House flipping is a form of real estate speculation where an investor will purchase a house with the intent of selling it at a profit.
Before purchasing a potential flip property, there are a number of important factors to consider, including market value, property condition, cost of repairs, and carrying costs.
The first factor to consider is the market value of the property. A potential flip property should be acquired at a price that is below market value. Purchasing property at a price that’s equal to or above market value will considerably decrease potential returns. A house that is priced below market value is considered, “undervalued.” Undervalued property is usually the result of a motivated seller which is someone who, for one reason or another, intends to sell their house quickly and as a result, will often accept a below market offer.
When considering market value of a potential flip, it’s important to take into account the after repair value (ARV) of the property. ARV is the value of the property after the upgrades and repairs have been completed. The after repair value is calculated using data from recent property sales in or around the area of the potential flip. Taking into account details such as square footage, property size, number of bedrooms, and neighborhood factors, the investor will analyze the data of recent property sales, in search of those which are most similar to the potential flip property.
Once ARV is determined, that figure can then be used to calculate maximum purchase price.
Many experienced house flippers recommend the 70% rule. This rule states that the maximum purchase price of a potential flip property must be no more than 70% of the ARV of the property, after subtracting the cost of repairs and upgrades.
Take, for example, a house which requires $30,000 worth of upgrades and repairs. The investor has calculated that the house will be worth $250,000 upon completion of the repairs. Using the 70% rule:
(ARV – Cost of Repairs) X .70 = Maximum Purchase Price
(250,000 – 30,000) X 70% = $154,000
It’s determined that the maximum purchase price of the house is $154,000.
The second factor to consider is the condition of the property. The ideal candidate for a flip is a property which requires mainly cosmetic repairs or upgrades. Cosmetic repairs such as new floors, paint, light fixtures, etc. generally provide a positive return on investment (ROI), while structural or mechanical repairs often provide a negative ROI, greatly reducing the investor’s overall profit.
Structural and mechanical issues such as foundation cracks, mold infestation or electrical problems may be difficult to spot, although the signs of such issues will often be discovered by a qualified home inspector.
Cost of Repairs
Completion of upgrades and repairs pose the largest expense when flipping a house. Many house flippers with a background in home renovation or other related fields, will perform all, or some of the repairs themselves. By completing the repairs themselves, the investor will save a significant amount of capital, increasing overall return on investment.
A house flipper who doesn’t wish to commit the time or who doesn’t possess the required skills to complete the repairs will opt to hire a contractor. A contractor will bear the burden of performing the necessary improvements to the property, releasing the investor of the significant time commitments. The cost of hiring a contractor will constitute a large portion of overall expenses, and as such, it magnifies the importance of market research when purchasing a property to ensure an acceptable ROI.
Under certain circumstances, the cost of time-saving measures, such as hiring a contractor, will be offset by the savings achieved as a result of reduced carrying costs. This is usually true in situations where carrying costs are higher than normal due to such things as high mortgage interest rates.
Timeframe and Carrying Costs
Another important factor to consider is the projected time frame for a property flip. A longer time frame will increase carrying costs which affect ROI. Carrying costs are the expenses associated with the possession of a property such as mortgage payments and taxes. If a property flip is expected to last for 6 months, projected carrying costs will be equal to the value of 6 months worth of mortgage payments, taxes, etc. Any additional time required to complete the project will increase carrying costs and result in a reduced overall return.
Generally speaking, quicker is better when it comes to flipping property.
House flipping, by nature, presents a significant amount of risk. The unpredictability of real estate markets, unexpected expenses and the use of leverage are all factors which must be considered to mitigate risk.
For the investor who’s prepared to put forth the necessary time and effort, house flipping offers the potential for exceptional returns.