OK – so I am not particularly a fan of flipping houses. There are many reasons for why I feel this way, but they all boil down to the reality that fix and flip strategy represents some of the hardest, most stressful, and most dangerous work in all of Real Estate Investing. And WORK it is!
However, fix and flips are a key portion of real estate investing and share some common strategy points that apply across different investing methods. This article will show you how to value a fix and flip.
Risk of Fix and Flip Work
You know, if flipping was full-prof way of making money in Real Estate perhaps I wouldn’t mind the extremely hard work so much. But, it is NOT full-proof; far from it. A lot of things can, and often do go wrong with the execution of a flip. In fact, a few paragraphs below I will provide you with a list of 10 basic steps as part of a flip, and believe me when I tell you that each and every one of those ten can be messed up, and if messed can cause nothing but pain.
Exit Strategies for Fix and Flips
As if this wasn’t bad enough, even having executed every part of the strategy perfectly, you still can’t get away from two underling realities of this strategy. First, flipping is a one exit strategy by design. The only exit is to sell the property, and if you can not do that for whatever reason, you hurt. Furthermore, since selling is the only way out, successful outcome of a flip ultimately depends on the market conditions, which we as investors have absolutely no control over and which can shift very quickly and without notice.
All of the above add up to a dangerous game indeed. However, it seems that none of these potential pitfalls seem to faze new investors. Not a day goes by when I am not approached with a conversation about flipping. Just this morning I spent a good forty-five minutes on Facebook talking to a friend about this, and incidentally she is the last person on Earth whom I would expect to be interested in the subject.
Wow – everybody is flipping houses…
Well – I am an investor, blogger, and a teacher, and to be any good at either I have to be a pragmatist. Thus, since everyone wants to know about flipping, I’ll tell you about flipping…
The 10 Steps to Value a Fix and Flip
The process of flipping can be described in the following 10 steps. Each one of these steps has to be completed perfectly – I say that again – PERFECTLY, in order to see the desired results:
1. Isolate the right location for your flip.
2. Buy the “right kind” of house for your flip.
3. Estimate the After Repair Value (ARV) correctly.
4. Estimate the repairs correctly.
5. Estimate your holding time and costs correctly.
6. Buy the flip for the right price.
7. Finance your flip the right way – boy, must you ever do that!
8. Good luck on this one – Come-in within Budget and Time-frame on the remodel.
9. Find a qualified, credit-worthy buyer.
10. Appraise your flip for enough to accommodate buyer’s financing – this is no gimme.
Obviously there is more to this process, but you get the point. I could write a separate post on this blog discussing in great detail every step in the process. That’s a lot of writing and I’ll only do it if you tell me that you want me to, so please leave a comment below and let me know…For now I’d like to focus on Step 3, which I think is the most crucial:
After Repair Value is the Most Important Flip Metric
In real estate investing in general, and flipping in specific, money is made at the front door – you’ve got to buy the property right! When it comes to long-term holds with the intention of Cash Flowing the property, “buying right” is a function of many contractual elements, not just the purchase price – this would make a good future post. However, when flipping, it’s all about buying low and selling high – that’s it!
So – how do we know what to pay for the property?
The basic formula is:
Selling Price (ARV) – All Expenses – Your Profit Margin = Purchase Price
Once you establish how much the house is going to retail for once we complete the remodel (this is called After Repaired Value – ARV), then you can subtract all of the costs, which include cost of labor and materials, holding costs, finance costs, real estate commission costs, inspection, contingency costs, all other transaction costs, and our desired profit margin from the ARV to arrive at the purchase price.
As you can clearly see, the basis for this analysis is this After Repaired Value (ARV). Since all expenditures in the formula are subtracted from the ARV, it is of utmost importance that the ARV is correct. If your assumption of the ARV is too high, this will lead you to pay too much for the property, causing your profit to shrink or worse…this is exactly what happens to a lot of newbies!
So, the real problem in all of this is How to Establish the ARV accurately!
4 Ways of Estimating Value in Real Estate
Establishing the After Repaired Value is a function of performing a market analysis. An important distinction, however, is that in real estate we have several totally different approaches that we can use to assess the value of a building depending on the type and intended use of the building, as well as the purpose for which the subject real estate is being valued. The following are the four methods of valuing property:
I. Cost Approach Analysis
II. Comparative Market Analysis (CMA)
III. Income Approach Valuation
a. Gross Rent Multiplier Method / b. Capitalization Method
For the fundamental investors, those of us who buy income-producing assets for long-term use, the income approach holds the key. But, for those of you who are interested in wholesaling and fix & flipping Single Family Residences (SFR), the Comparative Market Analysis (CMA) holds the key to success…
Comparative Market Analysis (CMA)
Comparative Market Analysis, just like it sounds, is a comparison. The objective of this type of analysis is to estimate value by compare-and-contrasting the subject property (the property being valuated) to other like-kind properties that have sold.
The CMA is by and large used to valuate Single Family Residences, and as such as investors we must rely on it to a great extent when performing a real estate investing technique called Fix and Flip.
Fundamentals of a CMA
First – in that we are comparing our subject house to houses that have sold (known as comparables or comps), we must make sure that the comps we pick to base our analysis on are located in the same general physical location as our subject property – same subdivision, the same block, the same street; the closer, the better. You should know that 1 block can be the difference of $50,000.
Secondly, we must use actual sales as our comparables. I see newbies basing their analysis on properties which happen to currently be on the market, but have not sold yet. While these do represent your competition and it’s important to recognize the competition and adjust your strategy to give yourself an advantage, the unsold properties simply do not represent the mentality and psychology of the marketplace. The asking price is not reflective of that which a willing and able buyer will pay – until the house has sold!
Finally, whenever possible our sold comps should ideally be from the prior 3 months, because real estate market can fluctuate rather quickly and going back any more than 3 months could yield misleading data.
The CMA Process
Now that we’ve covered those very important caveats, let’s dig into how this process works. Let’s say you are trying to place a value on a 3/1 (3-bedroom, 1-bath) home with an attached garage. Having researched the market, you come up with these 3 comps:
Comp 1. 2/1/garage sold for: $x
Comp 2. 3/1/garage sold for: $x + 6,000
Comp 3. 3/2/no garage sold for: $x + 9,000
As you can see, Comp 1 is a 2-bedroom, 1-bath with a garage which sold for x; Comp 2 is a 3-bedroom, 1-bath with a garage which sold for x + $6,000; and finally Comp 3 is a 3-bedroom, 2-bath without a garage which sold for x + $9,000.
You can see that the most expensive house which sold for x + $9,000 did not have a garage. It did, however, have a second bathroom, which even without the best shower head, or even a working shower – totals out to a higher value overall. On the other hand, the median-priced house which sold for x + $6,000 had 1 bathroom and a garage. From this we should learn that in our neighborhood a second bathroom carries more value than a garage, which is reflected in the fact that the house with 2 bathrooms sold for more than the house with one bathroom and a garage.
Understanding the Market Dynamic
You soon gain perspective on this market dynamic, because as you do further research you come to realize that this particular neighborhood attracts a lot of young families, and there are two reasons for this. One – people perceive the schools in the district to be excellent. And two – while the schools are excellent, the housing in this specific neighborhood remains relatively affordable – a unique combination indeed, which tends to lead to stability of values and rents.
However, and this is the kicker, it seems that in this neighborhood most homes were built with only one bathroom. Don’t ask me why, but it’s true – eight out of ten homes in the neighborhood have only one bathroom.
Therefore, if a family decides that they want, or need, to live in this location because they want their two children to attend schools in this particular district, but at the same time they must have 2 baths because of the number of people in the household, then it is reasonable that people would be willing to pay more for a house with 2 baths. This explains why a second bedroom is a much more valued amenity in this neighborhood. A garage would be nice, but they can do without it; a second bath they absolutely must have and are willing to pay for! than a garage.
Other CMA and Value Considerations
Obviously, since one of the comps is a 3/1 house with a garage, it is safe to assume that the market for our very similar 3/1 house with a garage will likely be the closest to x + $6,000. Naturally, you will need to make adjustments for condition, amenities, etc.
Also noteworthy – a 2/1 house with a garage sold for x, while a 3/1 house with a garage sold for x + $6,000. The only difference between those two houses seems to be the extra bedroom. What this tells you is that everything else being equal, a bedroom in this location seems to be worth around $6,000.
Thus, if you can find a 2 bedroom house, and make it into a 3 bedroom house, you will gain $6,000 of value. If you can do this for less money than 6k without running into Functional Obsolescence by making the bedrooms to small or without needing to spend too long on the remodel, then you can create some additional value in your flip.
If There Are Not Comparable Properties for Your Analysis
If there wasn’t a very similar comparable, which makes the job of assessing value rather simple, then you would have to do the best you could to approximate value by making adjustments to the comps that you do have.
For example, to approximate value of your subject based on comp #1, you would need to add to it a value of a bedroom, since the only difference between them is that the subject has 3 bedrooms while Comp 1 has only 2.
To approximate value of your subject based on Comp 3, you would need to subtract a value of a bathroom, since Comp 3 has 2 bathrooms while the subject has only 1, but add back in a value of a garage.
Conclusion on Valuing a Fix and Flip
Such is the basic process of the Comparable Market Analysis. The example I provided are very simple and rather cut and dry. In reality, whenever performing a CMA you will need to make a lot more adjustments, and unfortunately a lot of them will be judgment calls. This is precisely what makes establishing an ARV such an imprecise and tricky business – and we haven’t even taken into account fluctuations of the market conditions.
What do you think guys? Did this make sense?
Also, be sure to check out my article How to Choose the Best House for a Fix and Flip.