Real Estate For Fun and Profit

The fact is that you make your money when you buy (you realize that money when you sell).  If you buy it for too much, then you will lose money – it is a simple as that.

So what is the right price?  For rehabbing, there are several formulas out there – I like the following:

 Max Offer = ARV – Repair cost – Holding Cost – Buy/Sell Costs – Desired Profit

This can also be expressed as

 Max Offer = ARV x Z% – Repairs

But I would only use this short version when I am very comfortable with how long my rehabs take and the amount of time my end product is on the market.  The difference between 100% and Z% accounts for the Holding Cost, Buy/Sell Costs and the Desired Profit, so you need to be very comfortable with the estimates of these Costs before you can use this as a percentage.

After Repair Value (ARV) is your expectation of the amount for which you will be able to sell your end product in a ‘short’ time.  For single family houses, this is usually found by finding comparable properties nearby that sold recently and estimating your end product value based on this information.  Remember that your end product needs to be either ‘a better product for the same price’ or ‘a similar product for less’ in order to get sold quickly.  In general, I would like to see the 5 closest comparable houses (up to 1 mile away) that sold within the last 6 months.  I look at the features of these houses to price my end product house.

Repair Cost is an estimate of how much it will cost to change the condition of the house today to become the desired end product house.  Will you upgrade the property to low end, moderate, or luxury condition?  Are you just going to clean up the property, or are you going to gut it and start over (or somewhere in between).  What does it take to get permits or zoning changes in your area?  Who will be doing the work?  All of these decisions need to be answered to come up with a good estimate of the repair costs.

Holding Cost is an estimate of how much it will cost you during the entire time you own the house.  I usually calculate my monthly cost and multiply it by the number of months I expect to own the house.  This includes payments on mortgage(s), utilities, insurance, property taxes, etc.  The number of months is determined by the scope of the repair work and how that work is being accomplished (are you swinging the hammer or contracting the work?)

Buy / Sell Cost is the amount that you will spend for all of the process of buying and selling the property.  When you buy, this includes the escrow fee, the loan origination or points for your loan, inspection fees, title insurance or fees, taxes, etc.  When you sell, many of these same fees may apply plus you may need to pay commissions.

Desired Profit is what you would like to earn from this flip.  You need to decide this number and then compare the actual profit after completion – that is the only way to improve your flipping business.  A couple things to consider when you determine this number:

• Is the yield on your money better than other investment opportunities?  For example, earning 10K on a 200K cash investment in 9 months is the equivalent of 6.7% interest.  Could I invest my 200K someplace else with less risk and make as much?  Do you want to establish a minimum yield?
• Do you want to establish an absolute minimum that you want to earn per deal?  Will this set a boundary on the type / location of your desired house?

Max Offer is the resulting number.  This is the maximum value that you can pay and still make your desired profit.  If you pay more, you will make less!

This is, of course, a cash offer on the property.  If you got good terms, you could pay more if your exit strategy gave you additional profit because of these terms.  For example, if I can get seller financing for 2% less than any of my other sources, then my holding costs will be less.  I may then be able to sell the end product with seller financing and make some extra profit on the interest spread (if I charge 8% to my buyer and the seller charged me 4%, then I make 4% each month of payments).  In this example, I could afford to pay more for the house originally and still make my Desired Profit.

Also, this is a formula for rehabbing.  If your goal for the property is a long term hold, then you need to look more to the long term Return On Investment (ROI).  But that is a subject for a different post.