Not that $15,000 isn’t a bad profit, it’s just that you are unlikely to make that amount and could even lose money. The reason is all of the unexpected costs.
How to Analyze a Real Estate Deal
Deal analysis is one of the best ways to learn real estate investing and it comes down to fundamental comfort in estimating expenses, rents, and cash flow. This guide will give you the knowledge you need to begin analyzing properties with confidence.
I Thought It Was Purchase Price Less Repairs Equals Profit…
The house flipping television shows love to show super simplistic formulas for how much profit is going to be made that completely ignore costs that are typical for fix and flips. If they were to cover all of the costs normally involved, the font would probably end up being as small as the small print legal statements made on some commercials. They’ve got to keep it simple so that it is not confusing. It’s not really confusing so let’s take a look at what could happen if you choose to do a house flip with only $15k profit potential.
The Temptation To Do a Deal
I want to start by considering why people are tempted to do deals that show $15,000 profit on paper. The typical formula used for calculating what the most you should pay for a house to flip is 70% of the after repaired value (what it will sell for) minus the cost to repair the house.
If a house will sell for $100,000 fixed up and will take $20,000 to fix it up, you should not pay more than $50,000 for the house. To the uninitiated, this may appear to leave $30,000 in profit. That would be awesome but is almost never the case. There are other costs that are involved and the 30% in room covers your profit as well as those other costs.
If we’re underestimating these ‘other’ costs, we might be tempted to do a deal that shows the potential for $15,000 in profit. For the above example, that would mean buying the house for $65,000 instead of $50,000. We should still make $15,000 in profit, right? Wrong.
Fix and Flip Costs That Could Eat Your Lunch
- Closing Costs When Buying
- Change Orders
- Holding Costs
Holding costs will usually include loan payments,property taxes,insurance,utilities,HOA dues and any other cost associated with owning the house while you get it fixed up and sold.
It may not seem like these costs would really eat much into our profit, but let’s take a look at an example.
Say we are fixing up and selling the house in our initial example. We’ve bought it for $65,000 and need to put in $20,000 in repairs with hopes of making $15,000. Let’s assume we got a loan for the purchase and repairs ($85,000). It was a hard money loan that allows interest-only payments at 14% interest. The monthly interest payments would be $991.67. Woah. That’s a lot, especially when you consider that it could easily take you 6 months to fix it and sell it. If that happened, it would cost you $5,950.02. Add vacant house insurance on that and you could be paying another $1,000. Property taxes where I live and invest are roughly 3% and so for a house valued close to $100,000 would be about $3,000 for the year. So even if you fixed and sold within 6 months, you would be looking at a $1,500 property tax bill.
I’m sure you get the idea. It’s a wonder people don’t contemplate these costs more before jumping into an investment. With just the ones mentioned, we’re looking at about $8,500. That’s over half of your expected profit!
- Realtor Commissions
- Buyer Closing Cost Assistance
- Lender-Required Repairs
- Price Reductions
Oddly enough, people don’t tend to concern themselves too much with the cost of actually buying the house. If you are getting a loan (especially if you are getting a hard money loan), you could be paying thousands in points. Title policy, escrow fees, document preparation, courier fees, etc. can all add up to a good chunk of your intended profit.
You will find things that you have to fix that you didn’t plan on. Just count on it. Most rehabbers will come up with a repair estimate for a house and then add 20% or even double the entire repair amount. This is because repair costs can spiral out of control if you are not in complete control.
Sometimes we are tempted to keep certain things and relace other things in a house. It’s amazing how outdated or filthy things look after you paint the house and you left some things alone. This can lead to changing out a lot of items that you intended to keep.
I’m not even talking about over-remodeling a house, just doing what is necessary to make the house desireable to potential buyers.
Realtor commissions are typically 6% of the sales price. For our example flip, this would be $6,000 (normally $3,000 to the buyer’s agent and $3,000 to the seller’s agent).
Of course you could sell it yourself For Sale By Owner or get licensed and list it yourself to save half the commission, but that might be more than you are willing to do realistically.
Most of the fix and flip houses we sell are sold to buyers that are getting a FHA loan. The buyers are allowed to get assistance from the seller for some of their closing costs and usually need it. The Federal Housing Administration limits this assistance to the lesser of 6% of the sales price or allowable closing costs.
You could end up selling to a cash buyer or someone qualified for a conventional loan that won’t request closing cost assistance, but you are more likely to get a buyer that needs the assistance.
For our example house this could be upwards of $6,000! Not exactly chump change.
You don’t have to give the assistance, but if your buyer needs it and you were having trouble getting a buyer, you might be better offer doing it.
Just because you fixed up the house and got a buyer on the hook, doesn’t mean your costs in the deal have ceased. Many times lenders will require certain repairs be made because they have guidelines on what it is they feel is necessary for what is being used as the collateral for the loan (the house). For FHA these required repairs tend to be related to health and safety issues, structural issues and safety and security of the house.
You might be required to bring certain things up to current code and this could really cost you a small fortune. If you want your buyer to be able to get the loan, you might have to come out of pocket for these repairs.
You might need to reduce your price, which will certainly affect the amount you make as profit from the deal. This is not only because of over-estimating the after repaired value and not finding a buyer willing to pay it but can happen if the house doesn’t appraise for that amount if you do find a buyer.
So if the house is sitting on the market for months, you obviously need to lower the price (unless there is something else that potential buyers are saying is a major problem with the house). Remember, you only estimated making $15,000 and you’ve calculated that you’ve already lost most of that with your holding and repair costs. Dropping the price now is going to be super painful.
Sometimes it’s necessary though to stop the bleeding.
I’ve lost money on a rehab before and it wasn’t pleasant. That kind of experience can teach you a lot but you really don’t need to learn it that way. Just be mindful of all of the costs that can eat up your profit and make sure you stick to the formulas used to buy these houses and maybe even make them more conservative. I try to shoot for 65% of ARV minus repairs most times. It’s not a bad idea to do the same. Of course, you also need to know how the market is where you intend to invest. If houses are sitting on the market for a year, you probably should be even more conservative than 65% of ARV.
If you’ve been considering a flip that shows the potential for $15,000 in profit but does not take into consideration most of these costs, I don’t recommend doing it. Not unless your plan is to see how much money you can lose on a deal.
I’m sure some of you have had other costs that have not been mentioned here and I’d love to hear what they are. You can share yours in the comments below. Please do. Thanks.