In this step by step lesson I will give you the basic formula for estimating a fix and flip so that you understand clearly all of the different costs involved when purchasing real estate and renovating it to resell for a profit.
One cost people forget is capital gains tax on the profits of your investment! But don’t worry we’ll cover it all in this chapter.
If you’d like to learn how to estimate rehab costs, check out this resource.
Let’s get started!
The Formula:
- After Repair Value of the Home You Can Sell For $135,000
- Profit You Expect to Earn on the Flip ($25,000)
- Closing Costs during the Purchase ($5,000)
- Closing Costs during the Sale ($5,000)
- Commissions to Real Estate Agent on the Sale (6%) ($8,100)
- Holding Costs (Utilities, Loan Payments, Etc.) ($10,000)
- Renovation Budget aka Rehab Cost ($25,000)
- Max Purchase Price You Should Offer $57,000
Step 1: Determine the After Repair Value
You want to start with a bottom up approach and determine the end selling price of the home first. You need to know what the house can sell for in order to know if there will be any room for profits once you’ve factored in all your expenses.
The after repair value is what the home will be worth once it is all fixed up and in nice condition again. You judge the value based on comparable sales of other similar homes nearby.
You’ll want to have your realtor run sales comps for you using the MLS that they have access to as licensed agents.
They can quickly type in the features of your home such as the number of bedrooms, number of bathrooms, the square footage, whether it is one story or two story, and then find homes that have recently sold in the last 6 months or less with similar features.
Then you’ll need to tour these homes if possible to see the level of finish so that you don’t over-do or under-do the rehab like putting in way too nice of kitchen counters and cabinets that cost a fortune.
If you can’t tour a nearby home that recently sold, no worries.
You know the market price you can expect to get for your property so you’ll be able to judge the level of finish needed to stay within budget and make a profit.
And if the rehab needs exceed this budget, then the property isn’t going to work out and you’ll have to move on to look for another investment property. Let the math guide you in your decision making.
Don’t try to force something that isn’t there thinking you’ll make the flip work.
Resource: How to Buy Your First Investment Property + Bonuses
Step 2: Factor in Your Profit Expectation
The next most important cost to factor in is your expected profit. If a deal won’t yield the profit you determine necessary for the risk involved with the investment, then why bother investing in it when there are better deals out there?
I wouldn’t tie up my time and resources for a deal that’s going to pay me $10,000 when I could be getting $30,000 instead elsewhere.
Opportunity cost or as some call it “cost of equity” is important when analyzing investments so stick in your required profit early into the formula to make sure whether the deal will work or not for you.
It’s likely that this profit will differ as you may over estimate your expenses and end up with more profit or under estimate and end up with less profit.
This is why I recommend giving yourself a cushion when determining the profit you’d be happy with so that if things go wrong and unexpected expenses come up, you’ll still make a $5,000 or $10,000 profit instead of breaking even.
Learn –> How to Increase Your Income and Master Your Money (Saving, Investing, Taxes)
Step 3: Closing Costs at Purchase
You’ll be required to bring in money to closing usually to cover any expenses that your loan isn’t covering if you’re using leverage.
Otherwise you’ll be bringing in all cash anyway if you’re not using a loan. Closing costs vary but typically might include:
- A loan origination fee – which lenders charge for processing the loan paperwork for you.
- Attorney’s fees.
- A fee for running your credit report.
- Charges for any inspection required or requested by the lender or you.
- Discount points – which are fees you pay in exchange for a lower interest rate.
- Appraisal fee.
- Survey fee – which covers the cost of verifying property lines.
- Title insurance – which protects the lender in case the title isn’t clean.
- Title search fees – which pay for a background check on the title to make sure there aren’t things such as unpaid mortgages or tax liens on the property.
- Escrow deposit – which may pay for a couple months’ property taxes and private mortgage insurance.
- Pest inspection fee
- Recording fee – which is paid to a city or county in exchange for recording the new land records.
- Underwriting fee – which covers the cost of evaluating a mortgage loan application.
A good rule of thumb to use is $3,000 to $5,000 in closing costs but again, it will vary so don’t count on this as a hard number. Once you’ve done a deal or two you’ll be able to see your HUD statement and get a rough estimate of all the closing costs and how much they total up to.
Resources:
- Real Estate Investing School: How to Retire on Passive Income
- Personal Finance School: How to Maximize Money
Step 4: Closing Costs at Sale
Once you’ve decided to sell your investment property or your home, you’ll have several expenses to pay.
The obvious and most well-known expense you pay is the real estate agent commission which will run you about 6% of the sales price.
If you sell the house yourself you can save this expense but hiring a realtor to sell your home has many benefits including speeding up the sales time, marketing, access to their network of potential buyers, legal work and paper work knowledge, and more.
You’ll also have to pay for title work to make sure the property title is clear and ready to be transferred to the next owner without any defects.
This way there are no disputes down the road about who owns the property legally. It can get messy when heirs leave property to several of their family members in their wills.
Or maybe the county made a recording error during one of the previous sales of the property that wasn’t caught. Here are several of the expenses to expect:
Potential Seller Costs:
- Real estate brokerage commission (3% to 7%)
- Attorney or closing agent fees for preparing the deed and other documents
- Documentary stamp taxes, where required
- Recording fees for the certificate of satisfaction of the seller’s mortgage
Potential Shared Costs:
- Proration of Property Expenses
- Taxes
- Rental Income already collected ahead of time by seller
- Costs of other contracts that exist and can’t be cancelled yet
- Mortgage assumption costs beings transferred to the buyer from seller
Step 5: Commissions to Real Estate Agent
We touched on this already above, but to reiterate, you will likely use a realtor to sell your home for all the benefits they provide.
You may also decide to get a license yourself if you’re going to be doing several investment deals over your investment career.
For example, someone buying 4 properties per year may consider getting his or her license so that they can earn a commission each time they purchase the house and save themselves the expense each time they sell the house.
If you become a realtor, you’ll have several fees to pay though which is why it only makes sense to those who will be doing enough deals to cover the costs of being an agent and leave profit thereafter.
If you won’t being doing many deals, you might want to save yourself the hassle and just stick to hiring a sales agent.
Step 6: Holding Costs
This is an expense category people often forget to factor in. When you are doing a flip, you have to pay for utilities such as electric, gas, water, sewer, and waste removal.
These expenses will add up if you’re flip is taking several months to complete, for example, you may have the renovations done in 60 days (2 months) but then the property sits on the market for sale for another 60 days, bringing the total flip time to 120 days (4 months).
During this time you’ll also have to pay mortgage interest if you took out a loan.
You’ll also have property taxes and insurance which may or may not have been pre-paid for and prorated at closing.
Overall, don’t forget about taxes, insurance, utilities, and debt interest as well as any other holding costs you may incur when budgeting for your max purchase price to offer on a flip.
Learn –> How to Increase Your Income and Master Your Money (Saving, Investing, Taxes)
Step 7: The Rehab Budget
When estimating repairs it’s always wise to make sure you are conservative in your estimates.
By giving yourself a cushion when estimating, you’ll make sure the deal works out still because unexpected expenses do arise and can be devastating to your bottom line profits if you didn’t give yourself a conservative cushion.
On the bright side, your profits will be larger if everything goes as planned or you save more money than you thought on the flip.
Learn how to estimate rehab costs
Step 8: Max Purchase Price
Once you’ve determined your ARV and subtracted out all of the expenses discussed above, you should be left with a number that represents the max amount that you should offer to buy the property.
In other words, in order for the deal to work in your favor and come close to producing the profits you are estimating, you have to purchase the property at no more than this price.
If the max purchase price seems ridiculous and there is no way you see the seller accepting such a low offer, then the property is likely not going to work out and you’ll have to pass.
I recommend submitting your low offer still and seeing what happens because you never know. The seller may be pretty motivated to sell and accept your offer.
Typically, you’ll have to find properties that look old and outdated as well as distressed in order to get off to a good start with the low offer process.
You can use this as leverage when negotiating with the seller, letting them know how much the property needs to be updated to be worth market value and therefore why you are proposing an offer lower than their asking price.
They may say no but the important takeaway is at least you took action and didn’t pass up an opportunity because of a false assumption.
Maybe they would have said yes but you didn’t offer because you assumed you’re price was too low. Don’t assume, go talk to them.
Action Tip: Get out there and start making offers!
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