In real estate, you make your money when you buy. It’s a common phrase in the business, and no truer words have been spoken. Let that sink in. You make your money when you buy the property. Not when you sell. If you don’t buy the property at the right price and/or terms, then there won’t be any profit when you sell. There is no strategy or trick to making money on a piece of real estate for which you paid too much.
That is especially true for flippers. Flipping is a short-term strategy. There is no time for market values to increase and save you from a bad decision. A landlord might hit the jackpot and buy a home in an area that skyrockets in value over a 10-year period. A flipper needs to get out in less than six months.
Here’s a simple strategy for calculating your offer price on that next flip property:
Offer price formula:
Purchase price = ARV or after-repair value minus 25 percent minus renovation expense
ARV is what you believe the home will be worth after it’s fixed up. This is normally derived from looking at other nearby comparable sales. Usually this consists of similar homes within a half-mile of the subject property that have sold within the last year. I like to look at homes that sold in top condition if there are any available.
What’s the 25 percent?
The 25 percent discount constitutes your closing costs, finance costs, holding costs and your profit. This number may need to be bigger or it could be smaller, depending on your situation and market. Most people advocate for 30 percent. I typically do well enough with the 25 percent.
Closing costs when you buy and sell:
You have closing costs when you buy the property and when you sell it. These costs include real estate commissions, legal, transfer tax, title insurance, document prep and more. These costs can be significant. Depending on where I close a deal in the Washington area, I expect these costs to add up to 6 to 12 percent of the end sales price. I’m a licensed real estate agent in Virginia, so my costs are significantly less for homes I buy and sell there.
I’m not a licensed agent in Maryland, so I have to pay another agent to handle the sale there. And some Maryland counties have transfer taxes as high as 3 percent of the sales price. That has to be paid when you buy the home and when you sell it. That cost is traditionally split between the buyer and the seller but not always. Either way, it’s expensive.
Holding costs are things such as utilities, insurance and property taxes. For a property being flipped, you should get a commercial insurance policy with builder’s risk coverage. These policies are more expensive, but they’re necessary.
Finance costs are high in the home-flipping business. You can easily expect to pay 12 percent interest and two to four points on the money you borrow. You can go to a bank for your financing, but too often banks don’t move fast enough to allow you to capture the really great opportunities.
Your finance costs depend greatly on the situation and your creditworthiness. Even if you have cash you should still calculate in a return on your investment of at least 8 percent. If you’re not making a return on that cash, then you’re better off lending that money to other flippers at a 14 percent rate of return and save yourself all the hassle of dealing with contractors, permitting offices and home buyers.
Profit is your end goal. It’s the payoff for your aggravation, sleepless nights, risk and hard work. You need to make sure you’re reasonably safe and compensated. On average, homes sell for about 92 percent of the original list price. That means if you think you’re going to sell the house for $100,000 there’s a very good chance you’ll get $92,000. So, in this scenario, if you only built in a $5,000 expected profit margin, then you will have lost $3,000 when it’s all said and done.
I typically shoot for a 15 percent profit margin as compared with my expected end sales price. I never go below 10 percent. There are too many unknowns. In just about every deal, the renovation costs are higher than expected, and in most cases, the house sells for less than you anticipated.
In this business, you have to move the houses fast. That often means you have to leave a little bit of profit behind. You can’t sit on a home for an extra three months waiting for that buyer willing to pay top dollar — not when you’re paying private capital interest rates and missing out on other opportunities.
Don’t underestimate them! Most people are shocked when they hear how much a home remodel project will cost. The average kitchen remodel in the United States pushes close to $50,000. You don’t need to be anywhere near that cost, but it’s extremely hard for me to get my kitchen remodels done for less than $15,000 in the D.C. area. It’s very rare that my total home remodel costs come in below $75,000. Get multiple bids for the work and be careful about planning to do work yourself. Bad work is worse than no work at all, and finance costs can quickly eat up DIY savings if the project ends up taking months longer.
Here’s an example of a deal:
You find a home that you believe will be worth $500,000 after it has about $75,000 in improvements.
Purchase price calculations:
minus 25 percent of ARV or $125,000
minus $75,000 renovation expense
= $300,000 purchase price
You’ll want to pay around $300,000 for this home. Now keep in mind that depends on your situation, and you’ll have to fine-tune this based on your circumstance. If you have no cash of your own and you’re borrowing all the money at 12 percent interest and four points, then your capital expense on a six-month deal will be around $37,500. If you’re in a higher-cost state and your buy/sell/hold costs are 10 percent then that will be another $50,000.
With those details, you can work the math backward to fine-tune your offer.
minus $50,000 buy/sell/hold costs
minus $37,500 capital expense
minus $75,000 renovation expense
minus $300,000 purchase price
= $37,500 profit
The $37,500 profit divided by $500,000 is 0.075 or 7.5 percent. That means your profit will be about 7.5 percent of the sales price. That type of margin disappears really quickly. It’s easy to find your renovation budget passing $100,000 and the end sales price coming in at $480,000. Now, instead of making $37,500, you’re losing $7,500.
Because you know you need to shoot for at least a 10 percent profit, you need to add 2½ percent to your discount rate. Instead of 25 percent, you may need to use 27½ percent.
I know it seems absurd to plan to make $50,000 on one house, but making $50,000 on a $450,000 investment is not a real thick margin, and it’s far from safe. There are a lot of moving parts in this business. There are a lot of unknowns and variables. You have to make sure you’re covered. And you have to make sure you’re making enough money to stay in business.
Justin Pierce is a real estate investor and real estate agent who regularly writes about his experiences buying, renovating and selling houses in the Washington area.