How would you like to know how to lose a lot of money on a house flip? Sure. Why not?
We don’t want to lose a lot of money but we sure want to know how it’s possible so that we can avoid doing it. After all, making a mistake is one of the biggest fears that keep people from getting started flipping houses.
How to Estimate Rehab Costs!
Estimating rehab costs accurately can make or break your real estate business, and it takes years of experience for even the best rehabbers to master the art. However, you can expose yourself to less risk and get more accurate with your projections by learning how the pros think when estimating construction costs.
Meet Flipping Franz
Instead of another list post, I decided to try and make this one a little more interesting. We’ll be talking about a fictional character. Let’s call him Flipping Franz. Franz is going to make all the mistakes so that we can learn from him. Poor Franz.
Franz wants to escape the rat race. He’s tired of his job and feels trapped. He knows more than all of his bosses, yet he makes less than them. He doesn’t feel like he has a way to grow or experience more.
One of his friends, Surfin’ Shawn, was talking about the book he was writing about his life. He said it was going to be over 500 pages of pure thrills and excitement. Everyone had been begging him for years to write it. Franz was imagining how frighteningly boring a book about his life would be.
Something had to change.
While battling insomnia, he happened upon an infomercial about flipping houses for profit. Insane profits, in fact.
This was it. He could feel the excitement rising and was immediately invigorated. His mind was spinning and he needed to find out more. He was hooked. His new mission over the next several months was to learn as much as he could about the house flipping business.
It’s too bad he hadn’t found BiggerPockets. Had he found that site, this post would not exist because he would have learned about all of the mistakes he was about to make…
His Journey Begins
Franz, at this point, felt that he had enough knowledge to go ahead and pull the trigger. He had met a real estate agent, Agent Alfred, that told him he had worked with other investors in the past and could find him a good deal. This excited Franz. All he had to do was wait for this agent to bring him a deal.
He had been scanning listings on Realtor.com for a long time but just didn’t know which ones were actual ‘deals’. When he did spot a fixer-upper or a bank-owned property, he froze up and was too scared to even make an appointment to see it. After all, if it was a good deal, the experienced investors would have already snatched it up. Right?
So, now he had someone that he blindly assumed was capable of determining a deal from a dud. This took the edge off the stress of determining whether a house for sale was a deal.
One day, Alfred did bring Franz a ‘deal’. Franz just didn’t know that it was only a deal for the seller…
He promptly wrote up a full price offer, based on urging from the agent to put it under contract before other investors caught wind of it. After all, it had only been on the market for a week…
Why He Paid Too Much
There are several reasons why he paid too much. Let’s take a look at them.
— Relied on others for his due-diligence —
Alfred wasn’t really qualified to determine if the deal was a good buy. Franz relied on the information about the possible resell value of the house and the cost of repairs that the agent gave him. Based on that information, and Franz’s purchase formula that he had learned, the numbers looked good. Well sort of.
The price quoted for what he could sell it for, after it was fixed up, was $100,000. Which is great because it makes the math really simple. What a coincidence!
The agent told him that all he had to do in the way of repairs was, ‘slap some paint on the walls and throw in some new carpet’. Therefore, all it was going to cost him to fix the place up was about $5,000. Not bad. That’s cheap!
So based on the typical house flip formula of 70% of after-repaired-value, minus repairs, he should not pay more than $65,000 ($100,000 * .7 – $5,000 = $65,000).
The price for the house was $68,000. Under pressure from Alfred, Franz felt he should go ahead and do it. The numbers were close enough. What difference could $3,000 make. Who cared? It was finally the deal he had been looking for.
And, Alfred said it was a ‘good deal’. Why not listen to the agent? He was experienced.
What Franz didn’t know is that Alfred had found a couple of properties for an investor. The problem was, that was back in 2006 when the market was white hot and it was difficult to make a mistake with properties appreciating like crazy. The values were going up every month.
The market had changed though. The criteria for buying should have changed. The agent felt it would be ok and took the high end of the comps (comparable sales) to justify the retail value he told Franz. Why not? There would still be a lot of room for him to make a profit. Right? Wrong, as you will see.
— Let emotions affect his decisions —
Franz also made the mistake of letting his desire to get that first deal under his belt cause him to cloud his judgement. He wasn’t relying strictly on the numbers, as made apparent by his offering $3,000 more than the formula permitted.
He even fought the feeling he had in his gut that he should probably research things a little further. He just didn’t want to expose a reason for not doing the deal. It took so long to find the thing. How could he let his slip away now?
Why He Got Expensive Hard Money
In order to close on the deal, Franz needed to borrow the money. He only had a little money in savings and didn’t want to spend it on the flip.
While educating himself, he had read about hard money lenders. These are lenders that charge higher than normal interest rates and loan fees but are willing to lend on investment properties. Some of them don’t even consider the credit worthiness of the borrower. The numbers for the deal are enough for them to be willing to do the loan.
— Didn’t research lenders before hand —
He was under pressure to get a loan quickly as he had agreed to close within 2 weeks. Franz was under the gun.
The first lender he spoke to, the one that came up first in the search results on Google, agreed to lend the money. He thought that was a good thing. He was getting a loan for $75,000 which would cover his purchase and repair costs.
Franz was relieved and excited. He accepted the terms the hard money lender dictated. It didn’t even occur to him to try and negotiate the terms. How was Franz to know that 5 points and 18% interest was a little excessive?
Why He Hired The Wrong Contractor
The contractor that Franz used for the job was referred to him by a relative of his. Contractor Carl needed work and Franz was glad to be able to give him some. And, Carl was willing to do the job for the $5,000 that was budgeted.
— Didn’t check references —
Franz blindly accepted his aunt’s referral for the contractor as being enough to agree to hire him. Auntie Andrea hadn’t steered him wrong in the past. How would this be any different?
Had he asked for and called just 2 references from Carl, he would have found that he had a drinking problem, hardly ever showed up, had poor workmanship and charged for ridiculous extras after the job was completed. Franz was in for some big surprises.
— Didn’t have a good contract —
Franz just used the proposal written by the contractor for the job as he didn’t know any better. The proposal was completely slanted toward the contractor and didn’t allow for any control by Franz. He was at the Carl’s mercy.
— Paid too much, too early —
Franz started noticing problems after the first draw was paid out. Carl had gone through and painted all the walls. Not the trim, doors, etc. Just the walls. Carl convinced Franz that the majority of the work had been completed with the walls painted and proceeded to take a majority of the pay for the job.
There wasn’t much incentive left for Carl at this point. Unbeknownst to Franz, Carl went to start another job and put his on the back burner. Franz didn’t even realize anything was wrong because he hardly ever showed up at the job site.
When he did finally go to check on the job on Saturday (had to be on the weekend because he still had his full-time job). Forget going on a lunch break or before work. Traffic was just too bad and he needed that time to relax and enjoy his breakfast or lunch.
After getting angry and constantly having to prod Carl to go back and finish the job for weeks, the job was finally completed. Never mind that small things were still not corrected, but Franz was worn out and just never, ever wanted to see or talk to Carl again.
Carl even had a nasty surprise for when the job was complete. It turns out he had to do some ‘extra’ repairs that he never even told Franz about. According to the contractor, the ‘extras’ added up to an additional $2,000. Because he didn’t have a contract that mentioned how extras were handled, Franz felt he had to pay up, and did. So the total cost for repairs had now cost $7,000. It had taken 2 months for a job that should have only taken 2 weeks.
Franz was not worried though as he hadn’t really given much thought to how much his loan was costing him. He was just glad to be done with Carl.
Why He Over-Improved The Property
Once the job was complete, it was time to call his agent, Alfred, so that he could see the finished product and get ready to list it for sale. Alfred, being the ever mindful agent, suggested that Alfred go ahead and add some extra touches. Some things didn’t seem too outdated or dirty before the rehab. Now that new flooring had been installed and the house was painted, some things just were not acceptable.
So now Franz needed to replace the kitchen countertops, replace the lighting throughout and replace the front door. This added another $5,000 to the already exceeded budget, not to mention another 3 weeks to find the people to do the job and have it completed.
Those granite countertops sure did shine though.
Why He Let It Sit On The Market
It was finally time to put his baby on the market. He was so proud of the product he was putting out that it affected his ability to determine what his asking price should be.
— Priced it based on what he had in it —
Franz had added up what he had into the property and realized that he was quite a bit over budget. For some reason, he felt he could ask more because of this. Somehow it made sense to him to do that. His agent, Alfred also played along even though the comps didn’t support the price because he also wanted to make a little more in commissions.
They decided to list the house for $105,000 instead of the original $100,000. At this point (3 months after purchasing the house) he had roughly $87,125 ($68,000 purchase, $2,000 purchase closing costs, $12,000 repairs, $3,750 loan fees, $3,375 in interest owed). With real estate agent commissions, he was looking at about another $6,000 (6%) added to this when he finally sells it.
So at that point, he would have spent $93,125, not to mention the additional holding costs while waiting to close. He wasn’t about to just walk away with about $5,000. Therefore, they decided to list at the $105,000 so that he could at least get about $10,000. Wishful thinking.
— He wouldn’t negotiate —
The house ended up sitting on the market a couple weeks before an offer came in. Not bad. An offer within a couple weeks.
Franz wash’t happy with it. It was for $95,000. He wanted to make a profit though and so refused to negotiate. After all, it had only been on the market for 2 weeks.
Fast forward a month. His agent, Alfred, is now recommending a price change. He is trying to get Franz to lower the price to $100,000. Franz insists that it should sell for $105,000. After all, he put granite countertops in it. He wasn’t going to budge. His time was worth more than that.
What The Deal Cost Him
After yet another month, he finally got another offer for $95,000 and decided he had had enough. He accepted. Of course, this was what the comps were showing the whole time for what the house should sell for. Remember, Franz’s agent, Alfred, had favored the higher end of the sales data even though those houses were not really comparable.
Thankfully, the buyer was going conventional and only requested $2,000 in closing cost assistance and no repairs to be made after inspection (we’ll give Franz a little break). It took 6 weeks to close.
From purchase to final closing, it took 7 months to flip his first house. Besides costing him a lot of time and energy, the deal ended up costing him some serious money.
Let’s calculate how much. He paid $68,000 for the house with $2,000 in closing costs when he bought it. Then, he paid $12,000 in repairs. He had $3,750 in loan fees for his hard money loan. The interest for the 7 months ended up being $7,875. He gave his buyer $2,000 in closing cost assistance to help them buy the house. Realtor commissions ended up being $5,700 (6% of sales price). His closing costs on the selling side of the flip cost him another $3,000. His total costs ended up being $104,325.
With a sales price of $95,000, it appears that our friend, Franz, ended up paying $9,325 to do his first flip. (It was actually even more due to the property taxes he had to pay, but we’re trying to keep this somewhat simple.)
How He Could Have Made Money
Poor, Franz. Mistake after mistake cost him success on his first house flip. Let’s take a look at what he should have done.
- He should have stuck to the 70% formula and offered less than that as that just calculates the MOST he should could have paid.
- He should not have let his desire to get that first deal under his belt affect his decision making.
- He should have verified the numbers for the deal by asking to see the comps and actually studying them.
- He should had made contact with a contractor that has worked for investors and preferably been recommended by another investor to give him an estimate for the job before he made an offer.
- He should have already talked to hard money lenders and determined who would be the best to use.
- He should have had a contract (preferably given to him by another investor) that he could have used with the contractor he should have used. This contract should have spelled out a deadline and penalty if not completed in time. It should have spelled out how extras were to be accepted by him before being done. It should have spelled out when draws were to be given so that he never ended up ‘upside’ down in the rehab.
- He should have priced the house based on comps alone, or at least lowered the price if there were no offers within a short amount of time.
- He should have been willing to negotiate with the first buyer and more willing to lower his asking price in order to move the house. This is especially true because he had such an expensive loan.
- He should have bought the house for much cheaper. This needed to be repeated.
There are a thousand different mistakes that can cost you on a house flip. You can protect yourself from losing money by simply buying the house for as cheap as possible. That builds in a big safety net. Then, try to keep from making too many mistakes, like our friend, Franz.
Had Franz been keeping an eye on how much he had into the deal and how much it was costing him every day he owned it, he might have made different decisions.
I’d love to hear about some more mistakes that should be avoided while flipping houses. If you have some, please share in the comments below. I’d like to learn from them.