How to pick a fixer-upper you can flip

March 8, 2013

First in a series about investing in real estate

By most measures, the past eight years have been a disaster for most of the real estate industry.

However, for investors who had the prescience to buy real estate at bargain-basement prices and the financial ability to hold it, the time may soon arrive when those high-risk investments will pay off.

“Home sales are on a sustained uptrend, mortgage interest rates are hovering near record lows and unsold inventory is at the lowest level in 12 years,” said Lawrence Yun, chief economist at the National Association of Realtors.

Before making any investment, you need to answer two questions: Am I willing to be a “hands-on” investor? And how much risk am I willing to accept? Assuming you are willing to take a hands-on approach and can tolerate a fair amount of risk, buying, renovating and “flipping” may be just right for you.

A good candidate for a flip is generally a home that requires repairs and/or renovations to make it desirable for someone to buy and live in. Sometimes the necessary fixes are minor and cosmetic in nature, such as landscaping, painting and carpeting. Other times a property needs major work, such as replacing a roof, updating the kitchen and bathrooms or even reconfiguring the home.

The goal here is to buy the home at a discount below the fair market value, make the repairs and/or renovations, and then sell the home at the fair market value. But how much of a discount?

Experienced renovators often say that you make your money when you buy, not when you sell. To arrive at an offer price, you can use the same method they use.

First, determine the home’s after-repair value: the market price that comparable homes in mint condition, in the vicinity, have sold for within the past three months. A real estate agent with access to a multiple listing service record of sold homes can be a valuable resource.

Second, determine the expected repair costs as precisely as possible. To do that, you should assemble a team of honest, experienced real estate professionals, including an architect, home inspector, appraiser, general contractor and, if necessary, a carpenter, plumber, electrician, HVAC contractor, roofer, environmental or mold inspector and landscaper. They should inspect the home with you.

The results of their inspections can be used to determine three categories of repairs. The first is the must-make fixes needed to meet minimum building codes and the requirements of financing agencies such as the Department of Housing and Urban Development, Federal Housing Administration and Department of Veterans Affairs. The second is repairs to correct functional or aesthetic obsolescence. This is where the pink-tile bathrooms, avocado-green appliances and beige laminate counter tops get replaced with modern, natural-stone walk-in showers, stainless-steel appliances and granite counters. The third is a wish list of upgrades. Radiant-heated bathroom floors, wine cellars and high-end fixtures and finishes can shine, if your budget and the market can support them.

“But you must be careful not to over-improve for the neighborhood,” said Lisa Abrams, an agent at Re/Max Realty Services in Bethesda. “You don’t want to wind up being the most expensive house on the block.”

Finally, determine your anticipated carrying costs until sale. Those include the principal and interest payable on the money you borrow to acquire and repair the property, plus the opportunity cost of using your down payment (the amount you could earn if it had been invested in a risk-free investment, such as a bank certificate of deposit). They also include the costs of marketing and advertising, taxes, insurance, closing costs on the buy-and-sell sides, attorneys’ fees, settlement fees, recording and transfer fees and taxes, title searches, title insurance, surveys, permits, inspections and brokerage commissions.

To arrive at the offer price, start with the after-repair value, subtract the expected repair costs and carrying costs, then calculate 60 percent of the difference.

For example, here’s how you would calculate the offer price of a unit in the District with an after-repair value of $353,000, requiring $35,000 worth of renovations and incurring anticipated carrying costs of $25,000: $353,000 minus $35,000 minus $25,000 equals $293,000, multiplied by .6 equals $175,800. Unless you can buy this property for $175,800 or less, it might not be worth the risk.

This hypothetical example assumes that you make a 30 percent down payment ($52,740) and that you pay for the repairs ($35,000) and carrying costs ($25,000) out of your own pocket. Thus the total cash invested is $112,740, which generates a pre-tax gross profit of $117,200. Assume a 35 percent tax bracket, and your after-tax profit on cash invested would be 67.59 percent.

Not a bad return for several months’ work. As you successfully complete several projects, your estimates will become more accurate, and you might be able to increase your offer price and land more deals.

Next: Investing in rental condominiums

Harvey S. Jacobs is a real estate lawyer in the Rockville office of Joseph, Greenwald & Laake. He is an active real estate investor, developer, landlord settlement attorney and lender. This column is not legal advice and should not be acted upon without obtaining legal counsel. Jacobs can be reached at (240) 399-7900 or ask@thehouselawyer.com.

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