"Nobody likes math let alone complicated math. So if you didnt graduate college with a math degree this business might not be for you".
Thank god this isnt the truth in this business. In order to evaluate properties to churn a profit from your investment you need to be able to calculate simple formulas that will put you in a better position to limit your risk. In order to be successful in this business you have to be able to buy at a significant enough discount to ensure you meet your minimum profit requirements.
If you can add, subtract, multiply & divide or know how to use a calculator, I have good news for you... You will be able to come up with the proper numbers needed to evaluate a "flip" oppurtunity.
Quick Rules- Use Them As Guidelines
The simple rules we will address next are to be only used as guidelines to determine your MPP (Maximum Purchase Price). Do not solely use this rule to purchase your investments. These are meant to be used as a tool to see what price point you may need to stay under when you purchase.
The 70% Rule - This formula is used to get a quick estimate of the maximum price you will offer on a single property. The first step in this process will be to determine the ARV (After Repair Value - which we will touch on shortly). From there you will multiply the ARV by .70 & subtract your estimated repair costs to get your MPP (maximum purchase price).
The formula looks like this:
ARV = 150,000
Estimated Repair Costs = 35,000
(150,000 x .70) - 35,000 = MPP
= 105,000 - 35,000 = 70,000
The goal of this formula is to give you a good idea of what you should pay for a property while leaving room for your holding costs, profits & any other costs associated with this project.
*Tip: You can adjust this 70% depending on the ARV of the home. With a higher ARV you may be able to use 75% because there will be more of a spread while dealing with a lower ARV you may want to use 60-65% because there will be less room for you to make money. Remember profits are made on the front side (the buy side) *
A More Detailed Look
Dont get me wrong the 70% rule is a great tool to use in order to get a good estimate of what you are willing to offer on a property. But as I stated previously, if you want to be successful & limit your risk as much as possible you want your numbers to be as accurate as possible.
The most important number in this business is the ARV. This is the starting point in the formula and will dictate the accuracy of your final offer. You know the old saying "garbage in, garbage out" that applies here. If you misinterpret your ARV and determine you can sell the property for a higher number than you can you may have already just took a loss on your project. So I cant say it enough, make sure this number is as accurate as possible!!
ARV - After Repair Value
This is the price that you believe your investment will sell for after all the repairs are complete on your project.
I suggest that you use a system of checks and balances when determining your ARV. Your real estate agent will come in handy when determining this number.
Initially you should try and come up with this number yourself. To do this you need to run your own CMA (Comparable Market Analysis). This will be the same technique that your agent will use but she will have access to more information through the MLS (Multiple Listing Service) & hopefully have years of experience in your farm area.
CMA (Comparable Market Analysis)
To touch on the CMA quickly what you are trying to do is determine what comparable homes in the area have sold for.
Areas you will want to compare:
# of bedrooms
# of bathrooms
type of home (ranch,cape,colonial, raised ranch.. etc
age of home
# of garages
# of fireplaces
deck/porch
square ft
price per square ft
sales price
Try and make sure that you are looking at the most recent sales, looking for inventory that has sold within the last 0-6 months to get an accurate understanding of the market.
You also want to keep your search in the same neighborhood or 1- 2 miles away from the neighborhood you are investing in. Sometimes the price of homes can change drastically street by street so be aware of this.
This will give you a basic understanding of what you will be able to get after all the repairs have been completed on your investment. Your agent should take a more a detailed look at these comparables, examining: the condition, finishes, basement, lot size etc..
Repair Costs
The second most important number when determining your Maximum Purchase Price is the repairs needed to allow you to sell at or above market value. Repair costs can be difficult to determine especially if you have never estimated repair costs.
*Tip - Bring a General Contractor with you to walk the home with you to give you a number on what he would charge you for the job. *
Remember you are just trying to get an estimate of what these costs will be to give you a better idea of what you can offer on the property. During your due dilligence period you will be able to get a more detailed look when creating your Scope of Work.
*Tip- Be sure to add 10-20% contingency to the number your General Contractor gives you to cover anything he may have missed. Better to be safe than sorry*
Holding Costs
These are the costs associated with flipping homes that every one seems to be unaware of and can kill your profit if you do not account for them. These are costs that you will have to pay for owning the property or any other extra costs associated with the purchase or sale of a property. You want to make sure you account for everything when your doing detailed outlook on a specific property.
The holding costs:
Utilities
Insurance
Taxes
Buyers Closing Costs
Sellers Closing Costs
Commissions
There may be other costs involved in other markets such as HOA fees, maintenence fees etc but these are the common costs associated in my local market.
As you gain more experience you will gain more knowledge on what these variables will cost you monthly and the total costs associated with closing & sale.
Just make sure that you account for all costs associated with the purchase, sale and the time in between (holding) with a specific job. The risk that you limit when doing this is tremendous and it will allow you to make good investment decisions and determine what investments you should take on and which ones to let go.
Minimum Profit
The last step in this formula is the minimum amount of money that you want to make on this project. Typically I need to make atleast 15,000 or 15% of the ARV. So if the house is going to sell for less than 100,000 I need to make atleast 15,000. Anything greater than 100,000 you can take 15% of that.
I also consider the variable of risk when determining my minimum profit. The riskier the project (more repairs, more unknowns) the more I will need to make on a specific project. Do not sell yourself short when determining your minimum profit you require for a project. These projects can be stressful and time consuming so you want to make sure you will be making a good profit on each project you take on.
The Formula
After you figure out all of the numbers that we have detailed previously now you can go ahead and determine what the maximum price you will offer the seller.
ARV-Repair Costs- Holding Costs- Minimum Profit = Maximum Purchase Price
Example)
ARV = 175,000
Repair Costs = 45,000
Holding Costs = 14,875
Minimum Profit = 31,500 (175,000 x .15= 26,250) Risk Variable = 3% ( 175,000 x .18 = 31,500)
175,000 - 45,000 - 14,875 - 31,500 = 83,625
MPP= 83,625
This is the maximum price that you can offer your seller if you want to be able to make 31,500 on this specfic job.
Conclusion
The simple math involved in determing what you will offer the seller will make or break your business. Do not make the numbers fit the house but instead make sure the house fits the numbers. Sometimes investors can get caught up in a specific property and alter the numbers so they work- this is a sure way to become a loser in this game and be out of business soon after you started. Try and get the most accurate numbers you can when assessing each property to give you and your investors a more detailed look in the returns for this specific project.
* If anybody is interested in an excel version that will make the process more basic, comment below and I will send it to your email*
Stay Positive, Educate yourself & Keep Grinding