Property Flipping, And The Fundamentals That Make It Work

In the real estate world, “flipping” is a dangerous and often misunderstood word. There are two sides to the word “flipping”. One is legal, and a great business model when done correctly. The other is an erroneous application of the word “flipping” in cases where someone uses illegal tactics such as mortgage fraud, secret cash incentives or misrepresentation of some material fact. But those illegal practices can take place in any deal, not just a “quick flip”.

In the world of licensed real estate brokers and agents, “flipping” is thought to be referring to an illegal practice. In the world of real estate investing, “flipping” is basically a term which denotes the idea of buying and reselling houses quickly.

When you think about it, anyone who has ever sold a home, whether it was a personal home or an investment property, was “flipping” that property, simply because the act of flipping a home is to resell it. The term “flipping”, for our purposes is merely denoting the idea that you want to sell the home as quickly as possible, and hopefully reap a cash profit in the process.

There is nothing wrong with flipping a property, as long as all real estate laws are observed, and the buyer and seller do not have any hidden agreements, such as “cash under the table”. It is illegal anytime some material detail deliberately is hidden and not disclosed to all parties in the transaction. As long as a seller has the legal right to sell, and the buyer is a real buyer, not someone posing as a “straw” buyer, the transaction will be handled just like any other real estate transaction.

Banks flip foreclosures to buyers, and lately they’ve been flipping a lot of them to real estate investment companies. REO brokers market the properties to help enable the bank in completing a quick flip of a foreclosure. They also get paid a commission for it. There is nothing illegal about a typical flip deal.

What makes flipping work and work really well, is when the numbers in the deal are accurate and viable.

Flipping is most commonly used to sell properties for investment, though owner occupants can buy a flip deal and move in it. In fact, when the numbers are correct, buying a flip deal on a personal residence is a way to make sure you have some equity in your home from day one. Flip deals are good deals. In fact, when buying with a set of legitimate numbers, your deal would be among the best you can get.

Because of the confusion around the word “flipping”, I personally like to use the word “wholesaling” to refer to the practice of selling houses quickly for a cash profit. Buying a flip is essentially buying the property for a “wholesale” price, before the retail mark up, or ARV, is added.

Here is what might be viewed by most investors as the “standard” flipping formula:

After Repair Value X 65%, minus repairs, minus desired profit margin = Maximum Allowable Offer

This formula, or some variation of it, is commonly used by real estate wholesalers when they purchase a property, with the intention of reselling it quickly for a profit.

Here is how the formula breaks down:

After Repair Value, also known as ARV is the likely selling price of the property after it has been renovated or repaired, and is in excellent condition and ready to occupy. When estimated correctly and legally, the ARV represents what the property is most likely to sell for or appraise for, after the repairs are completed. Estimating ARV accurately is critical, because the rest of the formula is derived from the ARV.

Multiply the ARV times 65%. Lets say that your subject property has an ARV of $100,000. 100,000 X 65% = $65,000
In doing this, we are automatically allowing for a 35% margin for the next buyer. This is what motivates the quick sale. Leaving money on the table attracts more buyers faster. Essentially you are selling at a deep discount, and buyers are attracted to that. This is how you “flip” the property quickly.

Next, we subtract the repair costs. The wholesaler may or may not do any repairs himself, but he or she will need to have some idea of how much the repairs will cost, and include those costs in this number. Most professional investors will include holding costs, and allowances for the length of time it will take to repair the property. During that time there may be costs for utilities, insurance, property taxes, and mortgage or hard money payments that may have to be made, so a repair number can cover a lot of items. It’s important for a buyer to make sure he’s incorporating all of the anticipated costs.

Let’s say that our repair budget will be $20,000. We take the remaining $65,000 and subtract $20,000 for repairs. We now have $45,000 left.

The “desired profit” is how much gross profit we want to make on the property. Based on my experience with hundreds of transactions, the average gross profit to the seller should be about 10% of the ARV, give or take. This helps maintain the integrity of the deal for the buyer as well. Which helps build a sustainable business model for the wholesaler.

You subtract a $10,000 gross profit from the remaining $45,000 and you are left with $35,000. This is your Maximum Allowable Offer. (MAO) If you want to be a wholesaler, and buy properties at deep discounts so that you can “flip” them quickly for a profit, you have to be a good buyer who can find and negotiate the best deals. And these are the deals that represent the best opportunities for profitable investment property.

Fundamentally, as long as all of the numbers in the deal are legitimate, as long as the parties are disclosing all of the terms of the transaction on the HUD 1 settlement statement, and the transaction has a legal purpose, in that there is no type of fraud involved, flipping is a perfectly legal way to invest in real estate, and an awesome way to buy a personal residence as well.

Some basic rules of thumb that help these deals work for everyone involved are:

1. The ARV must be accurate, and not inflated. Inflated values and the resulting increase in ownership costs was a primary cause of the housing crash. Some blame the Fed, some blame the lenders and appraisers, and some blame the speculators. There is plenty of blame to go around. Keep the ARV’s accurate and reasonable, and things will go well.

2. Repair costs should not exceed 20% of the ARV. Especially on lower income, or entry level homes and never more than 20% for rental properties. Staying within your budget helps insure a stronger cash flow.

3. As a buyer, never assume that a flip deal is a good buy. Always double check the sellers numbers, trust but verify.

 

Donna S. Robinson is a real estate industry veteran, and residential investment consultant located in Atlanta, GA. She has provided hundreds of investment property evaluations to professional investors. Follow her on twitter at donnaconsults, Facebook.com/RealtyBizConsulting and watch her videos on youtube. Her latest book, Basics of Real Estate Investing, is now available for Kindle on Amazon.com

Main image courtesy © John Takai – Fotolia.com