Flipping can be a profitable business but you need to really know what you are doing or you can lose a lot of money. At least once a month I see one or two partially remodeled properties for sale. When I see this I know there is another “instant profit” flip victim.
Many things have to be right before you can profitably flip a property. I will explain a few of the items below but there are others. For example, contractor management. As part of our investment practice, we over watch the work getting the properties ready to turn over to the property manager. I am an engineer and have a good bit of program management experience as well as reworking homes. I still have to go on site at least every other day or things start to go wrong. Vendors do not show, poor work, wrong colors, etc. If these things are not closely managed your market ready costs and hold time will drastically increase. It does not take a lot for things to go really bad.
Below is an over view of the process I’ve used and I hope that it will help you avoid some costly mistakes.
The first step in successful flipping is to determine if flipping is possible in the location you are considering. In some locations/markets it is almost impossible to flip a property and not lose money. Below are some of the factors that I would consider:
- The price difference between trashed homes and homes in market ready condition (more about this later) must be significant. If there is only a small difference, you need to look somewhere else. We use software that we developed to scan the Las Vegas metro area looking for properties that are at least 20% below the sales comps of similar properties. Note that 20% is not a “magic” number. But, if you can’t find properties that are priced significantly below comps, you are looking in the wrong location.
- Seller’s market. If you are in a buyer’s market, it is unlikely that you will be able to sell the property quickly or at the price you estimated.
- Sales volume - There should be frequent transactions of similar properties. Not only will this increase the probability of selling the property in the shortest time, it will enable you to get reasonably good comps. Do the comps yourself, do not depend on others. (If you are not comfortable doing comps, contact me and I will explain how.)
- Skilled trades people are available at a reasonable price. A huge part of being successful is high quality, reasonably priced, readily available skilled workers. The skills you need will vary but if you can’t put together the right skills team, you are in serious trouble. Most people will work with a contractor or someone who will provide the overall quote and manage execution. Significant errors in market ready costs could turn a profitable flip into a financial disaster.
Maximum Price You Can Pay
To determine the maximum price you can pay for a potential flip property, start with the probable sales price and work backwards. For example, suppose you found a property that looks like a good flip candidate. The first step is to estimate what the property will sell for once in market ready condition and how long it will take to sell. Suppose, based on a careful examination of recent sales, you are confident that once the property is in market ready condition it will go under contract for $250,000 in less than 30 days. And, you know that it takes about 30 days to close.
Next you need to estimate all the major costs to make the property market ready. Below are some of the major cost factors.
- Purchase closing cost - This depends on the purchase price and location, etc. I will assume 3% closing costs. However, since I do not know the purchase price so I will estimate 3% of the anticipated sale price. So, $250,000 x 3% = $7,500.
- Market ready cost - Having a contractor you can trust to get the property market ready on time and on budget is the difference between losing money and making money. Suppose you have a contractor you trust and he says he can do everything that is needed for $50,000 and it will require 2 months. Assume that costs will go over by 10% to 20% and add a month to the time estimate. So, increase the estimated cost (I will use 15% in the example) to $57,500 and the time to be 3 months.
- Cost of capital - Suppose you estimate that the hold time is 6 months (2 months to repair and 2 months to sell plus one month each for padding) and you are paying 8% annually for the money. Then the cost would be estimated as follows: $250,000 x 6 Mo. x 8%/12 = $10,000. Again since I do not know the purchase price I’m using the probable sale price here to be conservative.
- Cost to sell - Suppose the cost to sell is 8% of the sales price, then the cost to sell will be 8% x $250,000 = $20,000.
- Other costs - I will assume that the sum of electricity, gas, water, insurance, taxes, trash, etc. to be $500/Mo. So, $500 x 6 = $3,000
- Padding - Nothing goes according to plan so you need to add a pad.
- Profit - If you don’t make significant profit why are you taking the financial risk? In this example, I will use 10%. So, $250,000 x 10% = $25,000.
Now it’s time to calculate the maximum price you can pay for the property. The process is to take the estimated sales price and subtract all the major costs. For this simple example:
|Purchase closing cost||-$7,500|
|Market ready cost||-$57,500|
|Cost of capital||-$10,000|
|Cost to sell||-$20,000|
|Maximum you can pay for the property||$127,000|
Based on the estimated costs and hold time the maximum you can pay for the property is $127,000. It does not matter what the seller wants, only offer what you can afford to pay. If you can’t get the property at the price you need, find another property.
A huge mistake I often see new flippers make is that they start with the purchase price of property, add the costs and based on the total, decide on the sales price. This approach is just about guaranteed to be a disaster. You do not control the sales price, the market controls the sales price.
I used the term “market ready” multiple times because I wanted to emphasize the importance of only (not more and not less) making the home similar to other homes rapidly selling in the local area. There is no universal “standard” for market ready. For example, if the vast majority of properties have vinyl flooring in the kitchen, vinyl is what you should probably install. Installing tile might result in the property selling faster but it is unlikely that it will increase the price by the amount you would have to spend on tile vs. vinyl. However, if similar properties have tile and you installed vinyl, your property will likely take longer to sell and will likely sell for less than market value of homes with tile.
Here is a real life example where failing to spend what was necessary resulted in the client losing a lot of money by "saving" money. This example concerns a rental property but the concept is the same. My client bought a nice 4 bedroom class A property and it should have rented in two to three weeks based on similar properties. However, the front yard looked terrible and my client was unwilling to spend the $350 required to make the yard presentable. When people see a destroyed front yard they just keep on driving because they “know” that if the exterior looks bad the interior must be worse. The result was that the property sat on the market for three months. What did this cost him? The estimated rent was $1,250/Mo. so he lost $1,250 x 3 = $3,750 by not spending $350. Curb appeal is very important. People judge a property starting the moment they see it.
Another frequent problem is “over improving” a property. This usually happens when the investor gets emotionally attached to the property and wants to remodel it to their taste. Two or three times a month I come across properties where way too much money was spent on “improvements” and important issues were left uncorrected. In some cases, the property is so “improved” that the cost to make it market ready eliminates it from consideration.
The lesson is that you need to get the property to market ready condition, not less and not more.
I hope this simplistic summary of the flipping process gave you an idea of how to profitably flip properties.