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What’s The Number 2 Most Important Factor in House Flipping?

by Michael LaCava on January 19, 2014 · 22 comments

  
House Flipping

Everyone has a Number 2, just like Dr. Evil.

In the movie Austin Powers International Man of Mystery, Dr. Evil had his Number 2 – played by Robert Wagner and then by Rob Lowe in The Spy Who Shagged Me.

Number 2, as you may recall, was responsible for the meteoric rise of Virtucon, the company that led to Dr. Evil’s astronomical rise in wealth, all earned by Number 2 while Dr. Evil was cryogenically frozen for 30 years.

So as you can see, Number 2 is pretty important.

In house flipping, we have our own Number 2 as well, but its far from evil…unless you grossly miscalculate it.

What’s Number 1 Again?

Number 1 is of course, ARV or After Repair Value. As the most important thing in house flipping, every one of your calculations and metrics when flipping houses flows from it.

But we already discussed its importance a few weeks ago.

So that leaves the question…what’s the SECOND most important number in house flipping? 

Or as Austin says in the first movie: “Who…does…Number…Two…work…for?”

It can work for you but it can also work against you depending on how you work it, because it’s typically the second largest expense in house flipping and in many cases, its the biggest cost in house flipping.

Introducing Number Two…

The Robert Wagner of house flipping is the renovation cost. It is the second most important part of making a deal profitable – not only because it’s the second largest expense but it’s also the one that is the most challenging to get right.

When you’re getting into bigger renovations, which includes renovation of $50,000 and higher, the renovation is a very significant portion of your overall costs. This is especially true when you’re getting into major rehabs, $50,000 and over – or maybe even $100,000 or more.

When you’re dealing with numbers that are that large, there is more room for error, more room for price discrepancies and more room to underestimation mistakes. We have a property under contract right now in Freetown, Mass where the renovation cost will be in excess of $140,000. Its one of the biggest renovations we’ve ever done, largely because it’s a total knockdown.

Regardless, it’s really important that you understand how the process works and you learn how to manage that process extremely tight. When you manage Number Two correctly, you can make solid profits. When you don’t manage Number Two so well, it can be the difference between a profit or in some cases, no profit at all.

With Number Two, You DON’T Need To Know It All

For most house flippers, they are not general contractors. Its OK, you don’t need to be, it helps but it’s not necessary.

Managing the renovation doesn’t necessarily mean you have to know every trade inside and out and become an expert plumber, electrician, insulation contractor, engineer or architect. The idea is to understand how all those different trades work; knowing and having some concept of how they all fit into the bigger picture.

In fact, I haven’t lifted a hammer on a renovation in nearly two years.

But that does NOT mean, I’m not involved, because I am, you have to be.

So what we’re really talking about here is how to manage the rehab process. Even if you’re not directly managing the project as the general contractor, you still have to understand how the overall project works.

Setting the Budget

Being able to determine the renovation budget is so critical to determining what you’re going to offer on a property. If you don’t set the budget correctly and then you base your offer on a rehab budget that’s unrealistic, you’ll have a hard time making money on the flip.

Now does that mean I get this perfect every time? Absolutely not.

Have I been off by $5,000, $10,000, $15,000 $20,000 in budgets? I have. Too many times in fact.

This is why we use a Cost Of Repairs Estimate form or “CORE” for short.

The CORE of Estimating Repairs

The CORE is just basically a one-sided form with 25 or so different things to look out for in your walk-throughs. Think of it as your checklist of repairs needed. It will remind you to look at the roof, look at the windows, look at the siding, look at the soffits, look at the fascias, look at the chimney, look at the landscape and so on. Each and every item that could potentially need fixing is on the CORE.

It will help make your own evaluation of the condition of those things and make sure you don’t forget anything as well.

A lot of improvements are self-evident. You can look at a roof and determine that it’s pretty bad and it needs replacing. Or it could be a question mark and it could be an unknown. Or it could be it looks pretty good, but maybe you need a professional opinion.

If you are in doubt as to whether something needs to be replaced, put a question mark next to it on your CORE and to be conservative even count it in as something that needs fixing. When you do your walk-throughs with your general contractor, have him fill one out as well.

At the end of the walk-through, share your CORE with him and compare notes. Maybe he has one that can be even more detailed. You can combine the two and come to a joint list of things that need replacing.

So by doing walk-through and checking off those items on your CORE, you’ll get a rough idea what things will cost. You simply add up all your costs, get your number and it’s as simple as that.

Or is it?

The “X Factor” With Number Two

It’s not quite as simple as that…

Nobody ever nails the repair costs. I don’t. I don’t anyone who does. I don’t think I’ve ever gotten one 100% accurate but I have a plan for that so I don’t worry about it too much.

The truth of the matter is you have NO idea what is lurking behind the walls once you start renovating. In some very rare cases, you can see what behind the walls. One in fact in Plymouth, Mass we just got actually had been gutted to the studs because of previous mold damage.

We LOVE houses like that, but they are rarely that easy. In most cases, you need an insurance policy of sorts in order to cover you in case you find additional repairs you either missed or underestimated.

This is why you need an X factor of 10 to even 20% of those costs on the CORE. Most of the time, we do 20% OVER our CORE.

This is especially true when you’re new and you’re not sure.

Renovation + X Factor + MAO = Profit

So for instance, once you do your CORE and you add it all up and the number comes to $50,000, you should base your offer on a $60,000 renovation just to be safe. Then do your 70% Rule and determine your MAO.

If your renovation come in at $50,000 INSTEAD of $60,000, think of it as a nice little bonus…but dont count on it.

Don’t worry about being perfect. But if you overestimate, you’ll always be covered. I’ve been doing this full-time for five years now and I still don’t get it perfect.

In fact, just the other day we were budgeting around $1,800 for the electrical on one of our flips and it was more like $3,200. There were a few things that we didn’t see and we quite honestly just missed them. But every time, we get better at it and we refine the process.

If you factor in the 20% X Factor, you’ll be safe. And that’s when Number Two will be working for you…

 

If you’ve made it this far, please leave a comment below! What do you think? Is the renovation the second most important thing in house flipping? Leave a comment below and ask me any question you want!

Photo: Rodfather

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{ 22 comments… read them below or add one }

Brian Gibbons January 19, 2014 at 7:17 am

Mike this is awesome. Rehabs scare me so I get them under contract and flip them to seasoned rehabbers.

What a great primer on “pencilling out” the offer on a rehab!

Go Pats!

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Michael January 22, 2014 at 3:01 pm

Thanks Brian – Not for everyone for sure.
Pats didn’t win but went pretty far considering all the injuries.

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chuck wilson January 19, 2014 at 7:52 am

Number 3 is the old over or under improvement variable. When I first started out I would over improve the properties. Assuming an average blue collar neighborhood house, bring it up to average overall condition. You can get a lot of bang for your buck out of new hollow core 5 panel doors, new baseboard / moldings, new hardware, and my favorite new splatter or knock down finish walls. I have a texture machine that transforms $8.00 worth of mud into a new wall that covers years of do it yourself patching. My airless paint sprayer is still by far the number #1 money maker. You should always be looking for the best return on your improvement investment. Don’t make the mistake I did, keep it basic, neutral, and simple.

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Perry January 19, 2014 at 8:55 am

If renovation is the #2, then what is the mini Me??? Great post, Mike. :-)

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Michael January 22, 2014 at 3:01 pm

Thanks Perry

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Mark Ferguson January 19, 2014 at 8:55 am

Awesome article! It is really hard to estimate costs, but so important. I always add about $5,000 to my estimate for things I know that will come up or I missed.

Go Broncos!

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Ralph January 19, 2014 at 10:17 am

Mark, you’re killing me! Go Pats! :-) Our contractor actually always adds 12% on his sheets so its good to compare notes.

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Michael January 22, 2014 at 3:04 pm

Everyone has their comfort level and $5,000 is ok but may not be enough on larger renovations especially over $100,000. Of course we have to back off on the mark up if we don’t get it at the price we want. all part of the business.

Congrats on the broncos win! as painful as that was.

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Ang January 19, 2014 at 11:01 am

Can you email me a sample copy of your C.O.R.E form. Very informative article!

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Brian January 19, 2014 at 2:05 pm

Do you have a copy of this CORE that you could upload to the File Place?

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Geoff January 19, 2014 at 6:34 pm

Nice post especially for new investors with little or no hands on experience. Having been in the contracting business for 30 years I know how easy it is to miss items and how quickly it throws off a working budget.
One thing though, your formula:
“Renovation + X Factor + MAO = Profit” is wrong! If an adequate sales price is not included into the formula forget about profit.

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Michael January 22, 2014 at 3:08 pm

Of course Geoff. I agree and that was not necessarily meant to determine your actual profit but more to say if you follow the rules it will = a profit. It is of course relative to what you buy it for and what you sell it for so if you get your ARV right then it will work as planned. Thanks for your comment

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Sergio January 19, 2014 at 7:01 pm

Great article

Thanks for sharing

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Michael January 22, 2014 at 3:09 pm

Your welcome Sergio

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djopgenort January 19, 2014 at 10:01 pm

So on my first house purchase I was within $100 of my estimate on materials($5k), HOWEVER this project was unusual in a number of ways; I did not include my labor (sweat equity was the only way I could afford the place). I was lucky. Dang lucky. I KNOW I was lucky — I replaced more linear feet of drywall than I had anticipated (mold, which had been enough to scare away other propsects — I guessed correctly that it was from a one-time pipe burst while the house was vacant. Replaced every piece of drywall that had ANY mold, and replace an additional 8 ft just to keep the hall wall level. That good luck helped balance out mistakes I made. The one unusual thing I did was use a lot of salvage items from Habitat for Humanity. I don’t know that I would do this if I were flipping houses, but it allowed me to put quite in a few higher end but slightly outdated components (ie $260 gold moen bathroom faucets and in all 4 bathroom sinks for less than cheapo Glacier Bays), Top of the line $100-$200 insulated blinds in most of the rooms for $5 each. The downside is that there were a few items that ended up being a waste, since it turned out I couldn’t use them (and of course, no returns).

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Michael January 22, 2014 at 3:11 pm

good you learned from that experience. Improve on the next one

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Henry Nguyen January 20, 2014 at 11:31 pm

Excellent article Mike!

I haven’t flipped a property yet but reading more and more articles about Flipping really adds to my confidence. Determining ARV and ERC are the most important numbers but also you need to buy it low enough to have a large margin of error still profit ala MAO. As Aaron Mazzarillo says “potential profits when you buy and realized profits when you sell.”

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Michael January 22, 2014 at 3:12 pm

That is true. Its all potential and that is why we have to do our best in the time we have before we sell it for the realized profits.

Thanks

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Shaun January 21, 2014 at 11:41 am

When you are saying renovations are usually your 2nd biggest cost I assume you mean that purchasing the property is the biggest? I was really trying to think of what it was for a few minutes since I wasn’t think of purchase price that way.

I have a rehab estimate sheet I use that works pretty well but I would be interested in seeing what items you feel are the most important to look at and how you estimate them.
That actually could probably be a nice article to do if you have writer’s block at some point. :)

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Michael January 22, 2014 at 3:17 pm

Yes usually the purchase price but once you buy it the price is the price and is not a variable like renovations. Of course you know that. But not always as I have one now that we paid $70,000 for but plan for a $140,000 renovation. The only thing staying is the addition and the original house is coming down due to major structural and it didn’t make sense to fix. We did price it both ways and opted for brand new.

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Shaun January 22, 2014 at 8:03 pm

I have had a few around here that I paid more for the rehab then I did for the house.
God willing I will be selling one of them at the end of the month! :)
That one was crazy where put in close to 3x the purchase price into the repairs.
Have done that twice and probably will for a 3rd time in PA though. It’s a lot easier to put more money into rehab when you pay less than $10K for the house. :)

Going to be out of the town for your next meeting. I do want to get down there at some point though. Have heard good things from several people.

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Brian February 25, 2014 at 6:47 pm

This was a great post. Good guidelines to keep in mind for a rehab. Where can I find an example of that CORE sheet?

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