Purchase Price vs. Rehab Cost

A frequent question we get is whether it is better to buy a property that needs significant rehab at a lower price or spend more for a property that needs little rehab. A great question but one (as usual) without a simple answer. Note that this article is focused on financed properties because if it is a cash purchase it is a simple spreadsheet decision.

Note: the examples I will be using are simplistic to the point of being almost silly. I did this intentionally because I want to communicate the concept, not the details of cost comparisons.

I will start with an example. Suppose you were considering the following two properties.

Property 1 Property 2
Purchase Price 200,000 220,000
Rehab 10,000 0

Common assumptions for the examples:

Term (Yrs) 30
Rate (%) 4.75%
Down (%) 20%
Hold Term (Yrs) 15
Rent (Mo) 1300

Note that I am ignoring property closing costs, property tax, rent, insurance, management, time value of money and other real world factors so I can focus only on rehab cost vs. purchase price. Below is a table showing the acquisition cost for both properties.

Property 1 Property 2
Purchase Price 200,000 220,000
Down Payment 40,000 44,000
Rehab 10,000 0
Acquisition Cost 50,000 44,000

As you can see, Property 1 requires $6,000 more initial cash out than Property 2. The above is a extremely simplistic comparison but the concept is valid. Buying the more expensive Property 2 results in a lower initial cash out.

Next I will look at the cash flow difference between the two properties.

Property 1 Property 2
Debt Service (Mo) -835 -918
Rent (Mo) 1300 1300
Cash Flow (Mo) 465 382
Cash Flow Difference (Mo) 83 -

10 year cost of ownership:

Property 1 Property 2
Debt Service -100,156 -110,172
Acquisition Cost -50,000 -44,000
Cost Of Ownership -150,156 -154,172

15 year cost of ownership:

Property 1 Property 2
Debt Service -150,234 -165,258
Acquisition Cost -50,000 -44,000
Cost Of Ownership -200,234 -209,258

I summarized the cost of ownership below. As you can see, there is little difference at the end of year 5. But, the longer you hold it the more advantageous Property 1 becomes.

Property 1 Property 2
5 Year -100,078 -99,086
10 Year -150,156 -154,172
15 Year -200,234 -209,258

Summary

In general, you will have less initial cash out if you purchase a more expensive property in near market ready condition than buying a property needing significant rehab, all other factors being the same. In the real world, no two properties are the same and the simplistic comparison shown in this article will not work. The comparison model you will need to build needs to include more than just factors like acquisition cost and return. Some of the additional factors and considerations should include: