deals in my area each year (this is why I'm currently doing fewer than that).  And most investors I know don't have the cash or credit to do anywhere near that number of rehabs in year one.

It's all a matter of personal preference and personal situation...there's no one right answer...

J Scott · Answer

Greg -

Here is the main reason many people prefer rentals:

If you only flip houses, when you stop flipping, you stop earning.  But, with rentals, if/when you decide to retire, the income doesn't stop.

That's why I believe a combination of flipping and buy-and-hold is the best way to generate short-term income, as well as long term cash-flow.

Michael Stole · Answer

"Put it this way, lets say you have one rental and bought it for 50k. Now lets say you put in 15k to rehab and plan on renting it for 1,200 a month gross. It would literally take over a decade just to get your money back on the rehab costs only."

Actually, you get your whole money back in 5 years.....

Steve L. · Answer

Yes, 1031 only can be done if you have owned the property over 12 months.  Unless you get real creative.

Greg, for the first year I started all I did was flip.  I did really well, so did the tax-man.  It is funny, now we do everything we can to keep our "best" deals as rentals versus selling them for a profit today.

I have found the same thing as J Scott. To do more than about 25 flips a year you either sacrifice margin or take a lot of risk.  Maybe others have found some tricks I haven't?

Taking a flip to the finish line is also 10x as hard as getting a house rented at a cash-flow in this market. In my market you have very little room for error as there is so much competition and money chasing short-term ROIs.

Jeff B. · Answer

Greg, I kind of see your point.  However, for me, I do the rentals a little different.  I use the 50k as my cash in on several rentals and leverage my way into several rentals.  I buy foreclosures for 60k or so using a rehab loan, put down 20% plus rehab costs (which I get back at the end of the rehab period).  I end up having several homes with very good cash flow with rents in the $1000 range.  Once I have my reserves built up enough using the cash flow, I buy another and do the process all over again.

Another thing I'm considering is to add a rehab and sale to help rebuild the reserves a little quicker.  My goal is to have a decent amount of passive income.  The rentals provide that, whereas doing rehabs are more of an active income.

Aly W. · Answer

Greg, I get HELOCs from TD Bank. The last one (6 weeks ago) was a 20 year, 3.75%, $99 application fee, for 75% LTV. It's our third HELOC with them, and we just applied for another.

Chris Clothier · Answer

Almost word for word the answer I give when people ask why i do not do more fix n flips.  I always had a pit in my stomach as soon as I deposit a check when a retail flip was completed, because I knew there was no more money coming in on that deal.  It didn't matter how good the deal was, it was over and from that day forward I was spending the profits.

Greg P. · Answer

Aly, what are the current rates for the HELOC's?  Is it comparable with 30 year fixed conventional loans?   Thanks.

Aly W. · Answer

This is exactly why I prefer rentals. My husband and I both work full time and invest mostly out of state. We've been leveraging the equities in each property (purchased with cash) to get HELOCs to purchase the next one. That's been the cheapest cash so far.

Dealing with tenants can be aggravating on occasion, but so can dealing with contractors. It's just part of the business.

Why Rent when you can Rehab?

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