If you are a fan of TV home flipping shows, you might be under impression that fixing-and-flipping homes is a glamourous job with guaranteed profits at the end. You stroll in, ponder the design, and voila! In a short time, the old shack is transferred into a fashionable abode making loads of money for you and thrilling potential buyers.
Come on now.
Things are much more complicated in the real world. A flair for design is a plus, but the first thing you need to be is a humble accountant. No amount of creativity will save your project if it’s missing fundamentals to make you money. The real estate investing industry is afloat in tools, formulas, and calculators to make it easy to evaluate the transactions. Let’s take a quick look at their ins and outs.
Scary house-flipping formula that leads to disaster.
We often speak to potential flippers who are, frankly, a ticking time bomb. How do we know? Because of how they estimate their profits. Just recently I spoke to an aspiring rehabber looking to flip homes in Baltimore County. He was planning to buy a property for $170,000, renovate it for $50,000, and sell it for $250,000. My calculations were showing over $5K in losses, while he was gearing up for a profit of $30,000. Can you guess what kind of fix-and-flip formula he was using?
That’s right, he was simply subtracting the cost of renovation and the purchase price from the after-repair value of the property. Revenues minus expenses equal profit, don’t they? Technically yes, but this poor chap is down for a big surprise. Unfortunately, he is not alone in calculating his potential profits this way. This is probably why there is so much talk about the 70% house flipping rule – to keep the guys and gals like him from going over the edge.
What is the 70% rule in house flipping?
One of the most frequently mentioned house flipping formulas is the 70% rule. The 70% house flipping rule helps real estate investors determine the maximum price they can afford to pay for a fix-and-flip property. The rule states that an investor should pay no more than 70% of the After Repair Value (ARV) of a property, minus the cost of necessary repairs and improvements.
For example, let’s use this same Baltimore County investment scenario from above. Based on the 70% house flipping rule, our investor should pay no more than 70% of $250,000 (ARV) minus the $50,000 he plans to spend on improvements.
$250,000 * 70% – $50,000 = $125,000
The popularity of the 70% rule is its simplicity. It’s also in the fact that it forces less experienced investors to consider all costs associated with the transaction. Our Baltimore investor, if he were using the 70% flipping rule, would not have offered $170,000. Even he was not sure why.
The limitations of the 70% house flipping rule.
While the 70% house flipping rule offers general guidance, I believe current Washington, DC real estate market is too competitive to use it effectively. The name of the game is to be nimble and flexible. You cannot be too prescriptive while looking for opportunities that present themselves so narrowly. A mid-priced home that needs few repairs might justify an offer that exceeds 70%. It’s especially true if you have a reliable crew that moves fast and expect few days on the market. Similarly, high-dollar flips with higher profit amounts might also justify offering above 70%.
Alternatives to the 70% house flipping formula.
Truth to be told there is not a single magic formula to figure out whether the profit your transaction would generate is worth your while. The main drawback of the 70% house flipping rule is that it’s way too prescriptive regarding what profit you need to generate to consider the flip a success. The $15K in profit might not sound too shabby for a novice investor. In contrast, a more experienced flipper might consider it mediocre at best.
Real estate investors might have different opinions on the acceptable profit levels, however, the formula for how to arrive at that profit is universal. It’s based on a thorough understanding of your balance sheet. Think of the balance sheet is a document that lists the company’s assets (ARV) on the right and the company’s liabilities (costs) on the left. All home flipping formulas and calculators ultimately estimate your profit by subtracting your costs from your revenue. And any formula is only as good as the numbers your use for them. Make a miscalculation in any of your inputs, and the final result will also be erroneous.
There are plenty of calculators out there, all of them with different levels of granularity. Typically, the more details they have, the more accurate they are. However, you can actually build your own calculator that analyzes the potential profits in your own unique ways. As long as you know what to include.
Costs: five cornerstones of any home flipping analysis.
The purchase price is the most obvious one – and the most important. Many other costs you incur in your fix-and-flip are proportionally related to it. It’s also likely to be the largest cost on your balance sheet. Your ability to negotiate the purchase price down is paramount to the profitability of your transaction.
One of the costs that is directly related to the purchase price are purchasing costs. You will incur them no matter whether you are buying in cash or working with a lender. The purchasing costs are the costs of hiring the title company to research the title and paying taxes to transfer the title from the old to the new owner. Transfer taxes vary depending on the state and county your property is in. To give you an idea, here are the lists of transfer taxes by the state and by the Maryland Counties. There is little room for negation on purchasing costs.
Unless you are buying with your own cash, you are likely to incur financing costs. Financing costs usually fall into two types: costs charged by a lender to originate your loan and interest rates charged for the duration of your loan.
Costs charged by a lender to originate your loan often include “origination point” and underwriting fees. Many lenders charge “junk fees” that they might not disclose until the closing. Make sure you work with a reputable hard money lender and have a good grasp on what total fees would be.
A lender will also charge you a monthly interest rate on your loan amount. This is also a part of the financing costs. The overall amount of the interest you pay to the lender depends on how long you hold the loan. The shorter the amount of time your loan is outstanding, the less you would pay. As a real estate investor, this is the cost category that you have direct control over. One piece of advice though. If you are working with a private hard money lender, find out about their pre-payment penalty to make sure you are not locked into the loan for too long of a time.
Many private lenders charge interest-only payments which makes calculating your monthly interest-only payments a breeze. The formula is simple: Loan Amount x Interest Rate divided by 12 (months) = Monthly Payment. For example, if you loan amount is $120,000 and you are charged 11%, you monthly interest-only payment will be $120,000 x .11 /12 = $1,100. If you hold the loan for three months, the total amount you will pay in interest is $3,300. In contrast, if you hold it for a year, it will be $13,200 ($1,100 x 12 months).
Carrying costs are all other costs of homeownership that you need to budget for as long as you own the property. Mark Twain famously quipped that death and taxes are the only two certain things in life. Sure enough, you will have to pay taxes for as long as you own the house. Many title companies would collect for at least three months of taxes at the closing. However, chances are you will need to make to pay them again before you sell the property. Homeowner’s insurance is another cost item that needs to be paid on the monthly payment. So are the homeowners’ association fees, water bills, electric bills, etc.
No home flipping formula, no matter how sophisticated, will work properly if you forget about the selling costs. After all, you are doing “fixing and flipping”, and that “flipping” part doesn’t come free.
Just like with the purchasing costs, you will be paying for a part of the state’s and county’s transfer taxes. As a seller, you would be covering the real estate agent’s fees for both your agent’s and the buyer’s agent. So, unless you are a real estate agent yourself, allocated at least 4% of the after repair value to this expense item. And one final thing on the selling costs: don’t forget seller’s contributions if they are customary in your market.
Rehab costs are typically the second-largest expense item and are both out of your control and within it. Out of it, because they are obviously dictated by the scope of work, the size of the property, and the labor costs in your market. Within your control, because the more experience you have the fast you can move. Of course, if you keep your construction crew busy, you can always negotiate the price.
After-Repair Value: The Alpha and Omega of Your Fix-and-Flip Calculations
If you think about your transaction as a balance sheet. the after-repair value is definitely on its right side. In accounting terms, it’s your assets against which you balance your liabilities. To estimate your profits, all your expenses, including the purchase price, will be subtracted from the ARV. Unless you deal with a unique property, the ARV is dictated by other sales nearby. Recommend Read: Practical Tips on How to Get Your ARV Right.
Give a Man a Fish, and You Feed Him for a Day. Teach a Man To Fish, and You Feed Him for a Lifetime. The 70% house flipping rule is like giving a real estate investor a fish. Hopefully, I just gave you a decent lesson on fishing. Remember another proverb: practice makes perfect. Don’t expect that you get everything right on your first flip. But trust me: the more experience you have, such analysis becomes less and less intimidating. For a visual example of how this home-flipping formula works, check out our hard money calculator. It follows the same logic and, better yet, provides visual illustrations of each component.