House FlippingPosted by Badger Coach on May 29th, 2014
Many investors get into the house-flipping business after spending a weekend at a high-end hotel, listening to a self-proclaimed house-flipping guru—profess his or her ability to make money buying and selling houses with little or no money down.
After the guru works the crowd into a frenzy with visions of “The Lifestyles of The Rich and Famous” dancing in their heads, these starry-eyed investors are told that all they need to do to get started on their wealth building journey is buy the guru’s books and tapes that normally retail for $2,500, but are now on sale “today only” for $995. And, if they are really serious about making money in real estate, they will need to invest in the guru’s personal mentoring membership services, which— by-the-way—will cost upwards of $5,000 to $10,000 or more. If only this were all that is required to successfully make money flipping houses. And if it were so easy and so profitable, one has to ask why a guru would want to share his or her secret sauce with you?
Many people get into house-flipping as a short-cut or fast-track way to earn large sums of money, to save for retirement or to pay for a child’s education. Some investors get into the business as an exit strategy from their current career path. Yet others get in to the business because a friend told them they tried it out once and made a lot of money and are now ready to do it again. In all of these instances, unrealistic expectations (greed) and an unsatisfactory work life are at the root of this endeavor. These motivating factors have, unfortunately, caused many wannabe house-flippers to suffer financially and physically as a result of unmet expectations.
Do Your Homework
The keys to becoming a successful house-flipper are many. I have listed a few for you to consider before you buy property to renovate and sell:
- Access capital through a participating whole life insurance policy loan before using your personal savings, or take a 203(k) rehabilitation loan from a bank, or use a hard-money lender
- Buy property that is at least 30 percent or more undervalue
- Identify the “wow” factor or curb appeal of the property
- Shadow a successful house-flipper through two projects before you get into the business yourself
- Do most of the repair, remodeling and renovation work yourself
- Know the housing market of the property where you plan to renovate
Please be advised that 203(k) loans take longer to close, and that very few properties will qualify, and are not offered by most banks.
Hire Your Dream Team
To increase the odds of a making a profit, you will need to hire the following talent;
- Real Estate Agent
- Structural Engineer
- Home Inspector
- Real Estate Attorney
- Financial Planner
Know Your Numbers
- Know what your profit margins need to be to make a profit
- Guesstimate a reasonable “After Repair Value” of the renovated property
- Estimate the number of hours it will take to renovate the property
The following “Know Your Numbers” example assumes you paid (cash) $125,000 for a piece of real estate with an appraised ARV of $215,000, and borrowed $50,000 to to renovate:
- $125,000 = price paid for undervalued property
Up-front Carrying Cost (expense)
- $125,000 = purchase price
- $7,500 = closing costs (assumes no 6% seller assist)
After Repair Value
- $215,000 = Assumes house resells for ARV
Capital Gains Tax (expense)
- $29,700 = tax rate (assumes 33 % tax rate)
Total Carrying Cost (expense)
- $162,200 = total carrying costs
- $52,880 = net profit after all expenses are subtracted
- $52,880/500 = $105/hr. (assumes you did all of the work)
Note: Numbers used do not include labor cost, interest on the loan, permits, or other unexpected expenses, which if added, would have a significant impact on the bottom line.
As you can see from these numbers, it is easy to conclude that this investor made $90,000—by flipping this house in one year—which is the difference between the as-is price and the ARV. However, when total carrying costs are factored, an investors pure profit drops considerably. The next time someone tells you they made a huge profit flipping a house, come back to this article and run the numbers to verify their claim. They may have received a large check, but that check is not pure profit.
Taxation of Investment Property
For income tax purposes, the IRS makes a distinction between repairs and maintenance, and renovation and rehabilitation. Additionally, if make a profit off your house-flipping project, you will only pay capital taxes if you do not sell the property for twelve months. However, if you sell the property within twelve months, you will pay taxes at the higher income tax rate. Be sure to consult with a qualified tax professional before starting your project.
There are four key ingredients that you will need to keep your stress levels down during the house-flipping project:
- A lot of time (always remember that renovations can take up to four or five hundred hours or more to complete, and are never completed on time).
- A lot of money (always remember that renovations accrue cost overruns).
- A lot of hard work (be prepared to get your hands and hair dirty).
- A lot of education (always learn something new from the contractors).
Managing these key ingredients will be extremely valuable to your sanity.
Before you buy the property to renovate, I recommend that you use what I call the Box-R (Boxer) system. This system helps house flippers take inventory of the work that may need to be done as well as forecast the anticipated costs. The Box-R system uses five Rs and works as follows;
- Replace (HVAC, water heater, windows, doors, carpet and roof)
- Repair (Plumbing, electrical, and fencing)
- Restore (Wood floors, cabinets, and fixtures)
- Remove (Walls, rotted wood, asbestos, etc.)
- Repaint (Interior and exterior of the property)
Not using this system to get an idea on what it may cost to cover these expenses can cost you a lot of money and heartache.
One of the most important aspects of house-flipping for you to remember is that depending on the type of loan you used to finance the renovation project, you may be forced to start loan repayments before you are able to sell the house. This can cause extreme financial hardship if you do not have enough access to capital reserves to carry you through. To protect yourself from this situation, have at least six months of capital reserves on hand to cover you from the time when the renovation project is complete and the house is actually sold.
At the end of the day, I hope you realize that the only people who are guaranteed to make money off of house flipping activities are the real estate agents, home improvement stores, banks, and the guru selling their house flipping systems. Yes, you may get lucky and make some money on the first or second house you try to flip, however do not think that because you were successful early on, that you can quit your day job and become a house-flipper extraordinaire. The only way for you to become successful at flipping houses, is for you to do your homework, know your numbers, and enlist reliable and affordable labor if you are unable to do the work yourself.