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Real Estate Investing Decision:  Rehab It And Sell, or Rehab It And Keep It?

Bruce W. Ford
10/30/05

I got this great question from a member of my discussion board.  The question went something like this;

Why keep property after it’s rehabbed?  Why not just sell it after the rehab and GET PAID!

Well, it depends, like so many things. It will come down to an investor's decision.

I want to present a different way of thinking about this decision. My position is essentially this: If you don't have an urgent need for quick cash, you'll make more money by hanging onto the property. In most cases you can generate the most short term cash by selling a pretty, like new, rehabbed house.  There are downsides though, such as giving much of it away in taxes come next April.

If you keep it, you stand to make quite a bit more!  In addition, you get to enjoy some killer benefits such as a tax break, cash flow, and a nice payday once you eventually sell the property thanks to natural appreciation.  Most times you stand to make some cash within a few months of buying the property when you refinance the property out of your hard money (at 70% loan-to-value) to long term financing (at 85% or 90% loan-to-value). Refinancing will have to wait until after you're finished with the rehab, and most lenders insist on it being occupied by a renter before approving the refinance.

As you'll see in the below example, a rehab real estate investor will make considerably more by holding onto a property.  But, it's not all wine and roses. You have to be a landlord, and you have to decide if you want to do that.  Some folks refuse to be a landlord. I personally think it can be done correctly on my own, or I can hire someone to do the day-to-day administration. The difference in money over time is substantial enough that it behooves me to figure out how to landlord, or hire someone to do it for me.

Let me illustrate the difference in profit between rehabing and selling, and rehabbing and renting types of investing with an example;

First we have to make some assumptions. Let's assume appreciation is 5% in your area and the average price of a rehabbed property is $100,000. Let's also assume there are two reall cool real estate investors named Bill and Fred.

Bill sells his properties right after rehabbing and makes around $15-18,000 per house. Atta boy Bill!

Fred hangs onto his rehab projects and cash-out refinances, and usually pulls out $10,000 per house within 3-6 months of owning.  (Fred trades his 70% loan-to-value (LTV) ratio hard money for long term, 30-year mortgages at a lower interest rate with an 85-90% loan-to-value ratio.  The difference between what it costs him to pay off the hard money and the new mortgage goes into his bank account. (Again, around $10,000 per property.)

Bill (rehab and sell) makes a great living by all standards. Ten houses per year is $150,000-$180,000 per year...nice cash! The downside is that Bill has to maintain a steady flow of rehabbed properties to maintain his standard of living year-after-year. He also pays taxes on all that money as regular income (ouch!) because of the short time he owns them...gotta love those IRS rules.  So his $150,000 per year is somewhat less after Uncle Sam takes his cut.

Fred (the rehabber) makes a great living as well. Ten houses per year nets him $100,000 in tax free, spendable cash. Fred controls a million dollars in real estate and it's going up in value as time passes.  Fred pays no taxes on that money he nets from the cash-out refinances.  Since it’s part of a mortgage, it must be paid back eventually and it not considered income! That's the best part! 

Let’s look at what Fred’s doing year-by-year. 

If Fred bought 10 houses this year valued at $100,000 each, he owes $90,000 on each one (after the 90% cash out refinance), so he controls $1,000,000 in property. If he keeps them 5 years (assuming a low appreciation rate...which is pretty conservative):

Purchase year - 10 houses x $100,000 = $1,000,000
Year 1 – Same 10 houses X $105,000 = $1,050,000
Year 2 – Same 10 houses X $110,250 = $1,102,500
Year 3 – Same 10 houses X $115,762 = $1,157,620
Year 4 – Same 10 houses X $121,550 = $1,215,500
Year 5 – Same 10 houses X $127,627 = $1,276,270

Things to keep in mind with this example...

• There are areas of the country that appreciate much faster than 5%.  Some areas will double in value in the next 5 years!
• I did not include the tax advantages of owning an extra ten homes in this example. That equates to thousands of dollars in real income each and every year.
• This example runs the numbers for a single ten-house year. What if you want to "top out" at owning 40 properties. In a few short years your buying can slow down to a trickle and you can start selling and cashing out of properties. How many ten-house years to you need before you have attained your financial goals?
• Forget the 5 year hold. What if you hold these houses 10 years?  The numbers get pretty crazy!

I don't want to work forever. You probably want to reach a point where you won't HAVE to do too much unless you want to. If so, holding properties for a few years makes a lot of sense, especially if you don't have much personal money invested in them.

So what of Bill?  I suspect that Bill will come around and start holding properties once he satisfies his urgent need for cash.  

Would you agree?