Ask Brian is a weekly column by Real Estate Expert Brian Kline. If you have questions on real estate investing, DIY, home buying/selling, or other housing inquiries please email your questions to [email protected].
Question from Leah in IL: Hello Brian, I’ve never flipped a house before but the thought of being my own boss and managing my own future is appealing. I’m sure that this will be a big risk but I’m willing to accept that. If I don’t do it now, I’ll regret not trying to break out on my own for the rest of my life. I’m not a great repair person around my own home, so I’ll be using contractors to do the work. My main questions as I start down this path are, how do I find the right property to flip and how do I know the right price to pay for it? Thanks in advance, I’m sure you will share your thoughts with me and others.
Answer: Hello, Leah. When you watch a 30-minute episode of any popular house-flipping show, don’t come away thinking you’ll pocket tens of thousands in profits for 30 minutes of effort - you won’t. There’s a little more to do between the time you buy a distressed house and when it’s ready for a prime-time sale. There are three critically important criteria for how to rehab or flip a house:
Leah, finding the right house has two major components. First is knowing the neighborhood and especially knowing there is an active market for the type of house that you will be flipping. This varies from community to community but a good rule of thumb is to look mostly in middle to upper-middle neighborhoods. These are neighborhoods for second and third-time buyers. Places where more prosperous buyers are buying up. Top-income neighborhoods aren’t attractive because these people want to customize their own homes. They aren't going to be very receptive to remodeling choices you’ve already made. Neighborhoods for first-time buyers aren't usually a good choice either because these buyers are too price sensitive.
Once you find a few houses to consider, you need to do the math. It’s time to determine the after repair value (ARV). You’re actually dealing with two different processes that blend together. First is the combined total of the purchase price plus the cost of repairs (don’t forget holding costs). This is the minimum of what you’ll have invested in the house after repairs. Your purchase price for a rehab house should be around 65% of the ARV. The 65% can vary a little but it shouldn’t be above 70%.
You need a basic formula to help calculate how much profit you’ll be able to make before you even make an offer on a house. Here is a basic profit breakdown:
+ ARV (After Repair Value or what it will sell for)
- Purchase price
- Repair costs
- Total closing costs (both when you buy and sell)
-Carrying costs (cost of capital and related overhead)
The ARV is a big part of the formula when it comes to purchasing the property. Here is the purchase formula:
(ARV x 0.65) – Repairs = Purchase Price
Take the ARV and multiply it by 0.65. After multiplying it by 0.65, subtract out your repair costs and that number will equal your purchase price. An example is a house in a neighborhood with an average selling price of $275,000 (that’s the ARV). Your carefully estimate repairs will cost $27,000. Here is the purchase price calculation:
($275,000 x 0.65 = $178,750) – $27,000 = $151,750 Purchase Price
Now it’s simple to calculate your profit. Your total cost is $151,750 + $27,000 = $178,750. You subtract that from the ARV for a gross profit of $96,250. But don’t forget to include all of your holding and closing costs. Here is a breakdown of what the entire formula could look like:
Buyer’s Agent (3%) -$8,250
Listing Agent (3%) -$8,250
State transfer Tax -$1,305
Title Insurance -$750
Pro-rated taxes ($4,000/yr) -$1,300
Other Misc. closing Fees -$1,500
Purchase price -$151,750
Repair costs -$27,000
Carrying costs (mortgage and others) -$8,700
NET PROFIT $66,195
Leah, there is a lot more to flipping a house but this should answer the basic questions that you asked. I seriously recommend that you carefully study the entire process before you jump in. It’s also a good idea on your first flip to partner with a person that has previously successfully flipped a couple of houses.
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Our weekly Ask Brian column welcomes questions from readers of all experience levels with residential real estate. Please email your questions or inquiries to [email protected].