Pre-Construction Flips

29 Replies

I want to get some feedback on an investment strategy I used in 2003-2005 that I call the "pre-construction flip".  It works like this:

  • Identify high appreciating markets (greater than 12% annual)
  • Identify home builders who don't care if an investor purchases and immediately resells a property in their housing tract.
  • Enter into a purchase contract with the builder to buy a house that has not yet been constructed with an "earnest money deposit", usually $1,500 - $3,000.
  • Qualify with the home builders preferred lender.
  • Wait for the house to be built.
  • Upon completion, if the current market value of the house (as determined by the market price that the builder is selling current homes) is at a minimum level (5% higher than your purchase price), then complete the purchase agreement.  Otherwise don't complete the agreement and lose the earnest money deposit.
  • Upon close of escrow, immediately list the new house FSBO at the same price that the builder is selling their homes.
  • Secure a buyer within 2 weeks and close within 30 days.
  • Make profit based on the difference between the purchase costs and the selling proceeds over a 4-6 month period.

Here are some real-life numbers for 2014:

  • Purchase price: $300K
  • 1st Mortgage = LTV: 96.5% FHA 3.5% down @ 4.5% for 30 years fixed = $289,500
  • Upfront points 1%
  • Closing Costs = $10,402
  • Total Cash Investment = $20,902 (down payment + closing costs)
  • 2nd mortgage = $20,902 (equity partner) LTV: 3.5% with $0 down @ 10% interest-only
  • 2nd mortgage holding costs = 6 months @ $174/month = $1,045
  • Reserves = 2 months of 1st and 2nd mortgage costs = $4,387
  • Total Investment = holding costs + reserves = $5,432
  • Annual Appreciation = 18% (1.5% per month) for 4 months
  • Future Market Value = $318K
  • Sales Commissions = $0 (FSBO)
  • Sales closing costs = 1.5% -= $4,770 added to sales price
  • Final Sales Price = $322,770
  • Less closing costs = -$4,770
  • Less Loan Payoffs: -$310,402
  • Net Proceeds from Sale: $7,598
  • Less Total Investment: -$5,432
  • Less Deal Management Fee: -$404 (this is my fee for putting this all together)
  • Net Profit: $1,762
  • Cash on Cash ROI: 32.43%
  • Annualized ROI: 97.30%

 

Please critique the numbers, the assumptions and the requirements. I did three deals like this in 2004-2005 when money was cheaper with less regulations.  We turned $10K into $25K, $12K into $50K and $7K into $180K.  I'm not looking to make a homerun off each deal, just a bunch a singles off each and every deal.  Tell me what you think.

 

God Bless You!

Its 2014, not 2005. There are so many new rules and restrictions in the mortgage industry that can cause your deal to fall apart that I don't see the risk being worth such a small reward. 

So your putting down up to $3k in earnest money, and if the deal closes you will have a total out of pocket of nearly $21k, to make $1,768 in profit. I could find better returns with less risk.

And if the home does not sell, then what is your exit strategy? I have to assume you can not rent it out profitably with such a small down payment.

As a home builder there is no way I would build a pre sold for such a small amount of earnest money. And just walking away from your earnest money if the home does not appreciate by the time it closes seems morally wrong imho. And could be considered fraud since this post is evidence that you never intended to close on the deal if the value does not rise.

If your trying this strategy in a new community why would a buyer come to you rather than the builder himself? 

I realize there was insane appreciation in the CA market back in 2005, but again its not 2005 and the rules of the game have changed considerably.

You didn't read the post right.  The total investment amount (out-of-pocket) is $5,432 with a return of $1,762, which equals a cash-on-cash ROI of 32.43%.  The model is also based on the fact that you are purchasing the house in the middle phase of a tract, so that when your house is completed, the home builder is still selling houses.  You simply price your house at the then current price that the home builder is selling houses.  The then current market price has to be at your predetermined price point, or you walk away form the deal.

As far as home builders requiring only $5K or less for earnest money, this is where you need to do your research.  KB Homes requires only $3,500 in Lancaster, CA for any of the houses, which sell in the low $200K - $300K range.  KB Homes won't even pull the permits on the property until they have a signed purchase agreement and earnest money.  Because I've done this personally and for other people, I know the ins and outs of the deal.  I also know which tracts to purchase properties in.  I've developed a system.  Anyone can try to do this on your own, but why?  You can take the risk and try to get a 100% return in 4-6 months, or you can go with me and my proven system to get a 30%+ return with no work involved.  It's up to you.

The CA market is heating up again.  One home builder told me they have increased their prices by $90K in the last 9 months, or an average of $10K/month on a $300K base price.  That's 3.3% per month or 40% per year.  Now that rate is not sustainable, but 18% (1.5%) is in the short term (12-24 months).  When people buy houses, the price doesn't matter.  What matters is how much money do I have to pay out to close the deal (down payment and closing costs) and how much do I have to pay per month.

Also, there is nothing illegal or unethical about the approach I use, and it definitely is not fraud.  You need to read and understand the definition of fraud before you go around making uninformed claims, as you only make yourself look ignorant.  Fraud is lying with intent to deceive.  There is nothing fraudulent about entering into a purchase agreement to buy a property in the future, and then changing your mind when the house construction is completed.  Deals fall out of escrow all the time for a variety of reasons.  That's the reason for the earnest money deposit in the first place.  Read the purchase contract!

We all have different risks tolerances and comfort levels.  Most people are not comfortable with things they don't understand.  This is a very unique investment model that most real estate investors don't understand.  But if you are an investor that deals with stock options, then you understand that this is taking the stock option concept of purchasing a "call option" with the property being the underlining asset.

I am available to answer any other questions you may have about this investment model and I thank you for the feedback.

God Bless You! 

You stated that you used this strategy in 2003-2005 and wanted feedback.  Then you stated that you currently have a "system" for doing these investments now.  So, are you selling a system (or trying to find partners) for a business model you haven't proven in over 10 years?

Personally, I don't think it matters.  Anyone willing to risk $3000 in EM and then willing to risk following through on the purchase of a $300K house in the hopes to earn $1700 in profit is not a tremendously smart investor in my book.  

Here's the problem:  If you do this one time, you might make $1700.  But, is it really worth the effort?  For it to be worth the effort, most people are going to want to make a lot more money using this "system."  So, do you recommend that they put 10x as much EM at risk and follow-through on the purchase of 10 houses (not that any lender would allow you to do that) so you can make $17K?  

That's a lot of work and a ridiculous amount of risk for $17K.

So, in short, I'd say the business model is horrible, the numbers are horrible, the risk is extremely high, the amount of work is way disproportionate to the potential payoff and the fact that you seem to be trying to sell a system that you haven't used in 10+ years is the final indication that people should stay away.

Thanks for the feedback.  I don't agree with you, but we each have our own opinion.  And from the investor's viewpoint, there isn't nay work that they put it.  The put up the money, complete the loan application and sign a Special Power of Attorney that allows me to complete the transaction on their behalf.

It's good to hear what people who haven't encountered this type of transaction have to say about it.  It tells me where I need to work on better educating people.

God Bless You! 

Originally posted by @Michael Evans:

Thanks for the feedback.  I don't agree with you, but we each have our own opinion.  And from the investor's viewpoint, there isn't nay work that they put it.  The put up the money, complete the loan application and sign a Special Power of Attorney that allows me to complete the transaction on their behalf.

It's good to hear what people who haven't encountered this type of transaction have to say about it.  It tells me where I need to work on better educating people.

Amazing how you went from not having done any of these transactions in 10+ years to suddenly wanting people to give you Power of Attorney to do these transactions.

Is your goal that people will put up the money and you'll get a cut?  In that case, they are taking a ridiculous amount of risk for even less return!

Funny how confident you are in these deals when you don't seem to have any of your own money in them.  It's easy to risk someone's else money...  :-)

I'm pretty sure there is no amount of "educating" people you can do to get a smart investor to be interested in a deal like this.  It's not 2003 anymore...you'll realize that when you try one of these deals today.

Good luck to you and any suckers you're able to find... (though it's highly unlikely you'll find any here)

@Michael Evans , You put up a post and invited a critique, got some great responses and then throw a hissy and treat us as ignorant 'cos you don't like what you hear. Sorry to tell, but you're already doomed as an investor. 

Best of luck to you. 

The profit margin isn't enough to make all this hoop jumping worth it.
$3000 in then $1762 profit for a $300,000 house flip ?
$3000-$1762=$1238
That's a loss of $1238 even if you minus your fee $400 is $800 loss and that's if the house sells at your pre determined price point and within your pre determined timeframe if not more cash loss
There's no margin for profit here the only advantage is you don't have to do the quote flipping work yourself
A regular fix and flip would yield more cash return even if you almost broke even the margins are larger
also depending on who the builder is you run the risk of them showing up on your doorstep with baseball bat in hand.

I am in CA and specifically know the Antelope Valley market, plus have experience in builder pre sells, so keep that in mind regarding my comments herein.

I think the time and effort needed to make a lousy $1700 is not worth it. A 35% annual return is great! but only when the net cash result makes sense and $1700 does not meet that requirement in my book. $17k, yes.

Also, as J pointed out, you are risking other people's money and if you don't get the returns, they are out the $3500 down payment, not you. This is not a fair trade off for the investor and not responsible of you to place them in such risk.

While you think 18% is sustainable here in the AV, I would argue it is not and while we have had a tremendous run up in prices here, it has already showed many signs of slowing and my due diligence shows the potential for another downfall. If you get caught in that, you will wind up placing unsuspecting, lack of knowledge investors in the same precarious positions these appreciation players were in in 2007-2008.

Lastly, as a moderator, your mention of a system and that investors should invest with you as opposed to running on their own is dangerously close to a solicitation and a violation of forum rules, so please refrain from making such references to avoid these violations. You are free to argue your pointing your model and the numbers. 

@Michael Evans  

 Frankly would not think anyone would consider this viable for 1700 dollar profit who cares about a 32% return when its on such a small number.. IF your making 32% on 500 or a million dollars then that's spectacular. I would bet that the bigger flippers on this site easily hit that 32% number cash on cash and much better and certainly home builders that have bank financing for vertical probably hit 100% or more I know I do. ..

Just the hassle factor of getting a loan would not be worth many peoples time for this small amount of money.  The new home flipping that I was familiar with was people would just flip there EM contract for a 5 to 20k premium much like bird dog wholesalers do right now... they would never take title the buyer would be an owner occ who wanted to get into the home to live.. And a builder may or may not go along with that.. in the day they did, as they did not care who closed, and I know builders that sell out subdivision in Texas and other markets in the south will do semi pre sold wholesale deals and probably would not care if there was a change in borrower/ buyer as long as it closed or they got the EM.  I know in my market there were folks doing this on existing inventory getting nice folks with credit to put it up and then doing the deals much money was lost with that model and the sponsor got in pretty hot water over the whole deal.

I suspect the builders are pulling permits without presales.. presales are nice but if you waited on all your lots to presale it would be hard to keep continuity and deal flow. of the 18 homes I currently have under construction I presold 4, 10 went into contract during the construction phase ( a lot of times buyers want to see the house framed and know they are going to have a house and then want to pick finish's) and 2 sold within 2 weeks of C00 and two are on the market one not completed one just got COO Friday.

So bottom line doubt you will have many takers for this investors could not get enough credit and scale to make it worth there while in my opinion

Originally posted by @Will Barnard:

Lastly, as a moderator, your mention of a system and that investors should invest with you as opposed to running on their own is dangerously close to a solicitation and a violation of forum rules, so please refrain from making such references to avoid these violations. You are free to argue your pointing your model and the numbers. 

 I almost pulled the thread, but decided that it serves well as a precautionary tale should he be pitching this to other investors who find their way here during due diligence...

After reading the OP I was waiting to find the hidden angle that I was missing, because this sounded like a guru taught tactic that just wouldn't work in today's market. Guess I read it right the first time. 

It is interesting the feedback I am getting.  Let me make some clarifications.

  • @ J Scott , @Will Barnard and @Jay Hinrichs : I am not soliciting any investors.  I am simply pointing out one of several investment models I have developed to get constructive criticism from fellow real estate investors.  I would not expect (nor ask) a real estate investor to participate in this type of investment model.  This is geared toward a person who has $5K - $20K to invest, is looking for a passive investment where they can earn 25% cash-on-cash return on their money over the next 4-6 months.
  • @Kathia L. and @Will Barnard: This type of investment would require a $5.4K investment for a return of $1.7K (32% ROI) with a risk of losing $3.5K (and the literal odds of losing the interest money is extremely low because of the types of homebuilders we are dealing with). With any investment, you gauge the risk/reward ratio, and each person's risk tolerance is different. Remember, the investor does nothing by complete a loan application, deposit money into escrow, and sign a special power of attorney for the deal. My company does everything else.
  • @ J Scott: Let me clarify my experience.  The last time I did this specific investment model was in 2005.  I completed 3 transactions like this.  I have not been a real estate investor since then.  I have completed a purchase of property using power of attorney for a family member in Dec. 2009.  I also have 15 years of government operations management experience managing multi-million dollar budgets, including real estate transaction, and currently am the Chief Financial Officer for Santa Barbara County's Alcohol, Drug and Mental Health Department, where I am responsible for managing a $106 million annual budget for FY 14-15.  I am responsible for securing and establishing two new crisis system facilities in south Santa Barbra County using $1.95 million of State grant funds, as well as relocating the County's Lompoc Children's clinic ($300K project).  So I am involved in real estate transaction as part of my "day job" and have experience closing real estate deals (large and small).  I manage very risk well (over estimate expenses, under estimate revenues, and have multiple exit strategies) in order to maximize the return on any investment.  I also understand the power (and danger) of leverage.
  • @ J Scott: I make money managing investments.  Most investors pay someone else to manage their investments who doesn't have any "skin in the game" related to their investment (real estate agent, stock broker, financial planner, property manager, etc.).  There are some investor (like most real estate investors on BP) who choose to manage their own investments, which is fine.  That's why BP isn't the site where I would market my company's services.  But it is where I have chosen to get some constructive criticism of this specific investment model.
  • @David T: I'm definitely not throwing a hissy.  I am respectively and professional agreeing to disagree with some of the opinions expressed in this discussion.  I'm not putting anyone down for being ignorant:  we all are ignorant about something.  We don't know what we don't know.  I just don't speak negatively about an idea or concept when I don't know or fully understand it.  It's one thing to say you wouldn't participate in a certain type of investment versus calling the investment model horrible.
  • @Jay Hinrichs :KB Homes does 100% of their home building based on presales. This is now their business model.  In the Antelope Valley, they won't pull permits until they have a singed purchase agreement and an earnest money deposit of $3,500.  The are doing 100% build to order.

I really appreciate the feedback from this group.  Like I state at the beginning, this specific investment model is not targeted towards traditional real estate investors, but I wanted to see what traditional real estate investors would say about this investment model.  The main thing I take away form it is that I don't have to worry about traditional real estate investors copying it, so I think I've found a good niche.

God Bless You!

Originally posted by @Michael Evans:
  • @ J Scott: Let me clarify my experience.  The last time I did this specific investment model was in 2005.  I completed 3 transactions like this.  I have not been a real estate investor since then. 

Given that you've only done three of these deals, and given that the last time you did one was nearly 10 years ago, I highly recommend that you do a couple with your own money before asking anyone to fork over their money.

@Michael Evans  sounds like a lot of work and risk for $1700. You'd be better off taking the $5400 and spending it on direct mail and give wholesaling a shot. If done correctly you should make far more than $1700.

The Trump Waikiki would not allow the flips!  Some people tried to get their earnest money back when they thought they might not be able to finance because of the market downturn.  Seems a financing contingency was not an option.  Their  claim to a loophold was that the Trump name was not guaranteed to stay on the property.  Nervous Nellies.  I'm sure all are glad they held on.

http://www.coldwellbanker.com/real_estate/learn/buyers_in_trump_waikiki_units_must_wait_to_sell

@Michael Evans  

  last word on this... NO mortgage broker in his right mind would participate in this... It has red flags written all over it from a Mortgage broker stand point.

1. Your not going to get a mortgage using a POA the mortgage company will want to deal with the borrower.. You have the patriot act and other issues that come into play.. In banking its called KNOW your customer.

2. Mortgage brokers get penalized if a loan pays off in less than 6 months. they are not in the bizz to make Bridge loans.. And if there is a pattern its trouble

3. last thing most investors are going to do is give you or anyone a POA to go out and put 300k loan in their name.. Way too many things could go wrong with this scenario that would be very detrimental to the investor

Good luck with it.. Like I said flipping the EM contract in a hot market seems a lot cleaner and easier to me..

I am a mortgage banker.. have been for many years.. I never did conventional lending just HML and I am not active right at the minute, But I did just take my 10 hours of CE and stay up on the rules an regs to a certain degree.. And as stated this would be a HUGE red flag deal and I really don't think you will get past square one with in on the loan side. And who really needs you anyway... If they have a few bucks and want to play the game its their money their credit,, what do you bring to the table that an investor would see as value.. Make them a huge whopping 1700 .... Do it for yourself but getting others involved is really a non starter I bet.

@ J Scott: My wife and I are actually in the process of determining if we want to do the pre-construction flip or the pre-construction lease-purchase (another investment model I've developed, but I'll save that for another discussion) using our own money. I'll also be leveraging money I put into a self-directed IRA come October, and my wife has a house she owns free and clear that she is not using to its full potential.

Like I mentioned, I'm getting back into the real estate game, and I'm going big this time.  In 2005 I was going big when I took my eye off the ball.  I had completed 3 deals, had 9 under contract with initial purchase prices of $1.8M using less than $20K to control them.  In 3 months they had appreciated by over $250K.  I was also in the process of buying a $1.5M penthouse at the Mirage in Las Vegas ( secured a contract to purchase in the 2nd tower of their  3-tower condo development).  Unfortunately I was going through a divorce (married right of college to my college sweetheart) after being married 9 years, and I lost myself.  I spent $200K cash in 9 months because I was "promised" a $1M fee for being the middle-man in trading historical currency, as well as a $15M line of credit to finance my other businesses (I also had a music development company and traded stock options online).  This promise was made by a woman who helped put me through college.

Long story short, I lost everything:

  •   My 4,400 sf. house in one of the most prestigious gated communities in Palmdale, CA.
  • My 5 series BMW
  • $200K in cash (I spent money like I had the $1M fee in hand)
  • Owed Las Vegas casinos $12K in borrowed money (I was a semi-professional Black Jack gambler.  I would be in Las Vegas 2-3 days per week and gamble with a daily bankroll of $10K.  I've been comp'ed every type of suite at the Hard Rock Casino except for the one with bowling lane).

I got down to my last $100 and was about to be homeless.  Looking back, God took everything away from me to make me realize what's important:  His Unconditional Love.  When all was said and done, the only people around to help me were my father (I'm a preacher's kid and I lived the story of the prodigal son) and my girlfriend (now my wife).  I started back on the road to financial and spiritual recovery in 2006 and God has blessed me to be in the position I am in now, both financially and spiritually.  I am quitting my $100K+ cushy government job as of the end of September.  I am doing real estate investing and services, government and small business consulting services, and personal finance educational services.

I was told in 1999 by Ken Hiyashi (former Japanese billionaire who went bankrupt in the late 1980's when the Japanese were buying up American commercial real estate):

"One you have made money and lost it, it's easy to make it again.  The question is what are you going to do with it the next time you make it."

I wish I had listened to him, but in 1999 I wasn't in the right mindset (was just starting an Internet marketing company at the end of 1999 right before the Dotcom crash happened in 2000).  So now here I am, 42 years old, and now in the right mindset to make money and to know what to do with it.  Money and material things don't run my life and they don't dictate my behavior.  I have a very close personal relationship with God, and my unwavering belief in God's Unconditional Love governs my thoughts, my behavior, my actions and my words.  There is nothing on this earth than cause physical, emotional, financial or psychological pain and suffering to my Spirit.  And the only things that can cause pain and suffering to my soul is that which I give authority to.  Through my belief in God's Unconditional Love I embrace my Spiritual Authority, which I exercise through my actions and words.  God gives us all Spiritual Gifts, and when you are led by the Holy Spirit to use your Spiritual Gifts to provide solutions to other people's challenges, you and the person for whom you are providing the solution are rewarded (especially spiritually).

I give this testimony hoping that I can be a positive influence in another person's life and plant a seed that will bring them closer in their personal relationship with God, because in the end, that's all that matters.

God Bless You!

@Michael Evans You're still talking ancient history. Much has changed over the last year, let alone the last decade. Things are different now. Lots of schemes and scams and shell games were possible in the past, not so much any more. And I don't think you will find anyone around here to buy in. 

Among the many red flags mentioned- my first question would was one mentioned above:  What do you bring to the table in this?

Originally posted by @Michael Evans:
I give this testimony hoping that I can be a positive influence in another person's life...

I respect that.  But, if your goal is truly to help others, than I highly recommend that you don't encourage anyone to pursue the investment you've been discussing in this thread.  You have a lot of very knowledgeable and experienced investors above who are telling you that the investment model you propose is not a good one, and your only argument to the contrary is that you made it work three times nearly 10 years ago. 

Now, if you want to put your own money at risk, that is purely your decision.  But consider that you also said that you're looking to "go big" this time around, I don't see how earning $1700 per transaction would allow you to accomplish that.  If you wanted to make just $50K per year, it would require you to complete 30 of these transactions.  That means you'd literally have to buy, take title and sell 30 houses per year just to make half as much as you're making at your current job.

Why not do 30 rehabs and earn 20x as much?  Or some other investment strategy where you can make a whole lot more than $50K if you risk actually buying 30 houses.

Just my $.02...but it doesn't sound like your strategy fits your goals...

@Michael Evans

This brings back memories. Around 2002-2003, I would fly back and forth from Chicago to Irvine, hoping to get my name called in the Casalon townhome development in Quail Hill zip code 92603 (Uni High School cluster). Those townhomes started in mid $300s and reached up to $700k at the peak in 2006. Every phase release, prices would rise $20k. Your new construction flipping strategy would have worked back then.

In my area in N.Atlanta, had you bought new construction SFR for $170k in 2012 and rented it out to a tenant for 1 year, you would have been able to easily flip it for a $30k profit. Personally in 2014, I think this is a dangerous game. An investor real estate colleague of mine bought new construction early this year at $299,000 and is trying to flip his property for 349k. Looking at the comps, I honestly think he is in trouble.

    

James Park, Lender in GA (#NMLS 157229)
678-865-6250

Michael, you have repeatedly posted that you have "developed this niche strategy" and "developed the lease option"as well. Both of these strategies were being completed many many decades before you ever got started, you did not develop them. Secondly, you don't seem to like or agree with the constructive criticism you have received from several investors with a heck of a lot more experience than you and most in this community and then you go on to mention this investment is not for us but for some other type passive investor. You also stated that you were very successful at this strategy about 10 years ago but the truth is,you completed only 3 deals, that is not a long or sustained track record of success. Let me be very clear, this strategy is not good in today's market for ANY investor. If you continue to disagree, fine, but please do a couple yourself first before taking anybody's money. Secondly, the SEC is very much in play on something like this regarding how you find these investors and what securities you give them. I recommend you speak to a securities attorney before attempting to market or pull in investors on such transactions. 

@Michael Evans  

The best deal you seem to have done is NOT buying the Penthouse in the Mirage as by 2009 you 1.5 M would have been worth about 450K.  You will never fly high again at $1700 per deal !

512-293-3885

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