Due to the proliferation of fix and flip shows on TV, the fix and flip strategy is typically people's first exposure to the world of real estate investing. I mean, who doesn't love Chip and Joanna Gains?
The fix and flip strategy consists of buying a property and renovating it with the hope to sell the renovated property at a profit.
At its core, the fix and flip and flip strategy is quite simple. But the devil is in the details. Spending less on the rehab, hold, financing, than the value created is easier said than done.
In order to consistently win at the fix and flip strategy, you need to understand the whole process and diligently stick to a strategy.
Why Listen To Me?
I have flipped over 30 houses in the last 4 years. During this time I have executed on a wide variety of strategies, with most of the flips being extensive renovations.
During these renovations, I have learned a lot about the process and identified many patterns in what makes for a successful fix and flip.
Let's Review Some Terms
MAO: Maximum Allowable Offer – The highest price you can offer on a property in order to achieve your profit margin. MAO = ARV – Rehab Costs – Holding Costs – Desired Profit.
ARV: After Repair Value – The expected value of a property once you have completed renovations. You get this through comp analysis.
Comps: Short for comparable sales. These are recent sales in the area, usually in a .5 mile radius within the last year that share similarities with the subject house.
Holding Costs: The utilities, financing costs, and taxes associated with the time you own the house.
Renovation Costs: The construction costs associated with the house.
A very popular rule in the fix and flip industry is called the 70% rule. It is defined as:
ARV * .7 > Purchase Price + Renovation Costs
Or, the purchase price plus the renovation costs should be less than 70% of the ARV.
The remaining 30% is not your profit. There are also holding costs and transaction costs associated with each property. Because of this, I don't find this rule to be particularly helpful for anything beyond getting an initial idea of feasibility of the project.
If you are using short term financing for the project, there is not much room in that pie for profit.
The Flip Profitability Formula
It makes more sense to include more precise estimated costs for as many items as you can possibly project such as: real estate agent fees and transfer taxes when selling as the transaction costs. Working backwards from desired profitability.
ARV * (1-Risk Adjusted Desired Profitability) > Purchase Price + Renovation Costs + Holding Costs + Transaction Costs + Contingency
Risk Adjusted Desired Profitability? What, you don't think you should start with the end in mind?
It is not necessarily a good idea to use the same desired profitability for every project. Some projects are simple and have very easy to support ARV's. Others may have more unknowns, require more intensive renovations, or have a wider range for the ARV. When this happens it is a good idea to adjust the desired profitability for risk.
The range of a risk adjusted desired profitability should likely be between 15% and 30%. 20-25% is a good area for most projects. Reserving 15% for the most simple of rehabs and in areas that are highly desirable with a lot of support to the ARV. Think the proverbial paint and carpet renovations.
Fix and Flip Overview
The process of fixing and flipping is broken down into 3 high level parts. These are the purchase, renovation, and sale. Executing on each of these steps are important for achieving the ultimate goal of a profitable flip.
Buying a Distressed Property
The first step when flipping a house is to find a property to flip. What is a distressed property? A distressed property, is a property that requires work to get it to the optimum sale state. Sometimes it can just be out of date or worn-out finishes. Sometimes there could be foundation problems, mold, or other major issues that need abated.
Typically, the house is distressed because the owner is in some sort of hardship and wants cash quick for the house rather than repairing it on their own.
There are four common ways to find a distressed property this:
- Finding a private seller through direct marketing
- Using a wholesaler
- on the MLS
Getting the Fix Right
If you have ever watched a show on HGTV about flipping houses, you would think that fixing the house is 95% of the business. Even though I know this is false, it feels like this is true because everything that occurs during the rehab has a sense of urgency to it. It is still definitively a majority of the work in a flipping business. Mistakes here can easily tank proper execution of every other step in the process.
Deciding on the Scope of Work
This is where you have to know what the competition is, and how you can provide a product that is competitive in a cost-effective manner. The goal is improving and fixing issues with the property without over improving to the point where profits disappear.
In an ideal world, you could line up contracts for every subcontractor before starting a project. This just is not realistic as dealing with an old house often leaves things on the ambiguous side until you open up walls. Today's market is moving too fast to be able to get contractors through every job before you put it under contract, so having a way to accurately estimate rehab costs is important.
Usually, the best you can do is figure out what units a trade usually uses to bid a job, how big your job is, and a range that subcontractors charge for that unit of work to make an educated estimate.
You will want to have a scope of work that contains a description of every aspect of the work in the project, the units, and an estimated price. For instance, “remove existing windows, and replace with vinyl replacement windows trimmed out with aluminum on exterior. 12 windows at $300 each $3600 total.”
This can live in an excel sheet for budgeting but will likely need to be put into something more like a word document to describe what all is included and excluded in each stage of the project.
The scope of work is important so you can provide an accurate description of what is expected of each subcontractor.
Executing the Scope of Work
There are many different ways to execute on the scope of work. On one hand, you could do all the labor yourself, on the other extreme you could hire a GC to handle 100% of the scope of the work.
Most flippers land somewhere in the middle. Hiring subcontractors for some work, hiring hourly labor for other work, and doing some tasks themselves.
Part of the challenge of all this is communicating with all the parties involved in the construction what the expectations are and what the schedule is looking like, so they know when the jobsite will be ready for them.
Usually you will want to stop by the jobsite in the morning and afternoon at a minimum to assure any questions are answered, they have the materials they need to perform their job, and that things are going in the direction you would like.
You can expect that your subcontractors will have questions and possibly will find items that are change orders that need approved or not in the process.
Staying on Budget
For anyone who has ever completed a construction project, it feels like the Ben Franklin quote “in this world nothing can be said to be certain, except death and taxes” could have just as well included construction budget overages.
You can get knocked out of budget by unexpected expenses when you open walls up, realizing something that seemed salvageable is not, or simply not being able to find subcontractors will do the work for the budgeted price. There is also a principle in renovations that everything you make new makes everything old look that much worse. This can lead to scope creep.
I am convinced that when it comes to flipping houses, all budgets are made by optimists. If they were not, the flipper would never be able to offer enough to get the seller to sell a house to them. Most successful flippers that I know of, budget each item optimistically then have a contingency to take care of things that go out of budget.
To be able to keep your calm through the process, you need a plan on what to do when you have to spend more than expected. Will you use money set aside in a contingency? Will you kick in some heroics and figure out how to save money down the road on the project? What if it is a major expense? How will you get the additional capital required to finish the project? This needs to be thought about and planned for before you start the renovation.
Getting the Sale Right
The “sale” portion of the flip is where you validate your strategy. It is the time when you realize the good or bad decisions made in the purchase and the fix stages of the flip. While the outcome of the flip is highly dependent on the first two stages, getting the marketing and sale right can weigh in on your success.
To Stage or Not to Stage, that is the Question
Quality staging can really make a listing pop. It is much easier for buyers to visualize what a home would look like furnished.
It also costs a non-zero amount of money.
So, when does it make sense to invest in staging?
With open floorplans it is often hard to determine how everything will fit in a home. This is especially true in houses that are on the compact side of things. By putting furniture in, you can show that yes, a dining room table does fit, and a couch and tv area can all work together in an area. It makes a lot of sense to stage in this scenario.
I usually do not stage when we are able to price a house very competitively in a market with high demand and very similar housing stock. In my area there are a few markets that almost every home in an entire half mile radius is essentially the same floorplan and age of home. The buyers that are interested are already fairly familiar with that and are interested in the floorplan, so staging it can feel a bit wasteful.
In a market that is close to equilibrium between supply and demand, the optimal list price is one that will get the home sold between 7-14 days. As it gets beyond that, buyers will start wonder if something is wrong with the house.
If the market is out of equilibrium, houses may sell quicker than 7-14 days if it is a seller's market. They may have a higher days on market as it turns to a buyer's market. It is good to have enough meat on the bone to be able to price the house so that yours is one of the first few to sell in a buyer's market.
Some home sellers can wait a long time for the house to sell because they are still living there, as a flipper you will likely have a large interest payment or high costs of capital that you will want to get it sold quickly and move onto the next project.
To Reduce Price or Not
Deciding whether it is time to reduce the list price, and how much to reduce it is a very stressful decision for a house flipper. Once you make the cut in the list price there is really no way to recover that money, and it comes right out of your theoretical bottom line.
While it is possible to sit on a property and wait for that perfect buyer to come, usually no offers is a sign that the house is priced too high. Especially if you did a good job flipping the home and there are not complaints about the finishes or amenities of the home.
So, when do you know when to reduce the price and when not to?
If you are in a healthy market, if you have gone 10-20 showings and a week has passed without an offer or indication that an offer is potentially coming, that is a pretty good indication that the property is overpriced.
Pay attention to the feedback from agents, there is another possibility that the buyers are put off by something that is actually fairly easy to fix. This is likely to happen more often on the first few flips you do.
But how much should I reduce the price?
This is a really tough decision, because you don't want to reduce the price too much and leave potential profit on the table. You also don't want to reduce it too little to where you don't spur any additional interest. From conversations I have had with top real estate agents in my area, and personal experience, I have found that usually a 5% reduction will get some movement.
This is definitely something you will want to have a conversation with your agent, and other investors in your area to get their opinion on how the local market responds to price changes.
What to Do Once an Offer Comes In
When you get an offer, it is time to decide how to respond and negotiate. It is extremely common for real estate to be purchased through some negotiation. You can negotiate both price and terms.
After Accepting an Offer
Now it is time to get to closing. During this stage there are a few things that have to happen:
- The buyer has to secure financing
- The house will have to meet appraisal
- The house will get inspected
- Most likely an inspection addendum will need to be agreed on
The largest item will be agreeing on items from the inspection addendum to be fixed and getting them fixed to satisfaction before closing. Usually you will not have an over abundance of time to complete these tasks, so time is of the essence.
This is a big day for your flip. The closing day is where you realize the good or bad decisions you have made in the process of the flip in either a profit or loss. Now is a good time to reflect on what went well, and what went poorly during the flip. Learning from the things you have identified that can be improved upon.
Profitably flipping a house is not as simple as it appears on TV. However, it is not an impossible task. It requires some planning and proper execution of the purchase, renovation, and sale of the house. Managing a flip requires a lot of day-to-day management and oversight.
The process of renovations is not the only challenge in flipping a house. You also have to market the property correctly and get the sale to the closing table. Then once you get to the closing table, hopefully it is time to celebrate.