The real estate investing process goes like this:
Sounds like a foolproof plan to build up your wealth, isn't it? But, is it possible to lose money in this?
As with any investment, it has its risks.
But there's a neat little rule to go by in order to minimize the risk and increase your profitability: it's called the 70% rule in house flipping.
Most properties that have turned out to be great investments are once ugly ducklings that have transformed into beautiful swans after investors have put in the work.
Unfortunately, the true extent of the work necessary and the total repair costs can never be known until the keys to the house were handed over and the money changed hands.
Therefore, as a real estate investor, you must have a cap on your purchase price so you still have enough for the estimated repair costs and what else may come up once you start the renovations.
As a general rule, seasoned house flippers offer no more than 70% of a home's After Repair Value less repair costs when buying a distressed property. To easily visualize the maximum amount you're allowed to spend, we have the following formula:
Maximum purchase price = 0.70*(After Repair Value - Repair Costs)
In the equation above, there are two variables affecting your maximum allowable offer on a certain property: the after repair value and the repair costs.
This is a little tricky, since there are unknowns at play, such as the state of the local market: is it still going to be dominated by sellers, or will it be transitioning to a buyer's market?
The best way to find a home's ARV is to run comps to establish your future selling price. Running comps, or doing a comparative market analysis means surveying the local real estate market by looking at the prices of similar properties that have sold recently.
When you work with a real estate agent, they can do this for you. Otherwise, you can do the market research yourself by going around your neighborhood or looking up online listings. Keep in mind that your comps must have the same features as your prospective property's projected condition.
You can then do a simple calculation by dividing a home's sales price by its square footage and then multiply that with your prospective property. Voila! You have your potential investment's ARV.
Experienced investors can quickly do some back of the envelope calculations to have a rough estimate of the repairs.
If you're new to the business, the fastest way is to check the average prices online for common repairs and upgrades such as interior and exterior repainting works, roof replacement, tiling works, and so on.
Alternatively, you can get in touch with contractors and request quotes from them so you'd have accurate numbers.
To illustrate, say there's a potential house flip, an old four-bedroom, at a great location.
You find that the comps in the area sell for $300,000, and you estimate repairs to be $20,000. You're tempted to make an offer.
Now that you have both the After Repair Value (ARV) and the cost of repairs, we can apply the simple formula of the 70% rule:
Maximum allowable offer per the 70% rule = 0.70*($300,000 - $20,000) = $196,000
You offer $190,000, take care of the unpaid property taxes, closing costs, and the seller accepts. When you sell for the After Repair Value of $300,000, that's a projected $110,000 in profit! Say, you encounter a worst case scenario in which the entire plumbing system needs to be overhauled.
Your repair costs then run up to $30,000, and your profit is now down to $100,000.
That's still over 50% profit on your initial $190,000 investment! Which is still not bad!
That's the power of the 70% rule.
It gives you the maximum buying price to ensure you have a nice cushion to protect your profit margin.
Do note that the above formula, and the 70% rule in general, is just a rule of thumb and used to quickly gauge whether a certain fix and flip property is worth looking at.
In reality, there are still a lot of additional costs to consider in a home purchase.
In order to avoid being blindsided by these, you must do a detailed analysis using the Maximum Purchase Price formula to account for all the costs and have a visual on the real profit that you can hope to make from a deal. This can be more or less than 70%.
Maximum Purchase Price Percentage = 1 - (Sum of all Costs and Profit/After Repair value)
Notice that this formula requires you to set your desired profit to be added to your projected costs.
What are these costs? They can be broken down into three: buying costs, holding costs, and selling costs.
Buying costs, also called upfront costs, include down payment, financing costs, closing costs, and cash reserves.
Sometimes, if there's an existing tenant on the property, you'll have to pay for them to vacate before you can start renovations on the house ("cash for keys").
The average down payment usually ranges from 3-20% if you're financing the purchase.
On the other hand, if you're working with a hard money lender, a popular option for home flippers due to lightning-fast processing and approval, you need to factor in hard money lender fees such as an origination fee which can be a hefty 3% of the loan amount versus the usual 1%.
Before you can finally have the keys to your investment property, you still need to pay the associated closing costs such as transfer tax (up to 2% of the purchase price), appraisal fee , title insurance, and inspection fees (not required, but highly recommended).
In sum, these costs can amount to 6% of the purchase price.
To ensure that you aren't getting wiped out financially from a single real estate purchase, some banks and mortgage companies may require you to show that you have enough liquidity in your bank accounts.
This amount is usually two months' worth of mortgage payments, which serves as a guarantee that you are capable of making your payments.
Holding costs, also known as "carrying costs" in real estate, are the fees you are required to pay for as long as the house is in your possession.
These include mortgage payments, taxes, HOA fees, insurance, and upkeep costs.
To minimize these holding costs, house flippers quickly put the house up for sale, oftentimes, even while renovation is still ongoing.
When you decide to offload the property later on, you'll have to factor in selling costs as well.
Realtor fees can run up to 6% of your selling price, shaving off a significant amount of your profit no matter how hard you stick to the 70% rule.
However, in return, they provide convenience by taking charge of the whole selling process: marketing, stagings, showings, negotiations, and all of the paperwork necessary.
Alternatively, other investors enlist the services of a listing agent to get their house into the Multiple Listing Service (MLS) and reach a wider buyer pool. On average, this agent's commission amount to 3% of the sale price.
If the value of the house appreciated from when you bought it, you're due to pay taxes on these capital gains. This usually happens when an area suddenly experiences a huge capital infusion for development, attracting businesses and families.
Fret not, there are a couple of workarounds to defer or avoid paying CGT, such as doing a 1031 exchange, or seeking a homeowner's exclusion on capital gains.
If the target market of your house flip are end users, then it's going to be worth it to spend for staging (approximately $700-$3,000). This would help your potential buyers visualize what it's like to live in the home you just flipped and make them more likely to close.
Additionally, staging can increase a home's value by up to 10%!
Other fees such as notary and filing fees, attorney fees, and accountant fees must be accounted for as well so you won't be shocked at the final amount on your closing statement.
When you're house flipping, all these costs can seem daunting and you might worry that it's all going to eat up your profit margin.
To put these worries to rest, let's apply the maximum purchase price formula to the same example above for a detailed analysis to help us determine whether the distressed four-bedroom house is a viable flip.
First, let's take stock of the total costs:
All of the costs add up to $48,000.
Second, let's set a desired profit of $40,000, or approximately 20% of the purchase price of $190,000. Real estate investors typically make a clean 15% off their investment, so you're good.
Lastly, recall the home's After Repair Value of $300,000, which will be the selling price of the property.
Will the amount fall above or below the 70% rule?
Maximum Purchase Price Percentage = 1 - (Sum of all Costs and Profit/After Repair value)
Maximum Purchase Price Percentage = 1 - ($48,000 + $40,000/$300,000)
Maximum Purchase Price Percentage = 0.707 = 70.7%
Although it's a little over 70% of the ARV, to determine the maximum price that you're going to offer, simply multiply the maximum purchase price percentage you have obtained with the ARV net of repairs, and you'll get $190,000.
The 70% rule is just a guide so you don't overbid or underbid on a property you're interested in. However, how much a house sells for ultimately depends on the conditions of the real estate market.
For instance, if a hot seller's market is present and buyers are competing for scarce inventory, the seller would have their pick of the litter, so to speak, so they might not accept your offer even if you came up with it using the 70% rule.
Therefore, it is important to research market conditions before turning in your offer.
If it's a buyer's market, the 70% rule might even lead you to overbid when sellers are already willing to accept even 60% of the home's ARV.
A property perceived to be undervalued isn't the only criteria to be satisfied before you jump headfirst into the deal.
Sometimes the reason why houses are at bargain basement prices is because it's in a blighted area. Even getting a property for pennies on the dollar won't turn a decent profit if you are unable to sell it or rent it out.
House flipping can be very rewarding as long as you stick to practices established by seasoned investors. However, you must understand that there are still risks involved, and not even the 70% rule can replace thorough research.
Remember, the 70% rule is just a rule of thumb.
Perform due diligence on the area you want to buy into, run comps, and estimate renovation costs before you start your fix and flip.
If you think you're ready to take on your first investing project, sign up with us at Property Leads! We can give you the highest converting motivated seller leads so you can land an incredible deal!
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