House Flipping: The Ultimate 7-Step Guide to Calculate Your ROI
When analyzing the gains of a house flip, you also need to consider the expenses and risks that will impact your return on investment. Follow along using the ‘House Flipping ROI Calculator’ from Business Case Guy to calculate the cost from acquisition to the flip.
House Flipping Introduction
House flipping is a popular real estate investment strategy that promises substantial profits if executed wisely in a relatively short period. House flipping involves buying a property at a low price, renovating it, and selling it quickly for a profit. The goal is to invest in improvements and sell the property at a higher price for a substantial return on investment.
Understanding the intricacies and potential pitfalls of buying and flipping a house is crucial for informed decisions. This comprehensive guide will dive into the financial considerations you should consider when embarking on a house-flipping journey.
Follow a real scenario in this extensive and exhaustive 6-step guide using the free house flipping calculator and see how I arrived at the investment summary below.
Table of Contents
- The 7-Step House Flipping Analysis
- 1. Acquisition of the Flipping Property
- 2. Financing The Property
- 3. Renovating And Repairing The Property
- 4. Holding Cost While Waiting To Sell The House
- 5. Selling Costs When Flipping the Property
- 6. Calculate your Flipping Return on Investment (ROI)
- 7. Know Your Risks And Have A Mitigation Plan
- House Flipping Conclusion
The 7-Step House Flipping Analysis
1. Acquisition
The first step in flipping a property is finding and purchasing it with the potential for profitability. It’s essential to evaluate the condition, location, and market value.
2. Financing
How will you finance the purchase? Will you use a conventional bank loan, private lending, a personal life of credit, or all cash? Each one has different fees when it comes to setup, interest rates, and early termination or discharge fees.
3. Renovation
After acquiring the property, careful planning and budgeting are necessary to renovate it and increase the market value, without overspending.
4. Holding Costs
These recurring monthly payments, such as mortgage or loan payments, property taxes, utilities, and insurance, can add up over time and cut into your profit margins.
5. Sale Costs
The ultimate goal of house flipping is to sell the property for a higher price than the purchase price plus the cost of renovations. Timing and pricing strategy play significant roles in this process.
6. Calculate your ROI Estimate
Now that you’ve understood and pulled all your information together from the first 5 steps, you need to calculate a profit and ROI estimate to know if the house flip will be worth your time.
Run the numbers and review the summary using the Business Case Guy House Flipping Calculator. This personal finance calculator will take you through the steps and line items you must know when creating a plan.
7. Know your Risks
Each stage of the house flipping process has associated risks. Understanding them is one piece; understanding the probability or likelihood of them happening is tougher. Having a reliable professional who can help you through the process, review your estimates, and provide feedback can save you time, money, and headaches.
1. Acquisition of the Flipping Property
Research your Target Market, Trends, and Forecasts
Conducting thorough market research and analysis is essential before searching for a property. This step helps you understand the current state of the real estate market in your target area and make informed decisions. Here’s what you should do:
Determine the neighbourhoods or areas where you want to invest. Research factors such as job growth, population trends, and school quality to gauge the attractiveness of these markets.
Look at historical data and market forecasts to assess whether property values are rising or falling in your chosen market. This information can guide your investment decisions.
Search for Homes through Real Estate and Foreclosure Sites
Using specific listing sites that provide access to undervalued properties can help you realize a higher profit. If a site has a subscription fee that provides you advanced access to unlisted properties, then that can help you find better house-flipping opportunities in foreclosures, bank sales, or auction listings.
Search for Distressed Listing @ Foreclosure.com
As the largest distressed listing provider on the web, you can access undervalued properties before they hit the general listing sites, and buyer visibility and demand increases.
To work through the home flipping calculator and this article, I will use the Foreclosure.com (affiliate) search and look for a foreclosure or distressed sale in Orlando, Florida.
Based on my search and filtering listings within my budget, I found the below listing in Orlando, Florida, that is in foreclosure status. Now that I have a property to analyze, I can move to the next step.
Find out the Actual ‘Sold’ Prices or the After Repair Value (ARV)
Knowing the actual vs listed prices will help you save time and improve the calculation of your ROI estimate. Using unrealistic bought and sold property values will only add risk to your house-flipping journey. Tools like Zillow (US) or House Sigma (Canada) are great research tools because they show you the actual prices sold and leased of comparable properties.
After all renovations are completed, the after-repair value (ARV) is the property’s estimated market value. The 70% ARV rule is often followed by experienced house flippers, meaning you should not pay more than 70% of the ARV minus renovation costs when acquiring a property. This rule helps ensure a sufficient profit margin to cover unexpected expenses and generate a desirable ROI.
Although Foreclosure.com shows an estimated Market value of $329k, it’s important to do further research to increase your confidence. Once all renovations are complete, your expected sales price will be the primary driver of your profit estimate.
I looked up comparables on Zillow, with 3 bedrooms and 2 bathrooms, with a comparable size sold in the last 6 months. I found 2 comparables ranging in price from 320k — $345k. I will use $320k as the target selling price.
Understand the Acquisition Costs
- Purchase Price: When purchasing for a flip, the property’s purchase price must be below the estimated market value after all renovations are complete. The fewer renovations and work required, the more likely the property will be near the market value. I haven’t seen the property’s interior; however, for this example, I will assume it requires material renovations, and we can acquire the property for $275k.
- Legal and Regulatory Fees: Some foreclosure transactions may involve legal or administrative fees beyond your conventional legal fees, especially if there are complications or disputes involved in the sale. Research any local government guidelines for foreclosure purchases. Legal fees should include a title search and insurance, ensuring the property has a clear title, free from liens and encumbrances. Title insurance protects you against any unforeseen title issues.
- Land Transfer Government Tax / Fee: A tax the government imposes on transferring property ownership into your name. Usually, this applies to the buyer when a property is purchased.
- Home Inspection and Appraisal: If you’re obtaining a mortgage to purchase the foreclosure, the lender may require an appraisal to determine the property’s value. Appraisal fees can vary but typically range from a few hundred to a thousand dollars. This inspection typically costs several hundred dollars but can save you from unexpected repair costs.
- Utility Reconnection Fees: If the property has been vacant for a while, you may need to cover the cost of reconnecting utilities and performing basic maintenance to make it habitable. These costs can vary widely depending on the condition of the property.
- Possession / Junk Removal Costs: Expenses associated with cleaning out and disposing of any abandoned belongings, debris, or trash left behind in a foreclosed property. This may include renting a junk bin, hiring a 3rd party, or incurring disposal fees at the junkyard.
- Tenant Eviction Costs: When tenants occupy a foreclosed property, expenses may arise in legally removing them. These expenses include fees for legal proceedings, which may require hiring an attorney, court costs, filing fees, court appearances, and other legal process costs that can add up during the eviction process. In some jurisdictions, landlords must provide tenants with financial assistance or relocation benefits as part of the eviction process.
- Unpaid Taxes and Liens: If you come across any unpaid taxes and liens in your legal review, you must factor these costs into your cost base.
- Other Fees and Expenses: Use this to capture any upfront fees not covered in the above acquisition expenses.
Between Foreclosure.com, the Zillow listing, and some research on Google, I could pull together the line items for the estimate.
2. Financing The Property
- Financing Options: Consider how you’ll finance the acquisition. Will you use cash, take out a mortgage, or explore other financing options? Each choice comes with its own set of setup costs, interest rates, and loan discharge implications. In this example, I will use 20% down.
- Expected Loan Duration: Given this article and personal finance calculator are targeted towards house flipping, you can enter your expected time to flip, with the maximum time being 12 months. Whether you choose 1 or 11 months, the business case’s ‘detailed results’ section will also show the full 12-month option.
3. Renovating And Repairing The Property
Renovation Costs
The renovation phase is where you can add substantial value to the property, but it’s also where many house flippers encounter unforeseen expenses. To avoid budget overruns, consider the following:
- Materials and Labor: Estimate the materials and labour required for renovations. Get multiple quotes from contractors to ensure competitive pricing.
- Design Approvals, Permits, and Inspections: Factor in the cost of obtaining necessary permits and scheduling inspections to ensure your renovations meet local building codes.
- Contingency Budget: Setting aside a contingency budget for unexpected expenses during renovations is wise. Experts recommend allocating 10% to 20% of your total renovation budget for contingencies.
For this example, we’ll assume renovations are required in the kitchen, bathrooms, flooring, painting, new appliances, and landscaping. In practice, you should build a detailed renovation estimate or have a contractor provide one.
4. Holding Cost While Waiting To Sell The House
While you work on renovating the property, you’ll incur holding costs, which can add up over time. These costs include
- Loan payments: This includes your loan principal, and interest is usually paid monthly but can also be set up as weekly, bi-weekly, or twice monthly. The longer it takes to sell, the more interest you’ll pay and the more cash you will require.
- Property Taxes: Property taxes are ongoing expenses that vary widely depending on the property’s location, government regulations, and the assessed value.
- Maintenance or Homeowners Association (HOA) fee: If you live in a unit that provides maintenance and management services for a group of units, you will have to pay these monthly fees as long as you own the property.
- Water: If you require water during the renovation, whether for construction reasons or the workers and washroom facilities, then add an estimate for this amount.
- Electricity: If you are in a hot climate and are performing renovations, you may want to have the AC running to keep the place cool. Conversely, if it is hot, electric heating (think baseboard), will also add electricity costs. Of course, for renovations, you will need power for the tools.
- Gas: If the home is outfitted with a gas furnace, then you will use natural gas to keep the place warm during the flipping period.
- Insurance: You’ll need insurance to cover the property during renovations. Ensure you have adequate coverage without overpaying for unnecessary features.
- Other Property Expenses: Use this placeholder to capture any expenses not addressed above.
Here is what I estimated based on the Orlando foreclosure property.
5. Selling Costs When Flipping the Property
When it’s time to sell the property, you’ll encounter various selling costs, with some costs driven by your sales price.
- Expected Sales Price: After completing any work on the property, this is the expected market value you expect to realise on the sale.
- Legal and Regulatory Fees: Similar to when purchasing, you will have legal and regulatory fees for selling and transferring the property to another owner.
- Home Inspection and Appraisal: If you did significant renovations, you should have the home inspected or appraised ahead of your listing. Some buyers may appreciate having this provided as part of the listing information.
- Loan Discharge Fee: The discharge fee will vary depending on your selected loan type. If you are buying to flip, you should use an open mortgage or something similar that lets you pay out the balance at any time. The trade-off is that you will have higher interest rates in the short term.
- Realtor Sales Commission or Agent Fees: If you use a real estate agent to help sell the property, you’ll need to budget for their commission, which typically can be negotiated to around 3% to 6% of the sale price.
- Other Fees and Expenses: This line captures any other fees and expenses not referenced in this section.
- Expected Tax Rate on Profits: If you know your expected tax implications, you can enter it here to see the difference in your ROI when comparing your gross profit (pre-tax) vs. your net profit (after-tax). Understanding your best options to minimize taxes is impacted by your country, state, region, income, and even how long you hold the property. Estimating this impact is best left to a local professional who can help you understand your tax implications.
6. Calculate your Flipping Return on Investment (ROI)
Calculating your Return on Investment (ROI)
With all the information captured and organized through the calculator, it is easy to calculate your expected ROI in 3 simple steps.
- A. Calculate the Total Invested
- B. Calculate the Gross and Net Profit
- C. Calculate the ROI using the above 2 figures.
A. Calculate the Total Invested
This total investment figure is crucial because it is the foundation of our profit calculations. We want to capture any funds tied up during this flipping process to arrive at this figure.
Total Investment = One-time costs + Holding Costs
The sales costs are excluded here since this money is not tied up. They are only triggered when sold and then deducted from the sale price, which factors into the profit calculator.
In this example, the Total Invested for an 8-month flip is $96,639.
B. Calculate the Profit and Net Income
Your profit calculation will be simplified with all the information entered into the real estate flipping investment tool. The two formulas are
- Profit (before tax) = Net Revenue — General Expenses
- Net Income (after tax) = Net Revenue — General Expenses
Net Revenue takes the sale price and deducts your purchase and selling costs. General Expenses add up all the acquisition, renovation, interest, and recurring expenses. In this 8-month example, the Profit shows a loss of $9,711. Because it is a loss, there is nothing to tax. So, the Net Income Profit (after tax) is unchanged from the Profit line.
C. Calculate the Return on Investment (ROI)
The ROI formulas below are for pre-tax and after-tax. This calculator will help you calculate both ROI options.
- ROI Pre-tax = Profit / Total Invested
- ROI After-tax = Net Income / Total Invested.
Because this property is showing a loss, both figures are the same, at negative 10%. Note that this is an 8-month ROI. If you want to see the equivalent ROI if annualized, it is shown on the ‘Annualized ROI’ line, showing -15%.
Break-Even Analysis
With the complete results in hand of this property and knowing that the ROI is negative, you are unlikely to invest in this house flip but keep searching for better opportunities.
The break-even analysis helps you understand what would change to make your profit = $0 or slightly above. This is still risky because it leaves you no room if any issues arise and costs increase. Based on the table below, the options to break even and make up the $9,711 difference would be to
- Reduce the purchase price from $275k to less than $265k
- Increase the sale price from $320k to $329k or greater
- Alternatively, if you can reduce your renovation costs by $9,711, that will help as well.
Compare House Flipping to Low-Risk Investments
When considering any investment, it’s best practice to have a low-risk, passive, alternative investment where you can park your cash. This serves as your baseline. In this case, a 5.5% alternative investment was captured.
Compared to this house flip example, the 8-month delta is 13.8%. Simply put, it says you should keep your money where it is for the 5.5% annualized gain.
Even if the results were both 3.7% over 8 months, most investors would not take on the additional work, time, and risk for a house flip that provides the same return as your passive, low-risk baseline.
7. Know Your Risks And Have A Mitigation Plan
House flipping can be financially rewarding but has its share of risks and challenges. Here are some common pitfalls to be aware of when evaluating a flip.
Identifying Deal Breakers
While assessing profit potential, it’s essential to identify deal breakers-issues or costs that could turn a potentially profitable project into a financial disaster. Deal breakers may include
- Severe structural damage that exceeds your budget.
- Legal issues that could prevent the sale of the property.
- A highly competitive market with slim profit margins.
Market Fluctuations
Real estate markets are cyclical and can be influenced by economic conditions, interest rates, and local factors. A downturn in the market can significantly impact your ability to sell the property at a profit. It’s crucial to have a backup plan in case market conditions change unexpectedly.
Unforeseen Renovation Costs
No matter how thorough your initial budgeting is, renovation projects often come with surprises. Hidden structural issues, unexpected permitting delays, or changes in design plans can lead to additional expenses. Maintain a contingency fund to mitigate this risk, as mentioned earlier.
Holding Property Too Long
The longer a property sits on the market, the higher your holding costs. You may eat into your potential profits if the property doesn’t sell quickly. Effective marketing and pricing strategies are essential to minimize holding times.
Regulatory and Zoning Issues
Local regulations and zoning laws can impact your ability to renovate and sell a property. It’s essential to familiarize yourself with these regulations and obtain necessary permits before remodeling. Knowing and complying with local laws will avoid costly delays and legal issues.
Ways to Mitigate Risks
- Due Diligence in Property Selection: Before purchasing a property, it is essential to thoroughly research and vet potential properties, taking the time to understand their condition, market potential, and potential challenges.
- Building a Reliable Team: A reliable team of professionals, contractors, real estate agents, and inspectors is crucial for successful house flipping. With the help of a skilled and trustworthy team, you can effectively overcome any challenges that may arise during the flipping process and make informed decisions.
- Create an Exit Strategy: Having contingency plans in place for different scenarios is essential. For example, what if the property takes longer to sell than expected? Or what if the renovation costs go beyond your budget? By planning for these situations beforehand, you can avoid any financial setbacks and minimize your losses if necessary.
- Selling Quickly vs. Holding for Appreciation: Many house flippers aim to sell a property quickly to make a profit and move on to the next project. This approach helps minimize the holding costs, but it may require competitively pricing the property. On the other hand, if you hold the property for an extended period, you may benefit from market appreciation and earn higher profits. However, this approach comes with higher holding costs and the risk of market fluctuations.
- Contingency Plans for Unforeseen Circumstances: House-flipping plans can be disrupted by unforeseen circumstances such as unexpected renovation challenges or a property selling more quickly than anticipated. It is essential to have contingency plans to mitigate potential financial setbacks. These plans may include adjusting the sale price, temporarily renting the property, or seeking additional financing.
House Flipping Conclusion
House flipping can be rewarding but not without its financial complexities and risks. Before deciding whether to buy a house to flip, you must carefully consider all the financial aspects discussed in this guide:
- Thoroughly research the market and analyze trends.
- Budget meticulously for acquisition, renovations, holding, and selling costs.
- Run the numbers! Assess the profit potential by estimating the upfront, renovation, and holding costs.
- Understand the tax implications of your house-flipping venture.
- Be aware of potential risks and challenges and have mitigation strategies in place.
- Plan a solid exit strategy that accounts for various scenarios.
Successful house flipping requires expertise, careful planning, and a willingness to adapt to unforeseen circumstances. This 7-step guide and calculator are here to help provide directional guidance. Consult with professionals, build a reliable team, and prioritize financial prudence by running the numbers when considering a house-flipping project.
Originally published at https://businesscaseguy.com on October 15, 2023.
