So you’ve been shopping for homes and just can’t seem to find the right one. You want the charm of an older home, but want it to be filled with modern updates and finishes. Every time a nicely-remodeled home comes up, it is just out of your price range or there is just too much competition from other buyers. What is a frustrated buyer to do? Some will say “Why don’t I just buy a fixer? I can get it for substantially less and fix it up to my own tastes.” At first glance, that sounds like a reasonable plan, but you need to understand what comes with buying a fixer. It is not for everyone.
What kind of fixer is it?
There are different types of fixer-upper homes out there. Some are simply horribly outdated. All of the major systems are intact and functioning, but fundamentally there is nothing wrong with the house. A home that has avocado counters, shag carpeting and nasty wallpaper is certainly livable from the start. Provided you can tolerate the interior cosmetics for awhile, this is the sort of home that you could move in to and update on a room-by-room basis as you’ve got the time and budget.
Fixers of a nastier variety may have major flaws, like missing flooring, a non-functioning furnace, a roof that needs replacing or a foundation that is sagging. Obviously to purchase one of these homes, you need the willingness and financing to address the rehab right after you purchase to make it livable. In fact, many mortgages would require some of these issues to be addressed before granting you a loan.
Are you willing to go through the remodeling process?
We’ve worked with hundreds of buyers, and there are plenty of folks that get stars in their eyes about buying a fixer. They’ve seen friends who’ve bought run down homes and updated them into a modern, sparkling charmer, and they want to do the same. But you need to acknowledge the time and money commitment necessary to successfully rehab a home.
If you are going to do a major rehab on a home, chances are it may be uninhabitable for an extended period of time. If you are replacing electrical, plumbing or making a major addition, it is simply not possible to live in the home while some of these systems are non-operational. Not to mention, the construction process can be extremely dusty and dirty. Depending on what you are doing to the house, you might have to move out for 3-6 months. More ambitious projects could run from 9-12 months. I did a major rehab a few years back that added a dormer, all new bathrooms, lots of new windows and a new kitchen. The contractors first estimate was ~6 months, but once we got into it, there were delays and it took close to 10 months to finish. Some of the delays were caused by what we found in the house, while others were caused by changes I made as we went along. Remodeling is never as fast as building a home from scratch, as you have to deal with the existing structure and work around what is already there.
The other challenge you need to recognize is the uncertainty of remodel costs. In a major remodel project, there are all sorts of things that can push you over your budget. The one truism in home remodeling is that you are going to go over budget. It is just a question of how much. On my own project, I had a nasty surprise when we opened up the ceiling. The framing in my old house wasn’t sufficient to support the weight of a bath tub in the new bathroom above, so we had to re-frame and entire section of floor joists. That one change pushed me $10k over my original budget. It is also easy to start making tweaks as the process goes along. Maybe you change the floor plan a bit or maybe you choose a few finishes that cost more. All of these costs add up. If you are unwilling or unable to deal with the uncertainty of the final bill, you probably should not start a major remodel project.
How will you finance the rehab?
Remodeling plans are great, but how are you going to pay for them? If you’ve got a pile of cash available after the purchase of the home, maybe this isn’t a big deal, but most people need help funding the project. If you spend every last penny to buy the home, you will be hard-pressed to afford the fixes you want to do.
One option to consider is the FHA 203(k) Rehab Loan. These loans are taken at the time of purchase or by refinancing and build in the cost of home repairs into the total loan amount. The loan process itself is a little laborious, but it can be an effective way to finance some fix ups. Make sure you work with a lender who has done these before.
The other option is to take out a construction loan. This is really the only option for financing a major remodel, other than cash, and you do have to have a significant amount of equity in the project. To get a construction loan, you will present a remodeling plan to the bank describing the changes that will be made. The bank will appraise the finished product and will offer a loan based on that value. Depending on the bank and project, they may offer a loan from 50%-80% of the appraised amount of the finished home. Let’s say you own a fixer and currently have a $300k mortgage. You present the bank with plan for a home that will be worth $500k when it is finished. The bank decides to make a construction loan at 80% LTV = 80% x $500k = $400k. You need to pay off the existing loan of $300k, so that leaves you with $100k to do the remodel project.
If you are thinking of a DIY remodel project, a construction loan probably isn’t going to be of much help. The process of getting a construction loan requires copies of architectural plans, descriptions of materials & specifications and a cost estimate from a builder. The bank will also want to approve the builder’s license and insurance status. The bank wants to make sure that a project is completed on time and on budget, and loaning money to a DIY home owner isn’t going to give them that confidence. The only exception to this is for home builders who can demonstrate that they have the knowledge, experience and resources available to do the project themselves.
When evaluating construction loans, you need to consider two items. During construction, are you willing to pay your mortgage payments in addition to paying for your temporary housing? You can build in interest payments during the course of construction, but this reduces the amount available for construction. Second, a construction loan is a short-term loan, generally at higher interest rates. It needs to be replaced with permanent, long-term financing when construction is complete. Some lenders may bundle the two loans together for you, like Washington Federal does locally.
How much should you pay for a fixer?
The first-time home buyer may be enticed by the low prices of a fixer and then be frustrated by how much competition there is for these homes. You are not the only one out there who aspires to buy a fixer and build equity through a remodel project. You will compete against like-minded home buyers and flippers who do this to make a profit.
The key to pricing a fixer is to look at the final value of the home once the remodel project is complete. If you’ve got a list of finishes and specifications for the final project, take a look at what similar updated homes nearby are selling for. (A real estate agent or appraiser can help you with this.) Let’s say that the home will be worth $500k when the remodel is done. Now you need to figure out how much the remodel is going to cost. Work with your contractor to create a realistic cost estimate for the work you’re looking to do. When you are buying a fixer, this estimate is going to be a bit rough, but you need to know if the project is going to cost $75k or $200k. For our example, let’s say that the proposed remodel cost is $150k on a house that is worth $500k when it is done. The difference between the two costs is $350k, which is about the most you should pay for the home. If you pay $450k, and then spend $150k on a remodel, you are going to be underwater by ~$100k if the final product is only worth $500k.
The unfortunate part about buying a fixer is that you will often face competition from builders and flippers. Folks who flip houses for a living have different economics than a home owner who isn’t a contractor. When you hire a contractor, you need to pay them for their oversight on the project and they will build in a profit margin to their costs. When a contractor does a project like this for themselves, they don’t have to pay themselves a profit margin or oversight on the project. This easily puts you at a disadvantage on how much you can afford to pay. However, remember that a flipper needs to turn a profit and sell the home quickly. You, on the other hand, may be remodeling a dream home that you plan to live in for 10+ years, so maybe you have some flexibility on what you are willing to pay.
Focus on your enjoyment of the home, not immediate resale value
Unless you are in the business of flipping home, the real reason you are doing it is for your long-term enjoyment of the home, not immediate impact on resale value. There are countless examples of remodel projects that don’t return a lot of value but may greatly enhance your enjoyment of the home. Maybe you install a kick-ass home theater in the basement that costs you $20k but only adds $5k to the value of the home. Hardly a great return on investment, but if you are going to love your home theater for the 10+ years you live in the house, maybe it is worth it to you.
You should be conscious of what you are spending and not over-improve the home compared to the neighborhood, as that will make it difficult to sell in the future. However, you should also look at your own family’s goals for remodeling the home and take into account that you’ll be there for a long time.
Remodeling is a lot of work
Do your homework before engaging in a major remodel project, and do not underestimate the demands on your time. There is a lot of up-front preparation with the architect/builder to get a plan in place. There is also a fair amount of work to secure financing if you need a construction loan. Once the project is underway, you will have lots to do. You’ve got to monitor the progress and keep things on track. I ended up visiting my own project each day on my way home from work. You will also be asked for a slew of decisions along the way. What light fixtures? What color paint? Which tiles? Which appliances? Each of these requires you to shop and evaluate your design options. It can be overwhelming if you’re trying to balance with work and family obligations.
A successful remodel requires a great team. Tap your real estate agent for recommendations on contractors and lenders and poke around at open houses and home shows for ideas before you get started. The better prepared you are, the more likely your project is to come in on time and on budget.