Top Five Things Wholesalers Miss
Before we get into the top five things wholesalers miss when walking a residential property, we need to first talk a little bit about wholesaling itself.
One of the easiest ways to enter the wide world of real-estate is wholesaling: The business of finding investment-grade properties for real-estate investment companies like Light Box Homes. A wholesalers essentially puts a property under contract, and then either sell the contract to someone like Light Box Homes, or closes on the property and then sells it the very next day. The wholesaler makes money on the markup he or she puts on the contract/property. They typically have little money in the deal, making wholesaling attractive to real-estate beginners.
Residential redevelopment companies like Light Box Homes utilize ace wholesalers year in and year out when buying properties; and in fact, they are one of the best sources for renovation-ready properties in the metro Atlanta area. If you’re a realtor working for investors, you probably deal with a few wholesalers, too. They perform the valuable function of hunting down investment-grade properties to sell.
But watch out. Because it’s a profession open to anyone and everyone, not all wholesalers are created equal.
Wholesalers generally deal in distressed properties; houses that are usually in need of major repairs and updates that the owner simply does not have the time, money or inclination to tackle. Wholesalers promise these owners a quick cash purchase with no closing costs and few contingencies, but in most cases, the wholesaler doesn’t have $75,000 or $150,000 cash laying around, but they have a list of people and companies who do, such as Light Box Homes.
After the wholesaler has the property under contract; say for $100,000, he then ‘markets’ the property to residential redevelopment companies like Light Box Homes for as much over that as he or she can get, normally a 10-20% markup. In order to calculate this margin, a wholesaler must know four key elements: His contract price, the repair estimate, the renovation company’s holding costs & selling costs plus what that renovation company can hope to sell the house for after completion of the renovation, the After Repair Value, or ARV.
A sample wholesale deal is outlined below. Notice that had the renovation company found and purchased the home without a wholesaler, they would have saved $25,000. However, the wholesaler did the work of finding the property. Wholesalers typically work in neighborhoods where the price difference between an investment grade property and a fully-renovated property is big. This pricing differential is known as the ‘spread,’ and a wholesaler must be careful how much of it he can take for himself.
The factors that limit how much of the spread a wholesaler can take are the costs to renovate the property, the interest a company pays on the money it borrows to do the project, holding costs such as taxes, and of course the costs of selling the property, including real-estate agent commissions and seller contributions to closing. It is to a wholesaler’s advantage to make sure these factors are as low as possible, and so it is not uncommon for a wholesaler to boost their take by over-stating the ARV and under-stating the renovation costs. Since most investment-grade houses are purchased in as-is condition, this leaves it up to the realtor or renovation company to find the ‘holes’ in a wholesale deal.
It is not atypical to get an email from a wholesaler that over-states ARV, or that lists comparable properties that are not in the same neighborhood, but the biggest hole in most wholesale deals centers on the renovation costs. Renovating a property is complicated, and knowing the costs and processes involved is both a science and an art. Newbie wholesalers might simply not know what work a property needs or even how much it costs, meaning they put the property under contract at a price that is too high. At the other end of the spectrum, the best wholesalers run renovation companies of their own and understand what needs to be done to a house to bring it to full market value. This difference in knowledge is what usually causes wholesalers to miss one of the five items listed below.
Below is the same example spread from above, but here is what it looks like when the wholesaler has had to understate the renovation costs in order to make up for putting the property under contract for too much money.
The spread above is typical of newbie wholesalers. They put the house under contract for too much money and then massage the numbers to make it ‘work.’ Many new investors lose their shirt when they miss these five important items and buy the property or contract at full price. They find themselves forced to cut corners and dodge permitting in order to make their renovation match the fictitious one handed to them by the wholesaler, the result being their poorly-renovated house sits on the market for months, passed over by buyers who know instinctively when a house is not in full-price condition.
So whether you’re an investor, new wholesaler, or a realtor who works with both, it’s important to keep these five things in mind when examining a deal.
In the neighborhoods in which we renovate properties, the best properties are made of brick. Brick is sturdier, termite-proof, and typical of the houses with the most character in a given neighborhood. Brick investment-grade homes sell for a premium, and sometimes new wholesalers will try and sell their frame-and-siding houses at a similar price, but there are a lot of problems with siding that must be addressed, and which can add tens of thousands of dollars to the cost of a renovation.
Termites are usually the biggest problem with siding. The little buggers infest the wood studs underneath the siding, and if the siding is wood, they eat the siding itself except for the final paint-covered layer. This means there could be millions of the six-legged lumber liquidators, and you would never know. Upon visiting a property, it can be very difficult for the newbie investor to assess whether there is termite damage, and if so, how bad is the damage, because the siding covers it up. It’s only once the project has begun that the truth ‘comes to light.’ And the only thing the truth will set free in this scenario…Is your money.
Not all siding is wood or concrete (like you find in today’s houses). In fact, up until the 1970s, a lot of siding was made out of an extremely hazerdous material called asbestos. Asbestos is a wonderful insulator, cheap, and weather and termite resistant too, but it causes cancer in humans and its use has resulted in billions of dollars in lawsuits and damages. Though no longer used, it is very common to find asbestos siding on many investment-grade houses found in neighborhoods like Kirkwood, Edgewood, Ormewood Park and surrounding areas. It is identifiable by it’s thin profile and wavy edge (see photo), and it must be remediated or encapsulated. Go HERE to learn more about the wonderful world of siding.
Siding also ages, especially if it is not militaristically maintained and regularly painted. Water damage from faulty drip caps or broken gutters can quickly destroy siding, making it impossible to paint or repair. In general, whenever we see a property covered in siding, we budget to replace it, and a typical 1500 square foot house can cost between $10,000-$15,000 to re-cover in new hardeeplank siding. That said, it is rare to see this line item on a wholesaler’s scope-of-work. Typically a wholesaler will put $2000-$5000 in siding ‘repairs,’ or in the case of newbie wholesalers, nothing at all. But beware: Buyers’ home inspectors check siding, so you better budget to replace it if it’s more than 30 years old and/or made of asbestos.
In addition to asbestos siding, there are other componants of houses built before the 1970s that are toxic or hazerdous. Lead paint is the biggest culprit, and in fact, most contracts to purchase a home come with a lead paint disclosure if the house was built before 1978.
Lead paint can be found almost anywhere on the house. Inside, it’s typically already encapsulated under layers of new paint and rarely poses a problem. Though also buried under newer layers of paint on the siding of a house, lead paint can pose a problem if the siding needs to be sanded before reapplication of paint. Georgia law stipulates that such paint should be removed, meaning that $3500 paint job is now going to cost you $7000 because the contractor has to have a special license for removing hazardous materials.
Due to it’s incredible insulating power, asbestos can be found in a wide variety of building materials and systems besides siding. In houses older than the 1960s, you can find ductwork held together with asbestos tape, thermal wall insulation made with it, wire and pipe insulators, even flooring tiles. Asbestos is an incredibly virulent carcinogen, and state and federal law demands proper removal, which adds considerably to any renovation budget.
Most new wholesalers we meet make no allowances in their repair estimate for these dangerous materials, as they might not be able to recognize it, and it’s important to assess a property’s exposure before signing on the dotted line.
The municipal government that rules over the neighborhoods in which we renovate houses maintain the value, character and safety of their communities by requiring construction and renovation projects to adhere to international building codes (if you feel like getting super nerdy, you can read them yourself, here). Permitting departments carefully monitor which houses are in construction and which are being renovated, and the permitting and inspection process can change dramatically from project to project, can be time-consuming and costly depending on the scope of work a house requires.
But some wholesalers don’t give allowances for the time and money lost to regulations. The faster a renovator is in and and out of a project, the fatter the spread. Wholesale properties advertised with the words ‘cosmetic changes only’ can be misleading. Sure, you’re just ‘upgrading’ the kitchen, but if you want to go with any layout besides the one that came with the house, you’re going to have to get a plumbing permit, plus a renovation permit, and if the inspector discovers any other work that you’re doing unpermitted, you’ll get slapped with a big red ‘stop work’ order. To quote one of my favorite Fortune Builders coaches: Ask me how I know.
When examining a scope of work for a wholesale property, we make sure to run it by a licensed contractor or home inspector in order to gauge our exposure to the long arm of the law. Be sure to understand the jurisdiction you are in, whether it be City of Atlanta, a county permitting department, or some other municipality. Get to know the inspectors on staff and ask other renovators about their experiences with that particular department. When it comes to permitting, the more you know, the better, whether you’re wholesaling a property yourself, buying from a wholesaler, realtor or off-market.
Would you pay $500,000 for a house with plastic countertops and vinyl floors? Of course not, but such glaring departures from normalcy are very rare in the home renovation industry. More typical is installing tier-one granite instead of finer tier-two or tier-three granite in a $500,000 house. Though not obvious to normal people, such a difference is readily apparent to the Pinterest-obsessed world of $500,000 home buyers. They know you cheaped out, and the excuse, ‘but the wholesaler said I could do it,’ doesn’t fly.
Whether you are wholesaling a property yourself, or buying a property from a wholesaler, you must do your homework, and a good place to start is by examining the properties that sold for the price you want to get for yours. Have a realtor draw up a list of comparables and study the photos carefully, paying attention to layout, configuration, square footage and finishes. If possible, visit ‘pending’ listings that match your subject property to really get the ‘feel’ of a winning combination. Remember: You don’t have to be the Gaines family from Fixer Upper to be a design hero. You can always copy what works in a given neighborhood just by studying the comparables.
As you negotiate with a wholesaler, be sure to examine the comps he or she puts in their package and make sure the cost to finish the subject property is in line with the level of finishes you find in their package or in your own research. It is not uncommon for a wholesaler to include higher-class comps to puff up the ARV for a subject property, so learn the valuable skill of knowning what is comparable and what is not.
When it comes to home renovation, it’s all about the squares, square-footage that is. Though modern technology and techniques make changing layout a snap in most home renovation projects, there is only so much house one can squeeze into the available square footage. One simply cannot advertise a 1000 square foot 2-bed, 1-bath house as being ready to convert into a 3-bed, 2-bath house…Without an addition. It’s. Not. Possible. Or it is possible, but the resulting layout will feel tiny, cramped, and won’t sell for the price promised in the wholesaler’s package.
Once again, the comparables tell the story. If fully-renovated 3/2s in the neighborhood are selling for $300k with 1400 square feet, don’t pay a premium for that 900-square-foot 2/1. You’re going to make it a 2/2, or you’re going to wipe it off the face of the earth and build a new home, or you’re going to have to add square footage to bring it in line with the comparables. All three scenarios are going to cost a lot more than that simple layout-change scope-of-work on the wholesaler’s property package. Alot.
A good rule of thumb for estimating new construction is $100 per square foot; perhaps a little higher for properties with an existing structure to be removed (see ‘Hazardous Materials’ and ‘Permitting’ above), and a little lower (but not much) for additions. At Light Box Homes, we typically budget $99 per square foot for additions of any kind. A simple 400-square-foot master bedroom addition can blow up a budget by $40,000, add months to the project hold time, and entail more permitting and inspections, so make sure you walk into negotiations with the comparables in hand. They can save you a ton of money when you buy.
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