May 25, 2016 by Jeff Lowen
Regardless of what the future holds, the present time has incredibly low interest rates and appreciating values staring at us. Second home and investor financing is starting to look very good again. Whatever your reason, buying a property for investment is a very good idea. I once knew an agent that would help his clients buy a home to live in and another home for every child in the family. Virtually securing that college tuition would be paid for! This approach works well with retirement plans, too.
So, you’re looking, and you’ve found a property that needs a little work, but has great potential. Or so you think. How do you know? And how can you find out quickly because if you think it’s a good deal, perhaps someone else with itchy trigger fingers thinks it’s a good deal too!
Personally, I think the picture to the right is little more of an adventurous project than the scope of this article, so we’ll cover some basics so you can be well on your way to analyzing your fixer upper quickly, but before we dive in, let’s verify a couple of things that you’ve done first…
- You’ve spoken with a lender, have a wheelbarrow full of cash, or whatever you plan to use for the purchase and,
- You’ve defined your investment criteria so you’ll know exactly what you expect (Return) from the purchase of your new investment property; and your exit strategy (Flip it, hold and rent it).
Now, on to analyzing it to make sure it fits your mold…
Let’s say for this example, we’re going to buy and sell it. The classic ‘flip.’ Make a great profit, do the same thing twice or thrice more and take the money and travel the world. We’ll need to approach this property with that in mind. We’ll take this one step at a time and in order to move forward with the purchase or pass and find another, this is what we’ll need to do:
- Identify the improvements. First, we’ll need to identify whatever improvements needed and any additional work. Whether you flip it or hold it for years, you’ll need to fix it. Since we’re flipping it, let’s put a little pizzazz on it. Make it pretty! We’ll use this Renovation Cost Estimate Worksheet to determine and figure the costs of what needs to be done. You will probably want to procure the expertise of a general contractor, home inspector, verify costs on some home renovation websites, etc. Or a least someone who knows homes inside and out, if you don’t yourself. It helps to know the neighborhood, too. This way, you can project improvements that would add value, like another bathroom, a deck or adding a garage that would make your house stand out without overbuilding it.
- The all important Selling Price. Some refer to this as the ‘After Repaired Value,’ or the ‘Eventual Sales Price.’ We’ll just call it Selling Price, because that’s what we’re gonna do, right? There’s a little more to it than just looking at a couple sold properties in the neighborhood. I know real estate agents that have been in the business for years and miss the boat on this one. Properly estimating what a selling price will be is no easy affair. It requires pulling comps (sold, pending, active, expired) that are as similar as yours will be when it’s completed, and I prefer to drive by them as well. Curb appeal, community amenities, the ‘feel’ of the area and how it compares to yours, all make the difference between a desirable (good profit) neighborhood and one that’s undesirable (not so much).
- Interpreting the market is next. Not only the recent and not-so-recent comparable properties are important, but how long they were on the market, how the market is different this month from the month before, which direction the market is going – all determines where you’ll need to price it to sell quickly. Remember, every day you don’t sell, you’ll be diggin’ in your jeans for maintenance, utilities, taxes, insurance, a loan payment if you didn’t pay cash, and a lot of your time. A word to the semi-wise: You can Zillow.com or Redfin.com or Homewyse.com yourself to death, but nothing beats peering into the data first hand. Which brings us to the next step:
- Get help. Even if you think you have all the answers, you don’t. Sorry, egomongers. You need to elicit others to help you with everything from the estimating and the actual construction, a money or credit partner, will you need an architect? Any zoning issues? How ’bout a real estate agent that can help you with the data you’ll need for step 3. That same agent can sell it when you’re finished, too. However, use a little caution and diligence when choosing someone to help you. With contractors, law mandates that they are in the trade for a certain amount of years before they can obtain a license – at least in most states. So, a good referral and some testimonials may do the trick. With selecting an agent to help you with the data and potentially list it for you, remember – with as little as 40 hours, some states will issue a real estate license. And, they don’t usually teach interpreting the market data, trajectory of appreciating or depreciating values or new and remodeled construction value pressure in a given neighborhood. So, you’ll need to ask questions.*
- Estimate (Very accurately) ALL your costs. By now, you’ve identified the work and perhaps even have a contractor on the ready. Estimating your costs for these improvements can make or break you. I’m always intrigued by those ‘Flip this house or flip that one’ TV shows where they waaay under estimate and go waaay over budget, and rarely show you the real numbers. If we buy for $400,000, $50,000 repairs, sell for $500,000, we make $50,000, right? Ha! Not so fast. First off, the more fix – the longer it takes. $50k could take you 6 to 8 weeks if you’re mondo-organized. Providing you’re spot-on with your construction cost estimates, there are holding costs that can drain you, too. If you’re financing the deal, you’re paying the note along with taxes and insurance while you’re working on the property. Need utilities, too, don’t you? When you sell it, there’s anywhere between 5% to 10% that will eat at our profit for selling costs. Just to name a few. Lest we not forget about short term capital gains… Snag another 15%. Yes there are tax and other strategies that can help make it all more digestible, but for this article, we’ll focus on making sure our subject property fits our good deal criteria.
Way back before our first step in all this, I mentioned that you have your financing in place, and your investment criteria, too. Your criteria is how much you want to make on the deal. If you spend three months of your life fixing this property, only to sell it and make an amazing payday of twenty five hundred bucks… Would you be excited to do it again? That’s what you need to know. Read on…
Let’s say, we need to make a minimum of $40,000 net on this house. In the example in step 5, we know with $50,000 in repairs and upgrades, it will sell for $500,000. We know this because we’ve exhausted the market for all its research and that’s what we and a few ‘experts’ we consulted say. We’ll assume with 2 months of work and 3 months on the market until we hand the keys over is what we’re expecting. Now, let’s add in the other costs:
- $15,000 – Closing costs when we buy it
- $12,500 – Mortgage payments
- $1,500 – Utilities
- $37,500 – Closing costs when we sell it (Incl. Realtor fees)
- $22,500 – Capital gains tax (If we don’t roll it over into a 1031 or IRA)**
- $55,250 – Total costs.
Yes, there will be other costs, but for this example, let’s stay with the major ones. At $55,250, plus the $50,000 construction costs (I always like to add in an additional 10% on the construction costs to give me a buffer (+$5,000), so total construction is $55,000, now. That’s a grand total of $110,250. Are ya with me so far? Good.
Now, let’s add in our $40,000 figure. Remember? It’s what we decided we want to make from a deal like this. We’re up to $150,250, correct?
Earlier, we said we could sell it for $500k. Great. There’s seller help in closing costs for the new buyers, market changes, inspection issues (Hopefully there won’t be any ;-), low offers, etc. Let’s pull 6% off that $500k figure, so we can allow for the market viability. Besides, if we sell it a month early because we’ve priced it better than the other homes on the market, that’s a good thing, right? Sale price: $470,000.
So here’s how we’re shaping up.
If we are going to buy this house and make our numbers, regardless what price it’s listed at (If it’s listed at all), we are going to have to pay no more than $319,750. See how that works?
Selling Price – Repairs – Costs – Our desired profit = The maximum we will pay for this property. In other words, $470,000 – $55,000 – $55,250 – $40,000 = $319, 750.
Pretty simple, huh? Now go out and find one!
A quick note: Whether you ‘massage’ the numbers to ‘make’ a property work if the figures are tight, you’ll do so at the cost of your profit. Costs and repairs by this time of your analysis are usually pretty stable. That’s why it’s best to figure out what your expectations are and set some realistic goals for flipping a property BEFOREHAND! Once you get all emotional and just have to buy it, you lose your walk-away power and you will soon feel it in your pocketbook.
Yes, all this equates to more than five steps, but in analyzing any potential income producing property, make sure you do at least the five listed here!
*What questions to ask, need help determining where to go for more info, etc. Just reach out to me and I can help.
**For Capital gains questions it’s best to employ the services of a competent tax professional.
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