As you may know I like to make the beta reading of my book open sourced so the community that will be using them can actually gain the information and request changes or additional information to be added as the book is being written.
This post is One Chapter of my coming book, “GET THE DEAL”. Which the idea has it’s origins from the live training with the same name that I have taught to thousands of real estate investors all across the country and have had time to refine the information to answer the questions most asked at those trainings. Without further ado I want to encourage you to read this chapter and leave your suggestions in the comments below!
How To Evaluate A Flip/Rehab Deal
“I don’t hire a lot of number-crunchers, and I don’t trust fancy marketing surveys. I do my own surveys and draw my own conclusions.”
– Donald Trump
In real estate is can be very tempting to trust real estate brokers and wholesalers who put together a good marketing package. Like Donald Trump, I want you to know how to do these calculations on your own when evaluating a potential deal to flip.
When I think back to my first flip I probably over analyzed everything and it honestly ran better than some of the other flips I did afterwards. One of the reasons I believe it went so well is because I had learned the numbers from a mentor who was flipping over 100 properties per year and had a great system for evaluating each deal.
I stuck to his system and bought a four-family building for $125,000, spent $60,000 replacing the roof, siding, windows, upgrading the electrical, plumbing, and renovating the apartments. As soon as an apartment was finished we proceeded by filling 3 of the 4 apartments with good tenants who where paying $850 rent each month, which was market rate at the time (times have changed and rents are always on the rise).
After 3 months the work was completed and I received a full price offer for $270,000 from a new investor. We closed on the property 2 months later and I was able to split the $72,000 profit with my friend who had lent me the money to do the deal.
The moral of this story is that I ran the numbers and knew I could control my renovation expenses enough to make a good profit. Because I spent so much time evaluating deals for my mentor at the time I had the confidence and experience to pull the trigger on this first flip. Prior to this first flip I had always been a buy and hold investor who was willing to pay a little bit more on a deal because I was getting the rents and holding for the long term.
Evaluating A Property To Flip
These next few chapters we are going to discuss evaluating properties. Knowing how to evaluate a deal is the key to success in this business. Unfortunately very few people in the industry (wholesalers, investors, realtors, appraisers, etc.) ever truly master this crucial skill. Believe it or not, after reading these chapters, you will probably understand this skill even better than most appraisers.
Rock-paper-scissors is NOT a good way to evaluate a property. You could find all the “deals” in the world but it wouldn’t do you any good unless you know how to properly evaluate them and make offers that will help you ensure a House Flipping profit. In fact, if you don’t know how to properly evaluate a “deal” and make offers on properties, you could end up losing money or worse, losing someone else’s money.
You have probably noticed that when you watch any of the house flipping shows on television they do not teach you how to actually evaluate a real estate deal. In fact they leave out many of the expenses which can cost you if you are not counting them in your initial property analysis.
Understanding how to evaluate a deal can separate you from being a “speculator” and a true investor. You see, a “speculator is someone who is just buying a house in the hopes that it will go up in value. While a true “investor” is someone who understands expenses involved in real estate and doesn’t just make wild guesses about the future.
The true investor takes very calculated and accurate “risks” and understands exactly how to create a good return on your investment. I’ve broken this into the most important steps you will want to understand in order to help you make offers that can ensure a profitable transaction.
Determine the ARV (After Repaired Value)
ARV is an acronym commonly used amongst real estate investors. It stands for “After Repaired Value” and is basically what the property will be worth after repairs and upgrades have been completed. Determining the price a property will be sell for once you finish rehabbing it, is your first step in the deal evaluation process.
Once you know the price a prospective buyer is likely to pay for your property, then you must determine all of your other expenses. These two factors are the keys to figuring out the right purchase price that will lead to making a decent profit.
You want to think of the ARV as the finished picture of a jigsaw puzzle. When you know what the puzzle is supposed to look like you can put the pieces in the correct places which creates a picture of profit. Otherwise you might spend time and energy just to end up with something doesn’t fit your investment objectives.
In order to accurately determine the ARV you will need to look at comparable properties or “Comps“. Good comps are recently sold properties similar to your subject property, in the same general area. These are used to determine the “going rate” for houses in that area and are a good indication of what your house will sell for.
To access data for comparable properties you can use a paid or free service such as Zillow or Redfin, but to really get the most detailed information you will probably want access to the Multiple Listing Service, or MLS. This is a service which provides every detail on a property that is up for sale or has recently sold. In order to access the MLS you will either need to work with an agent, become an agent yourself.
The first step with the MLS is to look for recently sold “rehabbed” comps which are similar to what your home will be like when it is complete. These comps are very easy to spot. They will have upgrades, nice pictures and will outshine the other recently sold homes. These comps should be given the most consideration when determining your ARV.
Next, depending on how many “rehabbed” sold comps you find, you may also want to take into consideration other recently sold comps, such as short sales or bank-owned properties (REOs) which have been renovated or are in good condition. As a general rule look for homes that have the following criteria:
- Sold in the last 90 – 120 days.
- Within ½ mile to ¾ mile from your subject property
- Close in size, square footage, bed/bath count and age
- Similar neighborhood.
After looking at recently sold comps, then you can expand your search to comps which are listed (currently for sale) or pending (under contract with a buyer and has yet to close).
- Listed properties will let you know what you will be competing against, so if you see rehabbed houses that are not selling you wouldn’t want to value your home for more than those listed.
- Pending properties might give you an idea of future values, but keep in mind that these might not actually sell for the stated price.
As a note, you should give little to no consideration to “listed” or “pending” short sales (a house being sold for less than the owner owes to their lender). This is just a number an agent threw out in an attempt to get an offer on a property. Often times the bank hasn’t even done their analysis on the property and there is a good chance the short sale lender will never approve the sale of the property at the listed price.
Although you want to focus primarily on properties that have been fixed up, also pay attention to the properties in a similar current condition to your subject property. If there are several comparable properties which have recently sold or are listed for less than your calculated offer, this might indicate you are over-paying and you might want to reduce your offer accordingly.
It is also a good idea to check the tax records to see what other investors paid for the homes they purchased in that area. If you are buying the property for less than other investors have paid, this could be a good candidate to wholesale the property.
Avoid using comps from a different city, school district or across a major barrier such as a freeway, river or railroad tracks. Also take into consideration swimming pools, garage size, lot size, views and other upgrades so you can adjust your value accordingly.
Finally you can consider current market trends and seasonal price changes for indications on both the resale value of your property, as well as the best time of years to buy or sell. These are a lot of things to keep in mind when determining your ARV. I have heard many different formulas for value determination, and we will address the most popular ones as we continue through the next few chapters. Here are some examples that may help.
Example #1 – You find three standard rehabbed homes that have sold within the last 2 months and are the exact same floor plan as your subject property. In this example lets they are a standard 3 bedroom, 2 bath, one level ranch. They sold for $260,000, $255,000 and $250,000.
The one that sold for $250,000 didn’t have granite counter tops, but the other 2 did and so will yours when you finish the rehab. You also see one rehabbed property that was only listed for 5 days and is now pending at $260,000 and you see one rehabbed property that has only been on the market for 2 days and is listed at $260,000.
You can feel pretty confident that the ARV of that property is at least $255,000, and would be safe to put the ARV at $257,500 when computing your offer.
Example #2 – You find one standard rehabbed sale which sold for $320,000 just last month. You also see 2 REO’s that recently sold. One has new carpet and paint and sold for $300,000 and the other although not quite as nice as the rehabbed sale looks a little nicer than the other REO and sold for $310,000.
You also notice a rehabbed sale that is pending at $325,000 and one listed at $330,000. You wouldn’t want to go with the $330,000 or $325,000 value since there isn’t any way of knowing if those properties will actually sell for that price. This additional data simply supports the value you see in the rehabbed sale at $320,000 and you can confidently use that as your ARV when determining your offer.
Sometimes the value is easily determined, and other times it can be a challenge. When in doubt you will want to err on the side of caution when making your offer.
Estimate Repair Costs
The next step in being able to accurately determine an offer price is to estimate the cost of repairs. In my company, we have become so good at this we can often look at pictures or just get a description from someone and if we know the age and size of the house we can guess the repair costs within about 10% without ever seeing the house.
I am not suggesting that you start out that way, but with time and some experience estimating repairs is not as difficult as you may think.
The “$20 per sq. ft.” rule is a guideline we use to give us a pretty good idea of what it is going to cost us to fix up a house. In a nutshell, this rule comes from our experience that most houses requiring a full “standard” cosmetic rehab will cost around $20 per square foot.
A “standard” cosmetic rehab usually includes all new flooring (carpet and hard surface floors), paint (inside and outside), baseboards, electrical and plumbing fixtures, new kitchen/bathrooms (including cabinets, granite, appliances), blinds and window treatments,, doors and maybe a little bit of landscaping.
For example, if you are buying a house that is around 1,500 sq. ft., you can plan on spending right around $30,000 for the rehab (1,500 x $20 = $30,000).
Now, this rule assumes you are rehabbing an entry or mid-entry type of house. If you are rehabbing a higher-end house and using higher quality materials and finishes, then you are going to adjust the rate closer to $25 or $30 per square foot. But for your standard basic rehab, the $20 per sq. ft. rule works like a charm.
From this point you can adjust up or down based on additional needs (or things you don’t need). For example if you need to redo the roof, you will want to add $8,000 – $16,000. A new HVAC system? Probably around $5,000. New pool equipment or resurfacing will put you out another $5,000. New windows run around $200 per window at the time of writing this.
You will also need to add additional costs if you have to rewire the electrical, redo the plumbing or if you are doing anything structural to the house. On the other side of that, you can adjust your price estimation downward if you do not need to do some of the standard items.
For example, if the house already has a newly refurbished kitchen, then you can remove this from your rehab costs. In fact, if all you have to do is re-paint the interior and change out the carpet or other small items, you might be able to do the whole house for as little as $5,000 – $15,000. It just depends on what the house needs in order to bring it up to retail (or after repair) value.
Overtime you will develop a better understanding of these expenses and will be able to easily calculate the rehab costs, up or down. We will continue to revisit this topic in more detail throughout this book as we discuss rehabbing and working with contractors.
Something to keep in mind is that you will probably only use this $20 per sq. ft. formula when you are coming up with your initial offer price. Once you get an “acceptance” on an offer, you will want to go through the property with your licensed contractor and come up with a more detailed “scope of work” and repair estimate to ensure you didn’t miss anything major with your first estimate.
You can either do that yourself or if you are looking to “wholesale” the property to another investor, you can just contact them and, if they are an experienced rehabber, they may just pay you a fee and buy the house without you ever having to even take this route.
Now that we’ve touched on the major rehab estimate we should discuss how to calculate for closing and holding expenses. This is one area they seem to “forget” to mention on all of those house flipping shows. Not sure if they think it is more “sexy” to show a bigger profit, because flipping houses wouldn’t be nearly as exciting if you find out that all the money you thought you were making is getting sucked up in closing and holding costs. Following are a few of the holding and closing expenses you need to be aware of when calculating your offer on an investment property:
Purchase Closing Costs – These are the closing costs you incur when you are buying the house. Traditionally most of the commissions and closing costs are paid for by the seller, so when buying a property your expenses will typically be less than when you sell the property. Since this post is on deal analysis and my goal is not to teach you about every single expense involved in buying a house, for now we will just say to calculate for 0.5% of the purchase price when buying a house for buying closing costs.
Selling Closing Costs – This is where it can get a little more expensive. If you are selling a house with an agent you can usually count on a commission of 5 – 6% for agents. Depending on the area and market your buyer may ask for concessions to help pay for their expenses as well. This can range from 1 – 6% but is typically about 3%.
Then you will want to include about 1% for additional closing costs such as title and escrow or attorney fees. Selling closing costs can really add up if you are using an agent to sell your house. and your buyer is asking for concessions. Depending on the area and type of home we are dealing with, we will typically account for anywhere from 6%-10% of the sales price for closing costs.
Holding Costs – Even more so than closing costs holding costs are typically something many people forget to take into consideration when buying an investment property. Holding costs can include, property taxes, insurance, utilities, maintenance such as lawn, HOA and or Mello-Roos, if any.You will want to make sure you know what these expenses will be and depending on how long you intend to hold the property you will need to calculate for those expenses during this time.
Financing Costs – If you are using your capital then you will not need to worry about financing costs. If you have to use financing like the rest of us, then be sure to account for this. It can really add up.
If you have a private money lender you can expect to pay anywhere between an 8 – 12% annualized return on your capital. If you are using a hard money lender in today’s market, you can expect to pay right around 12% annualized with additional points and fees. (Points are just a fancy way of saying percentage points.)
Most hard money lenders will charge you 2 – 3 points (basically 2 – 3%) however this is not annualized so regardless of how long you borrow the money this is what you will be paying on the money you borrow. The fees vary but you may want to calculate for an extra “point”, or an extra 1%, for these expenses.
So for financing if you are paying a private lender 12% annualized, that would be the same as 1% for each month you borrow the money. If you plan on holding the property for 4 months you will need to calculate for 4% of however much capital you will be borrowing. If you are using hard money you will need to calculate for an additional 2 – 3% on top, so that would be around 3 – 7% for financing costs for the same 4 month period.
For example, if you borrow $100,000 from a private lender, then for each month you are borrowing the money you would pay 1% or $1,000. If you hold the property for 4 months, then you would pay $4,000.
Taking this example, if you borrow the same $100,000 from a hard money lender, then you would calculate around 2 – 3% right upfront, which is $2,000 – $3,000. Then, for each month you are borrowing the money you pay an additional 1% or $1,000. So, for the 4 months from the previous example, you would pay $6,000 – $7,000 for financing costs.
Does this make sense? I know it is a lot to take in at first and it can seem like all of these expenses make it harder to profit on a deal. Trust me, there is a place for all of these financing tools. In the end, the number you offer has to include the cost of money in order to ensure a strong profit margin for you and your partners.
We will continue to discuss the options and the numbers throughout this book. The more you hear it, and start to put it into practice, the more you will understand. In time it will all become second nature. We will go over financing costs in more detail later on. For now just make sure you are calculating these in, because it can REALLY add up!
Determine Your Offer
Once you have a better idea of how to determine your potential selling price (your ARV), and you can estimate your expenses, then it becomes time to come up with an offer price!
There are several formulas you can use to help you calculate what to offer on a property. I am going to cover the 2 easiest and most basic ones here and we will get into the others later.
Formula #1 – ARV, minus Repair Costs, minus Closing and Holding Costs, minus Desired Profit equals your Offer Price. Simple enough, right? This is the most basic and most obvious formula, and probably the most accurate way to determine your offer price.
Basically it boils down to figuring out what can you sell the house for minus all of your expenses and desired profit. Then that gives you your offer price. Your desired profit will of course just depend on you and how much you want to make. You want to be conservative and leave some room for error, but you will quickly realize that if you are too low on your offers your chances of buying many houses will be pretty low.
For the most part I would recommend your profit be based on a percentage versus just a standard number. You will understand why I say this much more in the weeks and months ahead, but it has a lot to do with managing risk, returns on capital, and bigger picture thinking as you put together the pieces for your house flipping machine
Okay, once again I am getting ahead of myself! As a quick rule when first starting out you can just calculate 10% of your ARV for the profit. So if the ARV is $250,000 you can calculate a profit of $25,000.
Here is an example: You have a 2,000 sq. ft. home with an ARV of $250,000 which requires a standard rehab as well as a new HVAC and you are financing it all through private money lenders. Based on those numbers you would take the ARV of $250,000 minus $85,000 ($45,000 + $18,000 + $25,000) which gives you $165,000 for your offer price.
- ARV = $250,000
- Repair Costs = ($20 / sq. ft x 2,000 sq. ft =) $40,000 + (new HVAC =) $5,000 = $45,000
- Closing and Holding Costs = 1% (purchasing closing) + 8% (selling closing) + $X (holding) + 1% / month (private money financing) = approximately $18,000
- Desired Profit = $25,000 (10% of ARV)
Now that we’ve done it that way, let me show you a faster and easier way to calculate an offer for an investment property. You may sometimes hear this formula referred to as the “70% rule”.
Formula #2 – ARV multiplied by 70% minus Repair Costs = Offer Price
Basically you are taking what the property should sell for when fixed up, subtracting what it will cost you to fix up, and then you are leaving 30% to cover closing and holding costs, as well as desired profit. Does that make sense?
For example if the fixed up or retail value of a house (ARV) is $400,000 and the repairs to bring the house up to that retail condition will cost $50,000 then this is how you would calculate your offer: $400,000 (ARV) x 70% – $50,000 (Repairs) = $230,000. This will leave you with $120,000 to cover your profit and closing costs. Pretty simple, right?
Now I want to be very clear here. This is not a one size fits all formula, and needs to be adjusted based on the scope of the project you are working on, how long it will take, the type of financing you get, your acquisition strategy and the market conditions at the time of your offer.
I have seen this same formula being used with 60% in “high Risk” markets or up to as high as 80% – 90% for buy and hold investors. You can keep that in mind, but if you are just starting out, you will be pretty “safe” using the 70% rule and adjusting from there as you gain experience.
There is nothing more powerful than “knowing the numbers”. Understanding how to evaluate a “Flip” gives you the ability to quickly pull the trigger. This ability is kryptonite of “analysis paralysis”. You can not confidently make decisions unless you have done the numbers yourself first.
Search online and find 5 active properties for sale in your target area, evaluate each one using the “70% Rule” and have your real estate agent submit these offers. Do it THIS WEEK!