HOME FLIPPING PURCHASE PRICE FORMULA
In real estate, you make your money when you buy. It’s a common phrase in the business and no truer words have been spoken. Let that sink in. You make your money when you buy the property. Not when you sell. If you don’t buy the property right, at the right price and or terms then there won’t be any profit when you sell. There is no strategy or trick to making money on a piece of real estate for which you paid too much.
That is especially true for flippers. Flipping is a short term strategy. There is no time for market values to increase and save you from a bad decision. A landlord might hit the jackpot and buy a home in an area that skyrockets in value over a 10 year period. A flipper needs to get out in less than six months.
So here’s a simple strategy for calculating your offer price on that next flip property:
Offer Price Formula:
Purchase Price = ARV- 25% – Renovation expense
ARV is the After Repair Value. This is what you believe the home will be worth after it’s fixed up. This is normally derived from looking at other, nearby comparable sales. This is usually similar homes within a half mile of the subject property that have sold within the last year. I like to look at homes that sold in top condition, if there are any available.
What’s the 25%
The 25% discount constitutes your closing costs, finance costs, holding costs and your profit. This number may need to be bigger or it could be smaller depending on your situation and market. Most people advocate for thirty percent. I typically do well enough with the twenty five percent.
Closing Costs when you buy and sell:
You have closing costs when you buy the property and when you sell it. These costs include real estate commissions, legal, transfer tax, title insurance, document prep and more. These costs can be significant. Depending on where I close a deal in the DC metro area I expect these costs to add up to 6-12% of the end sales price. I’m a licensed real estate agent in the State of Virginia so my costs are significantly less for homes I buy and sell in Virginia. I’m not a licensed agent in Maryland so I have to pay another agent to handle the sale there and some of the counties there have transfer taxes as high as three percent of the sales price. That has to be paid when you buy the home and when you sell it. That cost is traditionally split between the buyer and the seller but not always and either way, it’s expensive.
Holding costs are things like utilities, insurance and property taxes. For a flip property you should get a commercial insurance policy with builder’s risk coverage. These policies are more expensive but they’re very necessary.
Finance costs are high in the home flipping business. You can easily expect to pay twelve percent interest and two to four points on the money you barrow. You can go to a bank for your financing but too often banks don’t move fast enough to allow you to capture the really great opportunities. Your finance costs depend greatly on the situation and your credit worthiness. Even if you have cash you should still calculate in a return on your investment of at least eight percent. If you’re not making a return on that cash then you’re better off lending that money to other flippers at a fourteen percent rate of return and save yourself all the hassle of dealing with contractors, permitting offices, and home buyers.
Profit is your end goal. It’s the payoff for your aggravation, sleepless nights, risk and hard work. You need to make sure you’re reasonably safe and compensated. On average homes sell for about 92 percent of the original list price. That means if you think you’re going to sell the house for $100,000 there a very good chance you’ll only get $92,000. So, in this scenario, if you only built in a $5,000 expected profit margin then you will have lost $3,000 when it’s all said and done.
I typically shoot for about a 15 percent profit margin as compared to my expected end sales price. I never go below 10 percent. There are just too many unknowns. In just about every deal the renovation costs are higher than expected and in most cases the house sells for less than you anticipated.
In this business you have to move the houses fast. That often means you have to leave a little bit of profit behind. You can’t sit on a home for an extra three months waiting for that buyer willing to pay top dollar, not when you’re pay private capital interest rates and missing out on other opportunities.
A quick word on Renovation Expenses:
Don’t underestimate them! Most people are completely shocked when they hear how much a home remodel project will costs. The average kitchen remodel in the US pushes close to $50,000. You don’t need to be anywhere near that cost but it’s extremely hard for me to get my kitchen remodels done for under $15,000 in the D.C. Area. In the D.C. area it’s very rare that my total home remodel costs come in under $75,000. Get multiple bids for the work and be careful about planning to do work yourself. Bad work is worse than no work at all and finance costs can quickly eat up DIY savings if the project ends up taking months longer.
Here’s an example of a deal:
The Scenario: You find a home that you believe will be worth $500,000 after it has about $75,000 in fix up.
Purchase Price Calculations:
$500,000 ARV -$125,000 25% of ARV -$75,000 Renovation Expense =$300,000 Purchase Price.
You’ll want to pay around $300,000 for this home. Now keep in mind that that depends on your situation and you’ll have to fine tune this based on your unique circumstance. If you have no cash of your own and you’re borrowing all the money at twelve percent interest and four points then your capital expense on a six month deal will be around $37,500. If you’re in a higher cost state and your buy/sell/hold costs are ten percent then that will be another $50,000.
With those details you can recalculate with more specific costs to ensure you’re projecting a relatively safe anticipated profit.
$500,000 ARV -$50,000 Buy/Sell/Hold costs -$37,500 Capital Expense -$75,000 Renovation Expense -$300,000 Purchase Price =$37,500 Profit
Here you can see your anticipated profit is only $37,500. Sounds great doesn’t it? Well, $37,500 divided by $500,000 is .075 or 7.5%. That means your profit will be about 7.5% of the sales price. That type of margin disappears really quickly. It’s real easy to find your renovation budget passing a hundred thousand dollars and the end sales price coming in at $480,000. Now, instead of making $37,500 you’re losing $7,500.
Since you know you need to make at least a ten percent profit you know that you need to get the price a little less than your original calculated price of $300,000. You know you need to add two and a half percent to your discount rate. Instead of twenty five percent you may need to use twenty seven and a half percent. Plugging that in to your original formula gives you a purchase price of $287,500.
This doesn’t even account for your overhead expenses. Deals that are good enough to flip don’t usually just fall into your lap. It typically takes some marketing to find them. You need to make sure all of your expenses are getting covered.
I know it seems absurd to plan to make $50,000 on one house but that’s a pretty small percentage given the investment and the risk factor. There are a lot of moving parts in this business. There are a lot of unknowns and variables. You have to make sure you’re covered. And you have to make sure you’re making enough money to stay in business.