Successful Flipping
Photo by Seth Doyle on Unsplash
Flipping can be a profitable business, but you need to know what you are doing and the market conditions must be right or you could 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. In this article, I will describe the process I follow for profitable flipping.
Work Backwards to Make Money
The crucial factor for profitable flipping is buying the property at the right price. If you pay too much, you are doomed from the start. The way to determine the maximum price you can offer is to start at the probable sale price and work backward. I will use an example property to show how the process works.
Suppose you find a property that looks like it might be a good flip candidate. Based on your research, you believe that you can sell the property for $200,000 within 60 days once it is market-ready. Knowing the items you need to renovate, you work with a trusted contractor, who estimates the renovation will cost $40,000 and take two months.
Knowing the time to renovate the property, you can put together a time estimate from purchase to sale.
Hold Time
Add up all the different times to get a total hold time. The time to sell and close will come from your Realtor. Add a pad because things always take longer than expected.
| Phase | Months |
|---|---|
| Rehab | 2 |
| Time to get under contract | 2 |
| Time to close | 1 |
| Reality Pad | 1 |
| Total hold time | 6 months |
Total Costs
Determine all the rates and costs in advance; no guessing. Then, work through all the costs.
- Purchase Closing Cost - I do not know the purchase price, so I used 3% of the anticipated sales price or 3% x $200,000 = $6,000. This is high, but I need to allocate some money for closing costs.
- RenovationCost - The contractor estimated $40,000, so I added 20% or $40,000 x 120% = $48,000. You can't count on everything going exactly as planned so you need a pad.
- Taxes - 6 Months x 1% x $200,000 / 12 months/Year = $1,000
- Insurance - $450/Year / 12 Months/Year x 6 Months = $225
- Profit - Profit is also an expense. I will assume a profit goal of 10%. So, 10% x $200,000 = $20,000
- Pad - There are always surprises, so you need to include a pad. This is in addition to the renovation cost pad. The amount of the pad depends on the odds of significant additional costs. For example, if the renovation consists well-defined costs like carpet, paint, appliances, and light fixtures, the pad can be small. If the renovation includes electrical, plumbing, HVAC, roof, or structural, you need a larger pad. I used $5,000 in this example.
- Sales Closing Cost - Sales Closing Cost - $200,000 x 8% = $16,000
- Utilities - $200/Month x 6 Months = $1,200
- Debt service - Debt service depends on the purchase price, which we do not know at this time. However, you can guess based on what costs you do know. If you add up all the above costs, the total is $97,425 (6,000 + 48,000 + 1,000 + 225 + 20,000 + 5,000+ 16,000 + 1,200). Based on the total cost, you know that you will have to purchase the property for less than $100,000 ($200,000 - $99,741 = about $100,000). If the current interest rate is 3.5% and you can finance the property with a 30-year term mortgage with 20% down, principal and interest will be about $360/Month. So, 6 Months x $360/Month = $2,160.
Next, create a table with all the estimated costs.
| Costs | |
|---|---|
| Purchase Closing Cost | 6000 |
| Rehab Cost | 48000 |
| Taxes (6 Mo.) | 1000 |
| Insurance (6 Mo.) | 225 |
| Profit | 20000 |
| Pad | 5000 |
| Sale Closing Cost | 16000 |
| Utilities | 1200 |
| Debt Service | 2160 |
| Total | 99585 |
Since a realistic sale price is $200,000, if you pay more than $100,000 for the property, you will likely lose money.
Flipping Considerations
Market Condition
You cannot successfully flip properties in just any market. If the market is not in the right state, your odds of making money are significantly lower. Below are three market states and what they mean for flipping.
Seller's Market - Inventories are low, and there is a lot of competition for properties. In this market, the difference between properties in poor condition and market-ready properties will be minimal, making it difficult to buy properties at the right price.
Buyer's Market - There is excess inventory, properties take a long time to sell. You will likely have to improve the property to above-average market conditions in such a market to get it sold in a reasonable time. It is difficult to estimate how long it will take to sell in a buyer's market and how much it will sell for. Also, you may have to discount the property significantly to sell it. All this creates a lot of uncertainty.
- Balanced Market - In a balanced market, the number of buyers roughly matches the number of sellers. Typically, you can find properties in poor condition selling for significantly less than properties in market-ready condition. You can estimate the sales price and time to sell reasonably accurately. A balanced market is the best market for flipping.
Financing or Cash
In the above example, I assumed you could get a conforming loan. That may not be the case if the property is not in livable condition. If the property is not financeable, your options are cash or a hard money loan. The last time I worked with a hard money lender, the terms were:
- Interest rate: prime plus 5%
- Closing cost: 5%
- Term: 12 months
- Amortization: Interest only based on a 20 year loan
Below is a comparison of the cost between a conforming loan vs. a hard money loan, assuming a $100,000 loan at 3.75% vs. a hard money loan.
| Cost | Conventional | Hard Money |
|---|---|---|
| Closing cost | 2000 | 5000 |
| Debt Service | $463 | $884 |
As you can see, a hard money loan increases your costs significantly.
Sale Price
A costly mistake new flippers make is to start with the property's purchase price, add all the costs, and decide on the sales price. You do not control the sales price; the market controls the sales price. You need to be dispassionate and use a conservative estimate of how much the property will sell for and how long it will take to sell, including the time to close. Be conservative on the sale price and time to sell because everything else depends on this.
Contractor Reliability and Availability
Thoroughly investigate the contractor and talk to recent clients. The big concern is whether they stay on schedule and budget. Also, use progress payments with well-defined milestones. If you pay most of the funds upfront, you will have little leverage to keep them on track. Your best source of such services is your investment team. They will no doubt have worked with a contractor for a significant period. Also, you are a small source of income to the contractor. But your investment team may be a long-term source of substantial income. The investment team is where your leverage will come from.
Onsite Management
If we don't go on-site at least every other day, things start going wrong. Workers do not show up, substandard quality, wrong materials used, overruns start piling up. If you do not have the time and skills to manage a significant renovation project, your costs can double, and the time to complete can double as well. On-site management is critical.
Market Ready
Market ready means the property attracts the segment of buyers who normally purchase such properties and are willing to pay full market value. Too often, flippers remodel the property to match their taste and not the buyer's taste. Your tastes do not matter.
You also need to weigh every item renovated against the minimum property condition you need to sell at market value. For example, if all recent sales have vinyl floors in the kitchen, you should install vinyl floors. Installing tile might decrease the time to sell a little and might increase the price a little, but it is unlikely you will recover the incremental cost. Also, you need to use colors and other items that are popular with your target buyer. Know what you're doing before you start, or you will lose a lot of money.
Purchase Price
Between 2010 and 2013, I worked with many clients doing flips. Only about once a month did we get an offer accepted at the price we needed. This was frustrating for clients. Some wanted to ignore the estimated costs and increase the purchase price to get a property under contract. Paying more for the property than the sum of the costs is a guaranteed way to lose a lot of money. If you can not buy the property for the price you need, look for another property.
In Conclusion
If you know what you are doing and the market conditions are right, you can make a lot of money flipping. If you do not understand what you are doing or the market conditions are not right, you will likely lose a lot of money. Also, keep in mind that flipping is very time-consuming. If you are not at the site every day, plan on things going seriously wrong. Think through every step of the process before you start. If you are in doubt, do not do it.