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How To Not Screw Up Your First House Flip!

by Michael LaCava on December 22, 2013 · 20 comments

  
First House Flip

Nobody likes to screw up.

And worse yet, nobody likes to screw up publicly while at the same time, losing other people’s money.

That money may be family money, friend’s money, private lender money, bank money…or your own money.

Justifiably so, this tends to be one of the biggest fears most new investors…but it doesn’t have to be.

The best way to NOT screw up a flip is to make sure your analysis of the deal is spot on.

So fear not new investors, read below and worry no more…

Learn How to Analyze the Deal

Learning how to analyze the deal is one of the most important things you need to know when you’re flipping houses. This includes knowing exactly what you can sell the property for (known as ARV), what you’re renovation costs are and of course what you can buy it for.

If you haven’t heard, ARV is the single most important number in house flipping - as all the other numbers stem from this one.

But as a new investor, you may be tempted to just do your first deal just to get it under your belt. You may think you can underestimate a few cost of repairs here, or overestimate what you can sell the property for on your ARV there, and everything will turn out just fine.

Not so.

To be successful doing this, you really have to follow rules, systems and formulas.  These will keep you out of trouble and safeguard your business from catastrophic losses.

No “Adjustable Spreadsheets”

Adjustable mortgages are fine, (although personally I don’t use banks at all), but not adjustable spreadsheets…especially in house flipping.

“The adjustable spreadsheet” – otherwise known as “eraser math” is one of the biggest enemies of the new house flipper.

But this is all too common – and I see it happen all the time, including some of the more seasoned real estate investors who still fall victim to it.

I even saw this week with one of my former coaching students as he desperately tried to convince one of my money lenders to fund one of his properties. Fortunately for my old student Jerry, my lender Elliott would not budge on his skepticism - because he knew Jerry was using an “adjustable spreadsheet” in his calculations!

Jerry may need to dump the property and move on – or figure out a way around some of his renovation costs,  which were just simply too high for the profit needed in the deal. His adjustments left him little margin for profit which worried Elliott as to the solvency of the deal.

Jerry aside…this is typically a failing of the new investor who is trying to get into a property for the first time. New investors have a tendency to want to justify or come up with reasons why they can pay more money than what their maximum allowable offer (MAO) should be.

Are you guilty of this?

When I talk about adjustable spreadsheets, what I mean is this:

  • Let’s say you’ve determined the property you found could sell for $400,000 once it’s all finished.
  • And let’s say you figured your cost of repairs were $80,000.
  • Assuming the above numbers are accurate, according to the house flipping math, you need to get this property at no more than $200,000
  • Then let’s say you placed an offer at $195,000, thinking you could get it for $200,000, but it was rejected because there’s multiple offers on the deal.

What do you do now?

  • Do you go up on your offer over $200,000?
  • Do you figure out how to get the ARV higher?
  • Do you lower your renovation costs?
  • Do you walk away?

For most investors, they start looking at things and start doing “adjustable spreadsheet stuff”.

This typically comes in two forms:

  • Up The ARV: They start to convince themselves that if they do a few more renovations or improvements that they might be a will sell the property for $410,000 or maybe even $420,000.
  • Fudge The Repairs: They start to fudge is there repair costs.  The investor might say themselves: “if I put some work in myself and if I can negotiate on my contractors I could probably get this renovation done for about $60,000 instead of $80,000”.

This investor then starts to convince themselves that this “alternate reality” in their deal scenario actually exists. They start “adjust the spreadsheet” to mathematically arrived at the point where it makes sense to offer a higher price.

Just because the paper (or in this case the Excel spreadsheet) looks good, doesn’t mean that it actually is good. So the new investor goes out and offers a higher price, gets the property does the renovation, experiences hire than anticipated renovation costs and a lower ARV and they end up losing money.

This unfortunately is a classic scenario…which leads to big heartache later on.

Here’s 2 ways to avoid this pain…

1. “Stick Like Super Glue” to Your Original ARV

If you have a projected ARV of $400,000 and you start to convince yourself that if you add marble countertops to the bathrooms, a subzero stove to the kitchen or maybe a certain type of designer tile in the entryway or a larger back deck, you’ll get $410,000 or even $420,000, you’re only hurting yourself and your profits.

When you start doing all this, it’s a slippery slope of rationalization upon rationalization – all doing nothing but clouding the numbers and jeopardizing your profit.

The reason is that the house flip rules take into consideration a conservative ARV and the potential for the ARV to drop 10% or even 20% by the time you’re going to sell.

By the time the renovation is completed and you’re ready to sell, the market always has the potential to shift. Perhaps now even after an excellent competitive analysis, the neighborhood in which you bought your flip now has ARV’s in the range of $390,000 or maybe even $380,000.

When flipping a good maxim to post on a sticky note on your computer is:

Hope for the best and prepare for the worst

Although you might think in the current market environment that real estate prices are consistently appreciating (and in most cases right now they are), this is extremely dangerous and risky thinking to EXPECT IT.

So let’s say you adjust your spreadsheet to convince yourself that you can sell the house for $410,000. If the market shifts to where you can only sell it for $390,000, you have now completely lost your safety net.

When your original ARV projection is $400,000, and you sell for $390,000 – although not ideal – this is certainly not catastrophic.

But with your “adjustable spreadsheet” ARV at $410,000 and selling at $390,000, that $20,000 spread could be your entire profit on the deal.

This is why fudging your ARV is very dangerous because it almost completely eliminates your safety net of profitability.

2. Don’t Fudge Repair Costs: They Rarely Go Down

With just about every flip I’ve ever done, it seems my renovation costs always come out higher than my projections.

As I write this, I would say it’s about one in ten house flips where they are lower than my original projections!!!

So I can nearly guarantee you that whatever number you come up with for repairs, it’s usually going to be higher.

So what we do now is when we get our renovation numbers, we add another 10% to the cost of renovation.

In some cases, we may go even as high as 20% over the original cost of renovation if we’re not 100% sure.

so in our scenario here, let’s say you’ve lowered your renovation costs to $70,000 – trying to justify the higher offer. But lets say, by the time you get done with the project that original $80,000 estimate now has turned into maybe $90,000…or maybe even $100,000.

Now you’re really screwed.

How To Not Screw Up Your First House Flip: Conclusion

Its easy to get emotinally attached to a house flip and WANT it to waork so badly that you convince yourself that it will work if only…

Forget it. Move on and find another one.

You just can’t get emotionally tied to anything.  You’ve really just got a think with your head not with your heart.  Stick with your math, stick with the numbers you come up with and go with it and if it works out it works out.  If it doesn’t owrk out, it doesn’t.

Get up and fight another day.

There’s always another house flip…

 

And if you’ve made it this far, please leave a comment below, I’d love to hear from you.

Have you made these mistakes? Do you have the same fears? If you haven’t that’s cool too, leave a comment and ask me any question you want!

Photo: Flickr

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{ 20 comments… read them below or add one }

Gerald Harris December 22, 2013 at 10:15 am

Great Article Michael

I wish i had known this on my first house deal in Victorville CA. I purchased the 3br/2ba house for 35k with hard money. It had a total of about 10k in repairs and fix up. First, I bought carpet from Sears for 5k for a 1000sqft house :( Second the Realtor who helped me close the deal begged me to paint my interior for 1k. which he ended up painting 1 wall in the kitchen. I then asked a contractor to hang a couple of doors and do some roof repair (which turned out pretty good). I found a painter on the Green Sheet newspaper who actually painted my entire interior for $300. I bought the material. He actually did a pretty good job. The property was worth 65k at the time but i decided to keep it and refi into a lower interest rate. My credit was shot and my income was weak, not to mention the appraisal came back too low. I eventually ended up renting it for $650 per mo. pulling in a monthly negative cash flow. My point is this. I made the mistake most beginner make. I over estimated value and I understimated fix up costs. As time went on, i made fewer and fewer mistakes.

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Michael December 27, 2013 at 5:20 pm

Thanks for sharing Gerald. As long as you learn from your mistakes because we all make them regardless of how well we are prepared we are then you can move forward more confidentially which you obviously did. Still investing in CA?

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Glenn English December 22, 2013 at 12:16 pm

Great Article, and too close to my current situation..I am going through the process of knowing that I am well on my way of screwing up my first flip. I can admit to my mistakes and learn from them, and hopefully not repeat them if I am in the position to be able to flip again. I purchased a home for $235K with my own money from a cash out refi on my own house, and figured $100K worth of repairs with an ARV of $400K. I got another HELOC for the repairs and I thought worst case scenario would make about $40-50K after the dust settled. I am anticipating that I will be into the property for $165K worth of repairs + $235K purchase price = $400K total..the home needed a complete gut. I am hoping that I break even, but I am currently at $120K in renovations and still have about 5 weeks worth of renovations which will cost me $45K. I have contemplated getting out of it now, but I don’t think I would get what I need for it at this point, so it’s back to the bank I go to finance the remaining renovations. My question is do I cut out on things like kitchen cabinets, and flooring which will probably save me about $20K total and just list it as “choose your own cabinets, flooring and colors”?
I knew this first flip was going to be more of a learning experience for me, but I should have passed on this house..I thought I had been patient in looking for a flip but I should have waited..shoulda coulda woulda..doesn’t matter now, just need to deal with the situation and get through this winter. Any advice is appreciated!
-Glenn

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Michael December 27, 2013 at 6:05 pm

Hey Glenn – Man this is a tough one. Your MAO from the get go should of been $180,000 to $200,000 max so you started off way to high on this. Where is this property located?
I think you need to finish it off but you need to negotiate hard on your repairs costs to finish it. It’s hard to get into too many details here. You need to talk to a real good qualified real estate agent here and do it now. She may be able to offer you some good advice based on the market conditions in your area. What is your total budget for the kitchen cabinets and tops and installation. What are your appliances budget?

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Mary B December 22, 2013 at 3:06 pm

Excellent points, Mike. The number adjustments can be the beast of failure no doubt. Sometimes there is a ARV margin i.e. $375K to $380K but there is always a maximum and going pass that $380K would be costly. I especially like how you pointed out about not cutting costs on renovation since very likely the work will have to be done anyway. Often no matter how little you think the repair is it effects something else and going around it is not an option. It must be fixed. I’ll run my numbers about a dozen times just to be super certained. I’m highly analytical in fix and flips moreso than wholesaling for obvious reasons. Thanks a bunch for the share.

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Michael December 27, 2013 at 6:12 pm

Your welcome Mary. I agree sometime what appears to be a simple fix can more than what you see. On one of our current rehabs we took out the sheetrock on the ceiling in a bedroom for something and what we found was not expected but some LVL and structural work later it was all fixed. Not expected and no real way of knowing but once we saw it we had to fix it. Not just for the code but it is the RIGHT thing to do!

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James Granger December 22, 2013 at 3:45 pm

Great Advice. I’m working on my first flip offer now. I have been a contractor for over 25 years and found to stick with your orginal figures and gut instinct. Every time I would cut my cost on a job I either lost money or broke even. Give your best shot first ,and walk away works well.

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Michael December 27, 2013 at 6:16 pm

Great point James and coming from a contractor you understand better than most.

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Ric Miller December 22, 2013 at 9:38 pm

I’m on my 6th deal.
So far, 2 have made between 33K and 61K.
3 I keep as rentals, 1800/month profit.
I find my deals on the MLS.
I put in about 200 offers before I get a deal.
Then I get scared.
The reason?
Why do I think I can make a profit on this home when nobody else in Denver can?

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Michael December 27, 2013 at 6:22 pm

Wow. 200 actual offers for one deal or viewing 200 with a percentage of them turning into offers? If it is 200 offers for one deal. How many houses for sale in your market and what is your geographic coverage. It must be pretty large to support that many offers.
Thanks for sharing and that is a testament to your willingness to get it done.
Great Job Ric!

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Ric Miller December 28, 2013 at 6:19 am

Michael,
My 3 year old and I make an average of 5 showings per day.
From those I will make at least 20 offers per week, no sense in
looking and not offering unless it is dangerous to work in.
The Denver market is good right now for sellers, buying is hard.
I go through agents like cigarettes, smoke ‘em til they burn up.

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Sharon Vornholt December 23, 2013 at 7:23 am

Great post Mike.

Eraser math gets more people in trouble. You nailed it when you said “stick like Super Glue to your original ARV. You will rarely get into trouble if you estimate your repairs on the high side (yes they always cost more) and use a conservative ARV. That is the best advice any rehabber can take away from this post.

Happy Holidays Mike to you and your family.

Sharon

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Michael December 27, 2013 at 6:21 pm

Wow. 200 actual offers for one deal or viewing 200 with a percentage of them turning into offers? If it is 200 offers for one deal. How many houses for sale in your market and what is your geographic coverage. It must be pretty large to support that many offers.
Thanks for sharing and that is a testament to your willingness to get it done.
Great Job Ric!

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Michael December 27, 2013 at 6:25 pm

Thanks Sharon –

The difference now is If I chose to adjust my MAO it only because I am willing to take less of a profit for deal flow but I understand why and it is not to make it something it is not.

Great Christmas – Hope you had a great one as well! You saw my FB post so I couldn’t be happier!

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kathy December 23, 2013 at 9:56 am

I don’t do flips but buy houses to rent and hold. Location if very important to me. I usually round up on my repairs and add an extra 10% for surprises. I also plan on the assessed value being higher than actual fixed up appraisal value and knock 25% off the value that I believe is the correct value. Then I make my best offer and if they take it fine. If not, I know I will find another property. I’ve actually had sellers come back months later and ask if I was still interested in buying. I just keep looking and making offers until someone accepts. Right now I have a great broker who knows my criteria and I don’t have to look at as many properties as when I was breaking in brokers. Find a broker who doesn’t wince when you make a low offer.

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Michael December 27, 2013 at 6:28 pm

So true Kathy and once you find a great broker it makes it so much more efficient.
Its’ great having a excellent team members that make it much easier for you!

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Joseph Murders December 24, 2013 at 6:52 am

Great advice. This applies to not only rehabs, but also wholesale flips as well. I learned this the hard way and, thankfully the investors in my RENC have been kind to me and very helpful.

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Michael December 27, 2013 at 6:30 pm

Absolutely Joseph. If you don’t get the numbers right – no investor that know what he or he is doing will buy that property from you and you lose credibility with them and if you sell it to a newbie investor the same thing will happen but it will cause someone financial harm which is the last thing you want to do.

Good point!

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Shaun December 26, 2013 at 9:30 pm

Great stuff Mike.
This is exactly the advise anyone getting ready to start trying to do rehabs needs to hear.
Sure maybe someone will be to conservative on the ARV or put way more padding than needed on the repairs, but that should just mean that the profit will be killer.
Better to lose out on something that would end up making you an okay profit here and there rather than get stuck with some that barely make you anything, or cost you money.

I suppose if you get to the point of the big machines that are cranking out 100+ flips a year you can go for thin margins but if you are doing your first couple you can’t risk taking a big hit or it could be game over pretty easy.

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Michael December 27, 2013 at 6:35 pm

That is a good analogy Shaun. I find myself taking on some deals with less profit because we want more deals and it keeps our lenders money in play as well which is important also. Don’t want them sitting at bay too long while we are working on more deals to put together. The difference is like you said and shouldn’t be done by newbies or anyone unless they absolutely understand the numbers the importance of hitting targets more than ever otherwise those slim margins turn into no margins or a loss possibly.

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