Calculating Your Profit and Maximum Purchase Price

Doing the Math to Ensure a Profitable Flip

Although late-night TV real estate gurus dangle the promise of easy money in front of investor wannabes, a 50 percent profit from a flip is rare, although it does sometimes happen. Investors who consistently see 50 percent or higher profits are either very good or involved in a dishonest scheme.

A good rule of thumb is to shoot for a 20 percent profit over and above your total investment in the property. If, at the end of the project, you invested $100,000 and sold the property for $120,000, you’ve done well. By total investment, I mean every penny you paid to purchase, repair, renovate, hold, and sell the property:

Purchase price plus any closing costs or other fees you pay when you buy the property
Holding costs from the time you buy the property until the time you sell it, including monthly interest payments on the loan plus property taxes, homeowner’s insurance, and utilities
Repair and renovation costs
Real estate agent commissions you pay to market and sell the property
Any costs or fees you pay at closing when you sell the property

Adjusting for market conditions

Shooting for a 20 percent profit in real estate is like trying to hit a moving target; housing values in your area may be going up, going down, or holding steady. To give yourself a better chance of hitting the 20 percent mark, adjust the percentage to your market conditions:

20 percent in a market where homes values are rising
25 percent in a market where home values are steady
30 percent or more in a market where home values are declining

This doesn’t mean you’re going to make 10 percent more in a declining market than in a rising market; it means that you set your goal 10 percent higher in a declining market so you can hit your target of making a 20 percent profit. In other words, you figure in more of a profit buffer when property values are falling.

Don’t even think of buying into an area where the market is in a steep decline and shows no signs of recovering. Wait for the market to bottom out and exhibit signs of improvement before you dive in.

Crunching the numbers

When you have a pretty good idea of the cost of renovations, holding costs, real estate commissions, and other expenses (read the rest of this chapter for details), you’re ready to calculate a maximum price to offer for the property:

Start with the future sale price of the home after improvements.

Base your estimate on recent sale prices of comparable homes in the same area, as I explain in “Estimating a Realistic Resale Value,” later in this chapter.
For an estimated profit of at least 20 percent, divide the amount from Step 1 by one of the following:
- 1.20 in a market where home values are rising (to shoot for a 20 percent return on your investment)
- 1.25 in a market where home values are steady (to shoot for a 25 percent return and likely see a 20 percent profit)
- 1.30 in a market where home values are declining (to shoot for a 30 percent return and likely see a 20 percent profit)
Subtract any back property taxes you’ll be responsible for paying when you purchase the property.
Multiply the estimated costs for repairs and renovations by 1.2 (to account for unforeseen expenses) and subtract that amount from the total determined in Step 3.
Subtract monthly holding costs for the expected duration of the project.

For example, if monthly holding costs are $3,000 and you expect to spend six months renovating and selling the property, $3,000 multiplied by 6 equals $18,000.
Subtract agent commissions and/or marketing and advertising costs for selling the property.

If you plan to stage (furnish) the property for showings, then be sure to include the cost as part of your marketing costs. (See Chapter 21 for more about staging.)
Subtract any closing costs you expect to pay when you sell the property.

The resulting amount is the maximum you can afford to pay for the property.

For example, to flip a house you expect to sell for $200,000 in a flat market, you may buy the house for $120,000, spend $20,000 fixing it up, and use $10,000 for other expenses (loan interest, insurance, utilities, selling costs, unexpected bills, and holding costs). Your total investment is $150,000, which is 75 percent of the estimated resale value. If you sell the house for $200,000, you earn a 25 percent profit, but if the market sours and you’re able to sell the house for only $180,000, you earn a 20 percent profit.

In an increasing market, you can invest a maximum of $160,000 (80 percent of $200,000) in the property. In a decreasing market, you invest a maximum of only $140,000 (70 percent of $200,000) in the property. After you decide how much you can afford to invest overall, adjust the purchase price accordingly. Don’t expect to make up the difference in your other expenses (including renovation and holding costs).

The maximum purchase price isn’t necessarily the price you want to offer for the property. This is simply a fairly safe amount to offer to be relatively certain you’ll earn a 20 percent return on your investment. Of course, the less you pay for a property, the better.

Accounting for Expenses

The tough part of deciding how much to pay for a property is accounting for all the costs involved in buying, fixing up, holding, and selling the property. Many beginners don’t account for all the costs and often overlook holding costs — loan payments, homeowner’s insurance, utilities, property taxes, homeowner association fees, and so on — from when you take ownership of the property until you sell it.

The following sections serve as a checklist to make sure you account for all of the costs associated with buying, renovating, holding, and selling the property.

Unpaid property taxes and water bill

If you purchase a property at a tax sale or in foreclosure, you’re responsible for paying any property taxes or water bills that are past due — an amount of money that may be significant. Prior to making an offer or bidding on a property, you should know of any past-due property taxes and other claims against the property, such as the water bill, that stay with the property even after foreclosure. For more about researching a distressed property, see Chapter 10.

Closing costs

Unless you’ve negotiated with the seller to pay all or a portion of the closing costs, you’re responsible for paying them. Your real estate agent, lending institution, or title company can provide a detailed estimate of closing costs, which, if you’re taking out a typical loan to finance the purchase, typically include the following items:

Loan origination fee: If you finance the purchase through a bank or other lending institution, it may charge a fee for establishing the loan. (See Chapter 5 for details about financing your purchase.)
Discount points: Some lending institutions charge discount points — a percentage of the total amount borrowed — to provide you with a lower interest rate or wring another few hundred (or thousand) bucks out of you.

Avoid loans with discount points. You usually have to hold a property for several years to justify the monthly savings, and when you’re flipping houses, holding a property for several years isn’t your goal.
Appraisal fee: The lending institution charges you this fee to have an appraiser ensure that the property is worth at least the amount you’re borrowing to purchase it. (See Chapter 13 for more about appraisals.)
Title insurance: Even if you researched the title or hired a title company to do it for you (see Chapter 4), the bank may require you to pay for title insurance or a mortgage policy (sometimes called a mortgagee policy). If your lender doesn’t require title insurance, buy a title insurance policy yourself; title insurance is essential for protecting your investment.
Insurance and taxes: If you take out a loan that requires you to pay taxes and insurance out of an escrow account, you may need to pay a prorated share of insurance and taxes upfront.
Deed recording fee: Whenever a property changes hands, the name on the deed changes and must be recorded. Yes, you’re charged for this, too.
Credit report charge: The lending institution does a financial background check on you called a credit report and then charges you for the privilege. (See Chapter 5 for details about credit reports.)
Closing fee: The title company typically charges a closing fee.

Most closing costs originate with the bank or other lending institution. By financing the purchase with your own money, through the seller, or with money from private investors, partners, friends, or family members, you can trim closing costs considerably. See Chapter 5 for details on these options.

Cost of repairs and renovations

Eager house flippers often underestimate the cost of repairs and renovations. They’re so enthusiastic about purchasing the house, selling it, and counting their money that they forget how much a carpenter or plumber charges per hour and the cost of materials at the local hardware store. Repairs and renovations are costly, and if you wait until you take possession of the house before obtaining estimates, you’re already too late.

If you’re still interested in a house after you take a quick tour of it, do a second, more thorough inspection of the premises to determine the repairs and renovations you want to make. (See Chapter 11 for details on the process of inspecting a potential flip.) List all the repairs and improvements needed to bring the property in line with your projected resale price (see “Estimating a Realistic Resale Value,” earlier in this chapter). Estimate the cost of repairs by doing the following:

Flag any repairs you can do yourself. These are zero-labor repairs, but you may need to visit your local hardware store to check out prices for materials.
Ask a member of your team who has more experience with construction projects to walk through the house with you and offer estimates and advice. (See Chapter 4 for details on building your flipping team.) To prevent the negativity of naysayers from undermining your vision, keep in mind that you’re taking the risk and making the final decisions.
Call one or two local contractors to obtain ballpark estimates for any repairs or improvements you can’t do yourself. You may be able to hire a general contractor to walk through the house with you and provide a professional opinion.

If you can’t look at the wiring in a house and come up with a pretty good guess at what it would cost to bring it up to code, you’d better consult somebody who can.
Research estimated costs online. Contractors.com at www.contractors.com (registration required) features a tool for estimating the costs of bathroom and kitchen renovations, room additions, decks, roofs, and other improvements. LetsRenovate.com at www.letsrenovate.com offers a toolbox packed with calculators for estimating the costs of repairs and renovations and the return you can expect on your investment.

Tally the estimated costs of repairs and renovations and multiply the total by 1.2 to add 20 percent for unexpected expenses.

You can trim the costs of repairs and renovations in several ways:

Trade your services for free labor. Bartering (or trading services) may have tax consequences, so check with your accountant. Chapter 4 has info on finding an accountant to work with.
Do some of the labor-intensive work yourself.
Negotiate with the property owner to share the costs.

Chapter 14 has more details on planning and prioritizing your renovations, including tips on tagging do-it-yourself projects and knowing when to hire professionals for certain tasks.

Holding costs

As a homeowner, you’re well aware of the monthly costs of owning a home, but when you first begin flipping properties, you tend to overlook the monthly expenses, such as your house payment, homeowner’s insurance, and property taxes. Reality hits after you’ve owned the property for four or five months and begin running out of cash. By then, your 20/20 hindsight leads only to panic and despair.

To keep the property, you need money to pay the mortgage, property taxes, and insurance. And if you plan on using any power tools on the premises and keeping the pipes from freezing in the winter, you’d better pay your electric and gas bills, too (in addition to other utilities).

If you’re using the home you’re flipping as your primary residence, you can safely skip this section. For you, holding costs are actually living expenses — the normal amounts you pay to have a roof over your head.

A great way to project holding costs is to assume, on average, an amount of $100 a day. This amount works for most houses and provides for any surprises along the way. If it takes you a total of six months to flip a property (including rehab and resale time), total holding costs break down as follows:

$100 per day
6 months multiplied by 30 days per month equals 180 days
180 days multiplied by $100 per day equals $18,000 (in other words, $3,000 per month)

Of course, holding costs vary depending on several factors. To establish a more accurate estimate of your monthly holding costs, add your total estimated monthly bills for each of the following items:

Loan payments: Mortgage payments and payments on any home equity loans you use to finance renovations make up a significant chunk of your monthly holding costs.
Homeowner’s insurance: Ask your insurance agent for a quote and explain your plans, including whether you plan on living in the house, to properly insure the property. (A typical homeowner’s policy allows for a home to be vacant only a certain number of days.)
Property taxes: Set aside enough money per month to pay the property taxes when they’re due. If you pay property taxes out of an escrow account, this amount may already be part of your mortgage payment.
Utilities: Gas, electric, water, sewer, and trash bills are all part of your monthly holding costs. The seller should be able to provide averages for last year’s bills, or you can contact the various utility companies to gather the information you need. (If nobody is living in the house, certain utility bills will be lower than normal.)
Neighborhood association fees (if applicable): You may prepay these fees at closing and chalk them up as part of your closing fees, but if that’s not the case, be sure to include them (if applicable) as part of your monthly fees.
Maintenance: If you pay somebody for mowing the lawn, watching the house, and letting real estate agents inside to show the home, include this amount as part of your holding costs.

Err on the safe side. Budget sufficient funds to hold the house for three to six months beyond the date on which you expect to place the house back on the market. Few experiences are more demoralizing than renovating a house and then losing it in foreclosure because you underestimated your holding costs and can’t make the monthly loan payments (or cash calls if you’re working with hard money borrowed from a private investor).

Holding costs can be a great motivator for completing the project on schedule. The faster you flip, the less you pay in holding costs, and the sooner you can redeploy your funds on another venture.

Marketing and selling costs

When you place your rehabbed house back on the market, you incur additional expenses for marketing the house before you sell it and selling the house when you close the deal. These costs vary depending on whether you sell the home yourself or through a real estate agent:

Agent fees: Attempting to sell your home without the help of a real estate agent can backfire, drastically restricting your number of potential buyers. Even if you choose not to use an agent, the agents hired by prospective buyers may not show your home unless they can get their 3 percent cut at the time of sale. Count on paying 3 percent to 7 percent of the sale price in agent fees. If you don’t use an agent, add $250 to $1,000 for attorney fees.
Marketing fees: If you choose to sell the home yourself, you can count on investing 1 percent to 2 percent of your list price in marketing fees. Whether you list your home in the classifieds or on a For Sale By Owner (FSBO) website, you pay for advertising. You also need a few bucks for a For Sale sign and for finger foods for your open house. (See Chapter 21 for more about marketing a property.)
Home warranty: Supplying a warranty for the house can make it an attractive deal while protecting you against any lawsuits in the event that some undiscovered defect in the property rears its ugly head after the sale. If you decide to offer a warranty, budget enough to cover its cost. The cost of a typical home warranty ranges from $400 to well over $600 depending on the add-ons.
Closing fees: A title company typically manages the closing and charges $300 or more for the service. Ask your title company for a more specific estimate.
Title insurance: Insuring the title ensures that you’re not liable for any hidden liens against the property. Title insurance can cost hundreds of dollars, so shop around for the best price and service. You can trim this cost by asking the seller to pay for the policy.
Deed preparation: The cost of preparing the deed usually goes to the seller and is typically about 50 bucks.
Transfer tax: Your state, city, or town may levy a transfer tax on the exchange of property. The amount varies depending on your location, so consult your accountant.
Delinquent water or sewer bills: At closing, you must pay any water or sewer bills that are in arrears (overdue or unpaid).
Other charges and fees: You may be charged other fees depending on local requirements and on the closing company you’re using. These fees may include a Title Insurance Enforcement Fund Fee (TIEFF) and a Closing Protection Letter (CPL) fee.

Don’t list your house while you’re rehabbing it, but feel free to talk to people during this time and pass out your business cards. If a buyer falls into your lap through your neighborhood contacts, contact a real estate agent or attorney to complete the transaction. Check out Chapter 22 for more details about negotiating the sale of your rehabbed house.

Income tax

When calculating the profit of any business venture or investment, you don’t subtract income tax. For example, if you buy stock that earns you a 10 percent return, that return represents a pre-tax amount. The same is true for any profit you earn by flipping a house. However, you need to consider how your profit from flipping is taxed for two reasons:

Your house flipping strategy may determine how your profit is taxed (for example, whether it’s taxed as employment or investment income) and the rate at which it’s taxed.
The amount you get to keep after taxes will help you decide whether house flipping is worth the time, effort, and risk.

How your profit is taxed varies depending on your situation and on how you choose to flip:

If you flip your primary residence in which you lived two of the past five years and you earn $250,000 or less ($500,000 or less for a couple), you walk away with your entire profit scot-free, at least according to the tax laws that were in effect when I was writing this book.
Owning the investment property for at least one year and one day qualifies your profit as a long-term capital gain, taxable at a rate of 0 to 20 percent, depending on your tax bracket (plus a 3.8 percent Medicare surcharge if your ordinary income places you in one of the top two tax brackets). Long-term is longer than one year plus one day. Capital gain is whatever you make on the sale of an asset that has increased in value. (See Chapter 23 for details.)
Owning the investment property for less than one year and one day qualifies your profit as a short-term capital gain, taxable at the same rate as the rest of your income from work-related activities (plus a 3.8 percent Medicare surcharge if your ordinary income places you in one of the top two tax brackets); the tax rate on your net profit could be as high as 43.4 percent.
If flipping is your main line of business, the IRS considers you to be a dealer, so you can’t treat your profits as long-term capital gains. The IRS treats your profits as income, subject to income tax and self-employment tax. You may find yourself paying 35 percent or more in taxes! This may be reason enough to keep your day job and flip houses in your spare time.
If you lease the property, any income you receive from the rental, minus the cost of owning and maintaining the property, is considered ordinary income and is taxed at the same rate as your work-related income.

The tax figures provided here are accurate during the writing of this book, but tax rules can change at any time. Consult your accountant for accurate estimates on the amount of taxes you can expect to owe on your profits.

House flippers often boast about how much they make flipping properties, but the real measure of success is not your gross profit but your net profit — how much you get to keep after taxes. To determine your net profit, simply subtract your taxes from your gross profit. Chapter 23 discusses tax issues in greater depth and offers techniques for trimming your taxes to keep more of your earnings and boost your net profit.