The cash flow risk when investing in fixer-uppers

One of the biggest problems in getting into the fixer-upper market is what happens to your cash flow. Without it come from tenants, you need to be able to make mortgage payments out of your own income, which could be quite a burden. Three important cash flow considerations you should always keep in mind:

1. It might be possible to find a tenant. It is rarely practical to work on a fixer-upper in a big way if tenants are in the house at the time. No matter how cooperative someone might seem, a tenant will resent construction noise and dust, and rightly so. If the repairs are restricted to landscaping and outside painting only, they will not be a problem. You could generate rental income while performing outside cosmetic work. Some landlords believe that they can get a tenant to cooperate by offering a place for reduced rent in exchange for the inconvenience. It usually does not work. The tenant will find major construction inconvenient and invasive and will quickly forget about having given up something for reduced rent. As long as your work will take you inside the property, you and a tenant wilt only be in each other's way.

2. You have to continue paying on your mortgage loan no matter how long the work takes. The risk in working on a fixer-upper is that those loan payments have to continue. The work probably will take longer than you plan, and the more time that elapses the more severe your cash flow problem becomes. Try to plan for the worst case, allowing an extra month, at least, to complete the work you are planning to do. As you get into a project, you will most likely discover additional problems in need of repair. Part of your projection of cash needs must include the monthly mortgage payment.

3. Market demand can change suddenly. You may buy your fixer-upper in one kind of market and end up selling it only a few months later in a completely different market. This can be an advantage or a problem. You might buy in a very quiet market, only to find a lot of demand when you finish your renovations—the best of all possible outcomes. Equally possible, though, is that you will buy a fixer-upper in a very hot market, only to discover that the market has gone cold just as you're getting ready to market your property. That means softness in demand and in the price you can expect, so that your profits would be reduced and possibly wiped out. When you buy a fixer-upper, be aware of the market risk. Keep an eye on the market and try to estimate the length of possible market cycles, to coordinate your holding period to allow yourself time to do the work. While real estate markets generally change gradually and not in sudden, rapid motions like the stock market, sudden adjustments do occur and this is a very real risk or opportunity.

A realistic plan for investing in fixer-uppers is to allow for more time than you expect to have to spend; more cost than you estimate; and more mortgage payments than you would like to have to make. If you are ready to sell but the market is not ready to buy, you can convert the fixed-up property to a rental and wait out the market. But even before you get to that point, you have to ensure that you have enough capital reserve to pay for all the costs of fixing the property and the mortgage payment— and you have to allow for more costs than you originally estimate.
If your independent contractor tells you the work will all be completed in two months, don't estimate for just two months of negative cash flow. Keep in mind the following: 

• The estimate might be too optimistic.
• Additional problems might be discovered.
• It could take some time to sell, perhaps an additional two months or more.
• The market could change between now and then.

If you can quickly convert the fixer-upper into a habitable rental property, you can offset virtually all of these risks. You have 100 percent vacancy while you are performing major work, and cash flow is critical. So if outside work also has to be done, put it off until the major construction has been completed.

 

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