How to make money, not lose money, when flipping real estate
I want to get into real estate and flip houses! That statement or the question that follows (How do I do that?) is made over and over again to me on a weekly basis. There are a few flippers out there who do very well flipping homes; but, the truth be told, most are floppers. I am going to present some of the basic real estate principles that should help guide you when making decisions about buying real estate. Remember, a small mistake is a BIG mistake when real estate is involved; real estate typically deals with hundreds of thousands of dollars. First, let’s go over some basic dos and don’ts: (These are in no particular order, so treat each one as a statement unto itself.)
- You make your money when you BUY the house, NOT when you sell it.
- Identify the market you are in: Is it a sellers’ market? Buyers’ market? Neutral market?
- Do not use the shotgun effect when looking for a house to flip: You need to be specific about the areas you are looking at, and you need to do your research about those areas before buying.
- Gather a trusted team of professionals to help you with the flip (very important).
- Do your due diligence by running your numbers up front, settling on a profit amount, and then getting it done.
Let’s address each one of these points one by one. First and foremost, the most important thing any real estate investor can understand is this: “You make your money when you buy the house, not when you sell it”; or, even better, “You make your money when you buy the house and cash your check when you sell it.” This being said, it is very important to find a house that “works”; take your heart out of the decision. Use your knowledge of the market to find a home that will fit your flip strategy. Do not deviate from this without giving great thought to the consequences. You must identify the type of real estate market you are working in. By identifying the current market conditions you can choose the correct flipping strategy. This is where most first-time flippers–flop. For the purposes of this article I will divide the market into three categories:
- Buyers’ market – low demand/high supply
- Neutral market – demand and supply equal
- Sellers’ market – high demand/low supply
Buyers’ Market – The Beautician Flip
In a buyers’ market there are more homes for sale than there are buyers to buy. In the illustration below we have 3 buyers and 10 homes to choose from. These 3 buyers will choose the top 3 homes to buy and leave the others untouched. This is where a savvy flipper can get involved and easily identify the reasons the other 7 did not sell and cure the deficiencies. By curing these deficiencies the flipper brings the home into the top 3 and thereby gets it sold. Identifying these problems is the tricky part; you only want to do enough (the more you do, the more you spend) to bring it into the top 3.
- Curb appeal –If you can’t get them out of the car, you have little chance of getting them in the house.
- Entryway – Once you have them in the house, you want to set the mood.
- Carpet and paint – For the beautician, lipstick and makeup are all that is needed in this market to move the home into your top 3.
These are some the first things that should be done. Most first-time flippers think that a great market is the best time to flip.
Sellers’ Market – The Cosmetic Surgeon Flip
This is one of the most difficult markets to flip in. In this market there are more buyers than homes for sale. For every 3 homes for sale there are 6 buyers. When a home goes on sale in this market, it is sold because it is always on the top of the list, regardless of the condition. In this market we need to find properties that are not at their highest and best use. An example of a property not at its highest and best use is a 2- bedroom 1 bath home in an area that is predominantly 3-4 bedrooms and at least 2 baths. Here we would add an extra bedroom and bath to bring it up to its highest and best use. Another common strategy is to take a duplex home in a nicer neighborhood and convert it to a 2-unit condo project. Individual units sell for higher values than do multifamily units in this scenario. Remember, rental rates affect the value of multifamily units, and the existing home-sales market determines the value of single-family unit. These types of flips are the most difficult to accomplish successfully because of the time, money, and expertise involved. Do not choose these types as your first flip; if you do, you are sure to flop!
- Find a home not up to its highest and best use.
- Add square footage to the home.
- Change the type of property.
Neutral market –
This market is typically a transitional market, and it is very important that you determine which way the transition is going. Are we moving into a buyers’ market or are we moving into a sellers’ market? Making this determination up front is very important. As a first-time flipper choose an area of town that is near to where you live, choose an area that you are familiar with, and employ an experienced, active, and knowledgeable real estate agent to help you with the research. This last point is of utmost importance. You need the right team to succeed in real estate flipping. Choosing the wrong agent to represent you can cost you. If you follow the guidelines for a great agent as I have outlined, your job will be much easier and your bottom line much bigger. Find an agent who is experienced. If the agent does not have at least 5 years under his or her belt, find someone else. Find an agent who is active in the market; some agents do only 5-10 transactions per year. Find one who does at least double that. Find an agent who is knowledgeable. Just because agents have the first two traits does not mean they know what they are doing. Speak to their past clients and ask them to get references from repeat clients, preferably clients who have bought and sold investment homes before. Dealing with investors is a specialty, and not all agents recognize the difference between owner-occupied and investment homes. You would not go to a general practitioner for heart surgery, would you? The next step to take is to make a determination about what your role is going to be in this. Are you going to be the person changing out the carpet, painting the walls, tearing down walls, adding bathroom or bedrooms? If you are not in the construction business, I recommend hiring a construction project manager to manage the trades for you. This will eat into your profits; but, if you can do the project correctly and on time the first go around, you may actually save yourself some money and aggravation. If this is your first flip, you probably don’t have a list of trades that will help you turn your investment into profit; therefore, I recommend this strategy for first timers. Financing: Most flippers, or should I say floppers, tend to ignore this aspect and choose a mortgage lender solely on how low his or her rate or closing costs are. This is a big mistake. Choosing the right mortgage lender can maximize your bottom line; or, if you choose the wrong one, it can cost you in the end. Just as with the real estate agent choose a mortgage lender who is experienced, active, and knowledgeable. Most lenders do only 3-4 transactions per month and have been in the business for fewer than 5 years. Choose one who has at least 10 years’ experience, closes at least 10 deals per month, and specializes in investment homes, not just primary residences. There are many programs available to qualified investors, and the right mortgage lender can match you with the program best suited to meet your needs. Know what your flip is going to cost. There are so many hidden costs involved in flipping a home that not adding them up BEFORE you purchase can lead to a flop. Below are some typical costs involved when flipping real estate:
- Cost to purchase – There are closing costs involved when buying real estate. Have your mortgage lender detail all these for you. Speak to your agent about the other costs not related to your mortgage such as inspections. (Never pass on the inspection – this is the best money you can spend.)
- Holding costs – This is one that many floppers totally ignore. You will have payments for the mortgage, insurance, taxes, HOA dues, utilities, and on and on. Add these to your spreadsheet when determining your bottom line.
- Rehab costs – This could be as simple as paint and carpet or as extensive as adding 1,000 sq ft. Get bids for this work. This should be on your spreadsheet.
- Cost of sale – When selling real estate there are certain costs involved, including agents’ commissions, title, and attorney fees. Make sure these are on the spreadsheet.
- Tax implications – Profits on flips are treated differently than profits when you sell real estate that you have rented out. Flips are considered real income, and you will be taxed on whatever tax bracket you fall in. When you sell, rental property profit sale is taxed at a rate of 15% (as of the date of this article). Don’t let anyone tell you that you can use a 1031 exchange on a flip; they are not eligible.
By now you should know how much profit you will walk away with on your flip. Take that number and divide it by the time you have put into the house. If you are making less than $20 an hour, you might as well go to work for a general contractor working on house for someone else. You can make the same money with NO risk. I counsel all my clients to run their numbers up front and determine what their profit will be in the end. Stick to this number; after you have worked on this home for a while, you may think it is worth more than you initially thought. Don’t do it–don’t let your heart get in the way of a good real estate decision. Choose an acceptable profit margin, finish the house, sell the house, and then move on to your next flip. These are the keys to a successful flip: Define the current market conditions so that you can apply the correct strategy, choose a team of experienced, active, and knowledgeable professionals to back you, know your market, and run your numbers. Sounds simple, doesn’t it? Just remember, a small mistake in real estate is a BIG mistake. Good luck. John McClellan