The common story line you hear from young investors is they want to make it big in the stock market, then use that money to flip houses. I am in no way saying this is a bad plan, it is actually a good string of goals for a young person. What I will say is this is not easy, and doesn’t happen as fast as people think. However, it is possible. Flipping houses is a very attractive investment vehicle because of the large sums of profit, with high profit margin. If you renovate properly and sell at a good time, your returns can easily be upwards of $150,000. I will discuss aspects of house flipping, and what to do or not to do to achieve the massive gains.
What is House Flipping?
The act of house flipping is purchasing a home, making various improvements to it, then putting it back on the market at a higher price. House flipping is sometimes confused with purchasing rental properties. Someone who has rental properties is renting all or parts of a home and using this cash flow to pay off mortgages or for profit. The major difference here besides the cash flow is time. Rental properties are to be held for years and becomes more like passive income, while house flipping is to be done ASAP, making it active income.
When house flipping, most are looking for “Fixer-uppers”. These homes are run down and often foreclosed. However, with effective improvements to the home, it can look like new, and drastically raise the value. Sounds simple enough, right?
70% Rule
The 70% Rule is a common rule amongst house flippers when factoring costs to purchase and fix a home. Knowing how much to spend on a home will help guarantee you are putting your money in the right place. By estimating the after repair value (ARV) of a home using surrounding home prices and other factors and multiplying it by .70, and subtracting the repair costs, the rule gives you the maximum price you should pay. Example below:
After you spend $25,000 to repair a home, it will be worth an estimated $150,000. By rule, you should spend no more than $80,000:
$150,000 x .70 = $105,000 – $25,000 = $80,000
Now, you know exactly how much you can invest into the home. Theoretically, the remaining 30% is considered to be profit. This can’t be farther from the truth, as there are many hidden costs in house flipping that start to add up…
Financing
If you had to take a second look when I said to spend no more than $80,000 on the home, I don’t blame you. $80,000 is not chump change; house flipping is a very expensive investment. Unless you are lucky enough to be a cash buyer, you will take out a mortgage to buy the home. Most mortgage require a 20% down payment, meaning you must pay 20% of the home value you right away. If a home costs $100,000, the bank expects $20,000 from you at the start. The remaining $80,000 is what makes up your mortgage, and the monthly break down of it is your mortgage payment. While the mortgage payment can be tax-deductible when you sell your home, the interest payments are not. The longer you take to fix and sell the home, the more the interest payment eats at your 30%.
Hiring a contracting team to fix the house can be a hefty check as well. A good way to avoid this is by being able to do the work yourself, or a small group. If you are blessed with the ability to fix homes, this is definitely the better route.
Another cost when flipping a house is agent fees. If you hire a real estate agent to help you buy or sell property, you will have to cover their payments. If you decide to sell on your own, you will have to pay to advertise your home so others are aware you are selling. Another cost to factor is your capital gains tax, which is taxed depending on your income bracket and the size of the gain. However, there is a way to avoid this tax! A 1031 Exchange allows someone to reinvest their real estate gains into a likewise investment, tax-free. So once you sell your property, if you actively look for a new property, you can duck the capital gains tax.
Time is Not Your Friend
I have alluded to this many times already, but being a house flipper has to be quick. The interest payments will stack up for sure. Your personal time will be affected as well, especially if you are fixing the home yourself. Also, once the house is ready to sell, you will have to be available to show the house to prospective buyers. If you work a 9-5, consider your weekends and nights gone when you are trying to flip a house.
Don’t think it is impossible though! There’s 168 hours in a week, you will be able to find time!
Knowledge On the Housing Market
Picking the right house isn’t easy. A good way to measure the value of a home is comparing it’s lot size, number of bedrooms and bathrooms, and price to that of nearby homes. If you can find a run down home in a nice neighborhood, the profit margin can be huge. This is why having a real estate agent with you can help, as they probably have more knowledge on the subject than you. They will also help you to remain patient. Taking your time to find the right property will lead you to more profit than buying the first house you see.
My father has been a Real Estate Broker for more than 15 years in New York and Connecticut, and he says there’s no better tool than patience when purchasing a home. I got my Real Estate license this past January and have seen the importance of having patience first hand for both parties. The payout and lack of headaches makes the wait worth it!
Final Thoughts
The tone of this article sounds like I am against house flipping. I am all for it! The profit margin can easily exceed 20%, something that is hard to replicate in the stock market. The amount of money and time liability that must be taken for house flipping though makes it a big process. It’s not like buying a stock today and selling it next week. As long as you are prepared, you can be the next great house flipper.
The Common Trader 