Ethan Roberts is a real estate writer, editor and investor. He’s a frequent contributor to InvestorPlace.com, and his work has been featured on Money.msn.com and Reuters.com. He was one of five contributing editors to TheTycoonReport.com and has also written for MarketGreenhouse.com and SeekingAlpha.com. He’s been investing in real estate since 1995 and a Realtor since 1998. This is the first of a two-part series.
Many investors today have realized that it can be lucrative to “flip” homes — buy an underpriced house, fix it up and quickly re-sell it for full neighborhood value. It’s so easy to believe the real estate cable TV shows that promise huge profits on every deal.
But they leave out all of the other expenses — closing costs, real estate commissions, taxes, insurance, utilities and miscellaneous property maintenance — that come with a real estate transaction. In real life, the actual net profit is often far less.
If you want to maximize your profits, it’s imperative that you learn how to minimize costs while rehabbing. Here are several tools that I’ve used over the many years of my real estate investment career.
1. Use cash or cash equivalents.
The least expensive way to flip a home is by using cash. Although you tie up those funds for a few months, when you sell the home, your return on investment should be substantial and much higher than parking your money in a savings account or CD.
If you don’t have enough cash to purchase a home, the next cheapest source is a home equity line of credit (HELOC). These are low-interest, variable-rate lines of credit that are secured by either your primary residence or an investment property. Typically, the HELOC rate is set about 1 to 2 percent above the prime rate, which is currently 3.25 percent. You need to put the HELOC in place before you bid on any homes; then you can bid on the home as a “cash deal,” rather than as a “financing deal.”
Just remember that a HELOC, just like a regular mortgage, puts a lien on the property that it secures. If you don’t make your payments, you could lose that property to foreclosure.
Many investors use hard money loans or other conventional mortgages to finance their flips. Because of the higher interest rates and points paid at closing, both will reduce your net profit considerably, and are not recommended for flips unless absolutely necessary.
2. Target homes that will sell quickly.
When choosing a property to buy and flip, make sure that you buy one that has the best chance of being re-sold quickly. That means you want to buy a home in an area that has a good reputation, good schools and a low crime rate, among other features. You should also buy one that will re-sell in a price range that attracts the largest number of potential buyers. For example, if you flip a home that’s really cheap, there may not be people in the area whose credit scores will qualify them for a loan.
Conversely, if you buy a very expensive home to re-sell, there will be fewer people who can afford to purchase it, and it will take longer to sell. Look for homes that you can flip into that sweet spot in the middle of the area’s price range.
I suggest flipping homes that are somewhat cookie cutter, perhaps even boring, simply because they’re the easiest to sell. Unique floor plans or locations may look intriguing on the cable shows, but in real life, they take longer to sell and thereby reduce the potential profit. I advise against buying difficult-to-re-sell mobile homes, homes on dirt roads or way out in the “boonies,” or homes with past damage from fire or floods.
Finally, avoid buying old historic homes that might be difficult to renovate or have mandated neighborhood preservation requirements. They’re more expensive to rehab and appeal to a smaller group of buyers, so they’ll take longer to re-sell.
3. Learn to estimate repair costs accurately.
One of the biggest errors that I see new investors make is that they don’t accurately estimate structural repair costs like re-roofs and heating and cooling system replacements, or cosmetic enhancements such as paint, new flooring and fixtures.
If you underestimate the costs, you’ll spend weeks rehabbing the home, only to discover when you resell it that your profit will be far less than you expected. Conversely, if you overestimate the cost of a project, you might either make a bid that’s too low to be accepted by the seller, or be outbid by a rival investor who estimated correctly.
The best way to learn how to estimate costs correctly is by spending time walking the aisles of your local home improvement stores to see what materials actually cost. Network with your local service providers, and team up with those who can do a dependable quality job at the lowest possible cost.
Finally, learn to estimate jobs the way contractors do — by listing a range of costs for each repair, rather than one fixed price. Here’s one way to do it. First, compile the total list of materials needed, and record a low and high price estimate for each. Once you have that, add both columns of numbers to get the total cost range.
MATERIALS LOW / HIGH
Paint: $1,000 / $1,200
Carpet: $2,000 / $2,500
Tile: $700 / $1,200
Doors: $200 / $500
Windows: $300 / $400
TOTAL COSTS $4,200 / $5,800
Then add the two totals ($4,200 + $5,800 = $10,000), and divide by two to get the average cost ($5,000). The actual cost may be higher or lower, but this is the most accurate way to figure the approximate cost.
You’ll find that some of your estimates will run low because of unexpected problems or repairs, while other major costs you anticipated will turn out to be nominal. I can remember times when I thought an air conditioning unit might need replacing for $3,000 or $4,000, only to happily learn that a simple $200 repair made it work like new. And by shopping carefully, I can find materials on sale that reduce the costs below my estimates.
4. Consider getting a real estate license.
If you have a real estate license, each time you buy a property for yourself, you’re entitled to a commission that generally averages about 3 percent of the purchase price. On a $100,000 purchase, that commission would be $3,000 (minus your broker’s cut), which will reduce your materials cost considerably and add to your total return. In addition, when you sell the property, you may only have to pay 3 to 3.5 percent in commission, rather than 6 to 6.5 percent.
While there are annual costs involved in getting a real estate license, such as Realtor® board and Multiple Listing Service (MLS) fees, if you buy one or more homes per year, you’ll still come out far ahead.
Next week: How to minimize costs during the rehab process and when you’re ready to sell.
This information was originally published on Auction.com, LLC, the nation’s leading online real estate marketplace. Founded in 2008, the company has sold nearly $20 billion in assets since 2010. Auction.com has more than 900 employees and offices in Irvine and Silicon Valley, California as well as offices in Atlanta, Austin, Denver, Miami and Newport Beach. Visit us at www.auction.com, or on Twitter, Facebook and LinkedIn.