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Real Estate Investing (Part 2) – The Flip

One man’s trash is another man’s treasure. House flipping is based on this principle. But how do we find the right kind of trash? A harder question yet… how in the hell do we turn it into treasure?

We should get one thing clear first:

This is not like the TV shows. Sorry… shows on HGTV make for great entertainment. Not great education.

What we’re going to try to do is unpack the realities of flipping a house. What we’re NOT going to do, is delve into the gritty specifics of the construction science of rehabbing a house. Not that I wouldn’t love to… I’ve been watching episodes of “This Old House” as long as I can remember watching TV. (thanks Dad). So, if you’re reading my blog to try to figure out how how to install a pedestal lavatory… again, sorry.

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Ahh… the joys of home flipping.

Let’s get started on the basics.

To evaluate prospects (leads) for potential flips you must do it objectively. You need to remove any and all emotional connection you may have with a seller or their property. Your decision needs to be based on facts and conclusions… not on emotions or opinions. Math is going to be a greater ally for you than any stylish taste or feng shui. Richard Warren said it well in his BiggerPockets.com blog,

“Your likelihood of success as a real estate investor will increase dramatically if you remove the emotional aspect from your decision making. How do you do that? By using tried and true formulas that are often ignored when you allow your emotions to overrule logic.”

Now that you’re objectively evaluating your deal prospects, what do you need to be looking for? If you’re checking out a lead for a potential flip, what are some of the things that make it a good opportunity? What math do we apply and how do we apply it?

Step 1

What are refurbished/renovated houses going for in this particular area?

To do this, we’ll need to pull comps. If you’re already working with a real estate professional, they should know exactly what you mean when you ask them for the neighborhood’s comps. If you’re NOT working with a real estate agent or REALTOR… you should. As you’re reviewing the comps of your target property’s neighborhood, you’re going to be looking for what the average sold price per square foot of flipped/renovated houses is going to be. (SP/SF)

Once we have determined the average SP/SF, we then apply it to the square footage of our subject property. The square footage of the property, multiplied by the average SP/SF, equals your subject property’s after rehab value. (ARV) This is hugely important; this ARV is what (in theory) the subject property could sell for on the open market after all the fixing up is done! This ARV is the number that we’ll work backwards from… to determine if this property is a deal for you or not.

Step 2

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Hard work pays off… eventually.

How much is this rehab going to cost?

IT DEPENDS! How much home does the rehab need? To determine this, compare and contrast your subject property with the rehabbed properties your real estate agent pulled in your comps. What kind of floors do they have? How nice are their kitchens and bathrooms? If you’re going to base your project’s future price on the comps… your project needs to be like the comps.

Once you’ve got your list of must-fixes… you’re going to need estimates- real, hard numbers from the people who are going to perform the work. If you don’t want a shock when your contractor’s invoice shows up, you’ll need to communicate with them throughout the process. Make sure you both have a clear understanding of the cost prior to using their numbers for your budget.

Step 3

How much am I going to make?

So, now that you know what your house is going to sell for, and you know how much the rehab is going to cost… you now know how much money is going to go in your pocket at the end, right? Wrong.

There are quite a few more costs to rehabbing a house than simply the construction. Utility bills, insurance, real estate agents’ commissions , property tax, etc… these are some of the overhead costs of flipping a house. A good rule of thumb for estimating these overhead costs is 10%; this should allow enough for those realty commissions (6% typically), and all of those other soft costs of holding on to your pet project until that magical buyer comes along.

But what about you? How much should you make? Generally speaking, most flippers set out to make at least a 20% return on their money. This might seem a bit high, but trust me: once you get a grasp of all the work and worry that goes in to a house rehab… you may rethink that.

Therefore, if we’ve got 10% of our sale price being eaten up by our overhead costs, and we expect 20% of that as a return on our money… that’s a total of 30% against our ARV.  (100% ARV – 30% = 70% ARV)

We now subtract those rehab costs.

If the remainder of this math equation is more than the bottom-dollar price of your potential seller… you MIGHT have a deal. If the remainder is higher than the bottom-dollar price of your potential seller… you DEFINITELY don’t have a deal.

Use this formula as a basic litmus test for evaluating a potential deal.

I must point out that I haven’t mentioned a word so far about financing. This is a huge topic, and one that I may write about later… but just keep in mind: if you are borrowing this money, the cost of borrowing it is going to eat in to your bottom line even further. How long are you going to borrow the required money for this flip? Do your arithmetic and calculate how much your financing costs (interest) will be, and subtract it just like your rehab costs.

Please keep in mind, these are VERY basic principles I’m trying to pass along here. I’m sure there are many exceptions to the rules I’ve laid out in this; however, I’m simply trying to teach this risky game the way I learned it. The equation I line out above is just a basic litmus test to apply to your prospective deals to determine if it is AT ALL POSSIBLE to make money off of them.

Absorb as much as you can from as many people like me as you can. Once you have, develop your own system and stick to it. In their book, Flip: How to Find, Fix, And Sell Houses For Profit, Rick Vallani and Clay Davis write,

“You have a formula for success, and if a potential investment doesn’t make the grade, you pass. And you keep passing until you find a property where the numbers say it will work. Following systems reduces the risk and improves the chance of success. The best flippers- those who win consistently- have and follow a proven system.”

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Voilá!

Happy hunting out there! Post your comments below and tell me about your house flip experiences. I’d love to read them.

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