Rehabbing is another very popular investment vehicle, or at least many investors talk about the desire to rehab a property. It's a trendy topic to discuss, but the actual act of rehabbing a property is probably the most active real estate investment vehicle. There are many hurdles in the process, but if you can successfully do it, you can profit in a very short period of time.

The draw to rehabbing is the idea that you will be able to find a distressed house, buy it below market value, fix it up, and then sell it for a profit. Conceptually, that's a great idea, and there are certainly properties out there that are worth rehabbing; but it's not as easy to locate profitable properties as one might think.

First the Bad News
To understand the reason it is hard to find viable properties to rehab, you need to understand the costs involved. When you buy a property you'll have to pay closing costs, which are about 3% of the purchase price. You will then have the cost of the repairs. As a minimum you'll have carpet and paint to pay for, and that is going to be approximately 3% of the purchase price. You will then have to sell the property. Assuming you are not a Realtor in the state in which you are rehabbing, you'll have to pay commission to sell the property. This tacks on another 6%, this time of the sales price. Finally, you'll have closing costs on the sale. If you put a binder on your title insurance, you can keep your closing costs down to about 2% of the sales price.

To be conservative, let's add the percentages up and calculate the cost based on the price at which you sell the property. That means just to break even, you need to be a minimum of 14% below market value. If you are a Realtor, or if your father is heir to the Carpet Barn empire, you might be able to reduce your costs, but only a few percentage points. If you hold the property for more than month, you'll have to make at least one mortgage payment.

Considering a normal escrow is usually 30 days, and it's highly unlikely you'll be getting a top condition fair market value offer the day after you close on it (before you do anything to the house), you'll have to spend at least a week or two fixing it up, so you can count on making at least one mortgage payment.

If the house will sell for $250,000, this means you need to purchase the property for less than $215,000. That is based on only doing carpet and paint repairs. How often do you think Sellers will discount their $250,000 house by $35,000 just because it needs some carpet and paint? Not very. For you to get that kind of discount, the property will need to be more distressed than just carpet and paint, and that means you'll have a greater expense.

Aside from buying the house at a big discount, the key to rehabbing is to have tight control over your rehabbing costs. Many rehabbers like to think they can do most of the work. Some can, most can't. It is definitely much cheaper and more reasonable to locate a reasonable carpet installer than to install carpet yourself. You might be able to paint the house yourself, but the cost of paint is about $1 per square foot or less, and most people would make better use of their time if they just let the professional painters do the job.

Finally, one last downside to rehabbing on the short term is that if you don't hold the property long, you are going to have a hard time convincing the IRS that you can do a 1031 Tax Exchange on the property. All this means is that you lose the benefit of deferring taxes on your capital gains, but that can be a significant issue, especially if you really intend to roll the profit into more properties. There isn't a rule on how long you need to hold a house to be able to do a 1031, but the word on the street is somewhere between six months and one year. The guideline is the "intent to hold," and if you feel you can convince the IRS that you intended to hold it for a while but instead you decided to sell it soon after you bought it, then you might be able to pull it off. The IRS is one entity I don't like to mess with, so I don't 1031 my rehabs. Talk to your CPA for further questions, or you can contact a 1031 Exchange company like Southwest Exchange.

The Bright Side
While the preceding paragraphs may paint a gloomy picture of rehabbing, it is an excellent investment vehicle for those who have vision and like to take an active role in their investing. There is very little I enjoy more than finding a property that has potential to be rehabbed. Some people have this vision, many do not. If you enter a run down house and actually enjoy thinking about what kind of flooring would go best in each area, what paint scheme would enhance the property best, and how scraping the popcorn ceilings will dramatically update the look, then you might be inline for rehabbing a property.

Locating the Property
The first step to rehabbing is finding the right property. While several MLS services have the ability to denote a property as a "fixer upper," most of the agents who list these properties don't even know they can denote this in the listing. One good way to start searching the MLS for rehabs is to sort by List Price per Square Foot. If the going rate for an area is $100/sq ft, and you find a property listed at $72/sq ft, you might have a fixer upper on your hands.

Probably the best way to find fixer uppers is to let several real estate agents know that you are looking for a property to rehab. Realtors are a great source for this as they are constantly going into houses, and every once in a while the run across a dog. I like dogs. Have them call you when they run across a property with potential.

Before you waste your time visiting the property, ask the agent to give you a CMA. Ask them what it would sell for in top condition. Ask them what they think you might obtain the property for. If you're not 20% below fair market value in top condition, don't even visit the property. The extra 6% is buffer as well as profit. On a $250,000 house, that means you need to buy it for $200,000 or you need to walk away.

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