Without having a client or a signed contract, remodeling becomes riskier although also potentially more rewarding. Tom Swartz talks with remodelers Frank Malpere and Arnold Karp about which houses work best for spec jobs, how to swing the financing, and when too much renovation is more than enough for the end buyer.
Tom: I'm looking for a definition of spec remodeling.
Arnold: We tend to buy houses that have been overlooked by the market. They have very good bones, but may need kitchens, baths and some sort of addition. Homeowners don't care to purchase it but it's not yet in bad enough shape to become a rip down. An older home that needs something else added as the family unit and family wants and needs have changed. In our community, no one wants to take these projects on.
Frank: For us, it has been houses destroyed by fire that nobody wants anymore. We'll evaluate how bad it really is versus how bad everybody thinks it is. The other thing we look at is foreclosures, the ones that have some structural problems that will take more than a coat of paint. The average layman sees it and runs out with his hands in the air screaming. We go in and take a few days to fix the structure and paint and make them look like new again.
Tom: When is it a good idea to do spec remodeling?
Frank: I think any day of the week. It is the best way that I know of to make some very good capital in the business. I don't see any risk in it. If I've done my numbers on the front end, then I know what I'll make on the back end when I sell it. For us, it actually has been very enjoyable — a "no clients" type of thing.
Arnold: I think almost any time is a good time. Our clients will pay more for a house that already has been renovated than for a house where they have to hire a contractor, pick out the tile, decide where the family room goes and deal with the permits.
Land is what's driving our market. Some of these older homes have great bones, good street presence and nice landscaping. That gives you a step up on some of the competition, which in our case can actually be new homes.
We're also taking smaller homes and increasing the square footage to what is more the norm for the area. What was built in these communities in the '30s, '40s and '50s is much different than what is being sold in 2005.
Tom: What's bad about spec remodeling? When is it a bad time?
Arnold: The regulatory aspect. If you're putting out as much capital as you would building a new spec home, and getting the remodeling changes approved becomes onerous, it can be easier to rip down the house and start new rather than integrate old and new. The bad time to get into this is when you're paying too much for the product going in or when you've finished it but didn't hit on what the market demands.
Frank: I don't know that there would be a bad time. People are always going to be buying the homes. You just have to buy them at the right price.
Tom: What are the dangers of spec remodeling?
Arnold: An overabundance of inventory. The downside is that you're putting a lot of capital out as exposure. You've got to make sure that what you do fits the market and that the next person who walks in, your potential buyer, likes what you've done. If you do too much the market will not pay you for the work that you've done. If you do too little the market will not pay you because they say, "It's still not what we want." Before we go into a spec remodel we brainstorm in the office with the project managers and say, "What do you think we need to do? Where does the line in the sand go?"
It may be a street that has not started to change. So yours is going to be the first updated house on the street, and that can be a risky time. You will also find a fair amount of risk when you've remodeled a house and the two or three around it are being torn down. You're using an older floor plan and, unless the house has a lot of character, suddenly you have this "interesting" house among new homes. That can also be risky.
Tom: Frank, what's your advice?
Frank: I think the danger is yourself. It's so easy to get wrapped up in the house and go, "Wow, if we could just do this to the kitchen, add a room here, push this out, do that," as if you were going to live in it.
What you really want to do is make that home safe and habitable, maybe update some things, but not go crazy. You need to have a plan of what to do to bring it up to market value before you buy the house and then really stick to your guns. Don't try to make the Taj Mahal out of it.
Tom: What kind of remodeling business is spec remodeling best geared for?
Arnold: I'm going to say the mid-sized firm. We saw it was a niche that not many people were going after. We do try to keep our subcontractors busy as much as we can. When we're doing client work and have lag time, we can get them right into our own project. If someone finishes at one of our jobsites at 1 p.m. and we would normally lose them, we will send them over to one of our spec remodels. It becomes a good way to keep your own employees or subcontractors with which you have good working relationships busy 350-odd days a year.
Frank: I see it working best for the full-service company that does roofing, siding and windows, and takes on the whole project. You're more apt to have an idea of what is wrong with a property and what's needed. We can look at a project and say, "This is the work that needs to be done, and this is what I would charge the average homeowner to do this job." If I cannot do that job and then sell it and make my return on investment for my risk, we don't want to do the job.
We don't want to buy a job to stay busy. The guys loved it when we had a house in the dead of winter when things were a little slow, but it was still treated as a job with a timeline. The company had to cover their overhead and make a profit on the construction end, so that if we did not sell it we could rent it.
Tom: My uncle would buy old houses and put his painters there in the winter. They had a tendency to milk those jobs and run the costs up. Has that been a problem for you?
Arnold: It hasn't been a problem. We have a very loyal core of people who have worked for us for a long time who think, "It's another opportunity for us to stay busy." Most of our work is not done time and materials.
What will really hurt you in this business is the interest carried on these projects. You want to get in and get out fairly quickly. Otherwise the only beneficiary of your hard work will be the bank that's lent you some of the money.
Tom: How much capital or financing do you need to pull this off successfully?
Frank: We just finished one where we put $8,000 down and got a $43,000 HUD home improvement loan plus the price of the house. I made sure the $43,000 I borrowed was enough to carry the house. We wanted to have a little comfort area there. We knew how long we were going to have to carry it in order to get top dollar. We're not looking to slap paint on it and make a quick $5,000. We fixed it up, and put it back on the market. It sold a couple of days ago.
Tom: Do you rely mostly on the banks for that capital?
Frank: I've done it both ways. It's a lot easier when you're relying on the banks for the capital. The other way, you're waiting for a job to finish to have that working capital or you're taking it out of your cash reserves. You run the risk of putting yourself in a bind eventually and hurting yourself.
Tom: Arnold, what about you?
Arnold: The big limiting factors in our case are how much equity, how much bank financing and how quickly we can turn these over. In Fairfield County, the average house is now in excess of half a million dollars. We just finished a project in Greenwich, Conn., where we actually bought the house for $1.7 million. We kept the facade, we kept the primary portion of the house, but then added a kitchen, mud room, two-car garage, master suite and two bedrooms. We sold it for $3 million. We got in and out of the market within eight months.
Tom: Is there a targeted profit or gross margin percentage on every project?
Arnold: Where we're doing a spec remodel, we need at least 30 percent margin to cover our overhead and to make these projects profitable because of the amount of capital that we're tying up for that period. At a minimum, margins need to be 30 percent, and I would tell people that 50 percent would probably be the right number. Having strong margins going in means you can cover the unknown and, in our case, cover the extensive carrying cost on these homes.
Tom: Frank, what do you shoot for?
Frank: We mark our remodeling jobs up 70 percent on average. On a spec job, I look at the repairs, labor, materials and our markup coming out to that 70 percent. I want to know that if I'm carrying this house for 12 to 18 months, which is not uncommon in our area, that I'm going to be able to get my sales commission and my monthly mortgage payments back, plus 50 percent.
Tom: Let's say you buy a house for $100,000. Is that $100,000 cost, or is that $100,000 of work that has a markup of 30 to 35 percent that you bring into your company?
Frank: I really look at it as if I'm two different people. If I estimate labor and materials costs of $20,000 and I'm going to do a 100 percent markup, then I'm going to look to borrow $40,000 for the job.
Tom: Then whatever you sell the house for beyond that is profit?
Frank: Yes. On the most recent house, cost plus improvement was $108,000. We then put it on the market for $190,000, which we got. After that, we were able to pay ourselves commissions and recouped about $70,000.
Tom: Arnold, tell me what you do with markups and how you get it ready to sell.
Arnold: We bill everything out as if it were third party. You can't say, "I'm going to cut the labor rate to make the numbers work." You need to say, "My people are working there, I need to use my billable rate plus my normal markup." Otherwise, what you will find is that you're making money but you're taking away from your core business. You want to get the margins that you get in your daily business.
Tom: Some folks think you buy a structure for $250,000 and put $100,000 of cost in it. Then they sell it for $450,000. They would say that they made $100,000, which is about 25 percent margin. What I'm hearing is that you actually mark up the $100,000, so you would put your cost at $150,000 to $170,000. Am I right?
Arnold: It's not necessarily that high, but if I would normally bill my lead carpenter out at $65 per hour, I'm making sure I'm carrying him on this project at $65 per hour. Otherwise, I might as well have him go work on a project that I don't own, because I would actually make more money. You also have to cover liability and holding.
Remember, you're now owning the basic structure. You've got to cut the lawn, plow in the winter, you've got to heat and cool it, and insure it properly. That's an additional cost that you don't face in a standard remodeling business that you need to put into your equation. Otherwise, what you'll find is you'll do a project and only make your sweat equity. And that's not a good way to approach this business.
Tom: How important is the neighborhood, and what do you look for in your spec buy?
Frank: It's definitely important. I want nice homes in the area. We want to stay close to the key arteries. In my area we have a lot of gated communities. I try to stay away from them because of additional cost. I don't want my guys spending 20 minutes every day trying to get through the gate or being told they have to leave early. We prefer to get them out on a major thoroughfare and get them to work real quick.
Arnold: Location is probably paramount. Neighborhood is important, community is important, but so are the bones of the house. What's there? Can it be used? If the ceilings are too low, someone hasn't maintained it, and everything needs to be done, that is not a good speculative renovation project. We like to walk through a house and see three or four rooms or areas that have some charm or interest to them, but the rest of the house has not been updated or it needs an addition to make it conform to today's family unit.
In the good old days, living rooms and dining rooms tended to be very large. With the homes we build now, the center of the home is the kitchen/family room. We want to make sure that we can get those elements into a house. We've passed on homes that were on great streets for homes on less great streets that had redeeming qualities.
Tom: Who does the design and the product selections for your spec houses?
Arnold: We use input from Realtors who know the market. They'll say to me, "This house needs some updating; this is where you should head with it." We also have an interior designer who will walk through and get the theme of the house and come back with some concepts. We also find an architect who understands this business. It becomes a team approach, seeing what the existing homes for sale at this price point have or do not have and what the new homes at these price points have or don't have. You're trying to hit the big features.
If you're going to put more money into this home and still not have the features that your competitor does, you must walk away no matter how cute or charming or wonderful the house may seem. If you're over the market, you still will not be able to sell this.
Frank: We've always done our own design work and our own selections. When you try to figure out what that home is going to sell for when it's fixed up, appraisers are only going to look at homes within a 1-mile radius. You want to know what other homes have sold for in that area. That's going to relate back to what we're going to do to that house. We're going to look at what a three-bedroom, two-bath house or a four-bedroom, two-and-a-half-bath house brings dollar-wise; how many days on the market; what the asking price was; and what the final selling price was. That's going to help us make decisions. As a remodeler, we get into a lot of houses, and some of them are brand new. We get to see what the new market wants, too, and relate that back to the house we're remodeling to sell.
Tom: What happens when something happens to the market, or you put too much into it? What do you do with the house now?
Frank: You're going to have to rent it out. You need to decide when you're purchasing the house if you want to be a landlord. If so, what will rents bring in that area and will those rents cover the expense of that house? This is an investment. If none of the numbers work for the selling or renting of the home, you've got to have the courage to walk away from it and look for another one. You really need to do all that research in the beginning.
Tom: Arnold, what do you do?
Arnold: Because we have much more capital tied up, we will reduce the price. I'd rather break even than sit with this because of the holding costs involved. Rental is our last thought. After it's been rented you're no longer selling a newly renovated house, you're selling a standard house that has taken some hits on the high-end appliances. Certain things always get scratched. You've got to do your numbers and your homework up front. When we do our cash flows, we figure we're in for a minimum of a year, and we will run it out for at least 16 or 17 months to make sure we have the dollars to be able to carry it.
Another very important tip is one project at a time. There is a learning curve. The most successful builders and remodelers I've met doing this are people who started off slowly, learning what the pitfalls are and learning from their mistakes before they jump into the second project. You have so much at risk as far as time, effort and liability.
The other thing is, for a remodeler thinking about going into this, I would tell you to start another business. An entirely different name and entity. You don't want to lose the core business that you've built up because you get into a bad project on the other side. We do these projects under a different LLC. It is affiliated with us and owned by the same principals, but we're not mixing up our two businesses.
Tom: Your last thoughts on what you'd tell a remodeling contractor who's thinking about getting into this?
Frank: Get to know your market first. Don't jump into it. Track the real-estate section of the paper, meet a few real-estate agents that you think you can work with, not order takers. Don't let them convince you that your profit is going to be your sweat equity. They love to tell you that you're going to buy it for $60,000, put $30,000 into it, and sell it for $90,000 or $100,000 and that's your profit. That's not your profit. When you're doing that, you're buying a job and you don't need to buy a job.
Arnold: Study your core business first. If you're running your business at 65 hours a week and barely getting home for dinner, adding another project using your own capital isn't going to make your life easier. See if this is something you can do and handle. Do you have the right staffing and background to do it? And get into it gradually. If you miss on a spec remodel, you've got a lot of your capital, the bank's capital, tied up, and it's for a much longer period. The risks are greater. Approach it with that understanding.
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How to pick properties and make margins