4 questions to ask when evaluating fix-and-flip deals
Four essential questions to ask before you flip
- What is the after-repair value of the home?
- Are the costs of repairing the home practical for my budget?
- Does the deal make financial sense after comparing the costs?
- Can I afford closing costs and other associated expenses?
Fixing and flipping houses has become increasingly popular as a way for new investors to get started in the real estate business. Reality TV shows and get-rich-quick articles can make it sound like a gimmicky enterprise, but there are profits to be made for those who are careful and systematic about evaluating potential fix-and-flip properties.
Fix-and-flip margins are usually relatively thin, which makes it exceedingly important to clearly evaluate potential deals and compare lenders closely. You do not want to pay too much for a property and find yourself in a financial hole.
To get started, ask yourself these four questions when evaluating a potential deal to reduce the chances of overpaying.
What is the after-repair value?
Your own observations, combined with a close look at sales figures, can give you a reasonable idea of what a house is potentially worth.
Observe the neighborhood when you're considering whether to buy a property. It's been a truism for decades, but location really is one of the most important elements of a home. The condition of a neighborhood usually sets the parameters for the value of any property.
In desirable locations, some basic rehabilitation can significantly boost the selling price of a home. In less-favored spots, there will be limits on the house's resale price, no matter how much work is done to improve the property.
For a good estimate of what an improved property might be worth, combine what you observe about its location with the most precise information you can find about home values in the area. Municipal-tax and property-sales records are useful for finding home selling-prices, as are real estate magazines and the local Multiple Listing Service (MLS). Investigate the selling price of properties comparable to the one you're eyeing to help you determine the after-repair value.
What's a comparable property? Look at houses located within a half mile of the property you're planning to purchase that are comparable in size, square-footage, number of bedrooms and baths, and that have sold within the past three months. Also, look for listings that advertise newly redone kitchens or baths — signs that the property has already been fixed and flipped. These homes should give you a feel for how much the fixed-up house will be worth once the project is completed.
Are the costs of repairing the home practical for my budget?
If the necessary repairs are cosmetic, you are more likely to have a workable deal. Relatively inexpensive fixes like a paint job, new carpet, repaired flooring and updated kitchen counters and cabinets can make a significant impact for a relatively low investment.
With a little research, you can estimate what each of those improvements will cost and set a little more aside for any inevitable costs that you did not anticipate. Alternatively, fix-and-flip experts recommend using the $20-per-square-foot rule. For a 1,000-square-foot home, for instance, figure $20,000 to cover standard rehabilitation costs.
Beware, however, if the property needs more extensive work like structural improvements or a new roof. In this case, you are looking at a new level of expenses and repair headaches and it's important to bring in a professional to estimate the cost of the work — even if you plan on doing it yourself. If it's your first venture into fixing-and-flipping, consider rejecting deals that require major structural repairs and stick to homes that need cosmetic changes you can pull off more easily.
Does the deal make financial sense?
If you have conducted your due diligence, identified the cost of rehabilitating the property and know what the house is likely to sell for after repairs, it's relatively easy to come up with the price you should offer for the property. Don't forget to figure in a reasonable profit, too.
For example, consider a house that you have determined will sell for $200,000 when it's repaired. From that figure, subtract the rehab costs and your expected profit. Say you think improvement costs will total $30,000 and that you are looking for a profit of 10 percent on the selling price of the house, or $20,000. Plug in the numbers, and you have $200,000 minus a total of $50,000, which translates into an offer of $150,000 for the property you're interested in purchasing to make the deal work for you.
Rather than tallying the costs and expected profits, some rehabbers use a formula called the 70 percent rule to figure out what to pay for a property. That is, your offer should amount to 70 percent of the after-repair value of the property. In the case of the $200,000 fixed-up house, the formula would bring an offer of $140,000.
Can I afford closing costs and other associated expenses?
You will be going through a closing process both when you buy the property and when you resell it. That means lender fees, as well as expenses for attorneys, appraisers, title companies and others.
Unless you are able to market the house yourself, you also will need to pay a real estate agent to sell it. All of those expenses — as well as any interest you pay on the mortgage while the house is being fixed and awaiting a buyer — are costs that you need to tally when deciding whether it makes sense to buy a property for a fix-and-flip deal.