4 Things to Consider When Evaluating a Property for Profit
Seasoned real estate investors will tell you time and again that your success in this business will depend on your ability to evaluate a property for profit…and they are right. Finding a property is not as difficult as knowing how to evaluate it properly and make the right offer that will yield a fine profit. That being the case, we have compiled a list of some of the most important things that will help you evaluate a property’s potential. Have a look!
1. After Repair Value (ARV)
Whenever you evaluate a fix-and-flip property, your first step should be to determine the After Repair Value or ARV. ARV is what the property will be worth after you have completed all the repairs and upgrades. It serves as a baseline for calculating all your other expenses and the profit you stand to make if you decide to go ahead with the deal. There is no fixed formula for calculating the ARV of a property, but that’s where “Comparables” or “Comps” come in.
For the uninitiated, comps are similar houses that have been sold recently in the same or surrounding area. This will give you a good idea of the selling price for your rehabbed house. You can get this information from websites like Zillow or Redfin but generally the most accurate source of sold listings will come from your local Multiple Listing Service. You may also want to talk to a local realtor who is in on the day-to-day happenings and can provide a true picture of what the market is like right now. Looking at similar properties that are currently put up for sale is another way to gauge your competition and find out what you will be going against when you finally decide to put the house on the market.
2. Repair Costs
If you’ve been flipping houses for a long time, you will by now have become a pro at estimating the cost of repairs for a house just by looking at it. If not, you can use the standard $20 per sq. ft. rule to find out what the flip is going to cost you. The $20 per sq. ft. usually includes all cosmetic updates such as new hardwood floors/carpets, paint, new electrical and plumbing fixtures, new appliances, cabinets and countertop in the kitchen and bathrooms, window treatments, and basic landscaping. So if you buy a mid-sized house somewhere around 1,200 sq. ft., you will spend around $24,000 on repairs, assuming you will use standard materials and finishes. If you plan to use top-notch, superior quality materials for the rehab, you will have to adjust the rate accordingly.
Also, this is again just a baseline for your calculations and does not take into account any property-specific repairs that you may have to perform. If you want to install a new HVAC unit or make structural changes, you will have to add the costs correspondingly.
Many newbie real estate investors do not realize that house flipping involves a lot of other expenses like financing costs, closing costs on the buy and sell sides, and holding costs – all of which eat into your profit margin.
Typically, selling closing costs are higher than buying closing costs because it includes additional charges like attorney fees and title. If you are working with a realtor to sell the house, you will have to take into account his commission too. If not, allow for the additional money you will have to spend on marketing the property after you have finished your repairs.
Holding costs include property taxes, insurance, HOA, utilities, and so on for the full period the house is in your possession. Most flips take an average of four to five months to reach completion. If you have taken a loan to finance your investment, then you have to calculate costs associated with that as well.
4. Final Offer
Once you have your ARV, your repair costs, and other expenses, it’s easy to calculate an offer price that will give you your desired profit. Essentially, your offer price is what you can sell the house for after deducting all your expenses and estimated profit. Experts, however, caution against using a fixed number as your profit and instead recommend calculating a percentage of the ARV.
Of course, you may find the method that works best for you comes from your on the job experience with flipping, But many investors use the below formula, also known as the 70% rule, for calculating the final offer price.
Offer Price = ARV * 70% – Repair Costs
This method gives you around 10 to 15% of the ARV to cover the closing and holding costs and the remaining 15 to 20% as your profit. Depending on the market condition, the length and nature of your project, your experience level flipping homes and the type of financing you are using, you may want to adjust the percentage accordingly. This is just a standard formula and you can adjust the percentage to as low as 60% or as high as 90% when you understand all the factors involved.
In closing, here are several examples of the formula.
$116,000 = $200,000 * 70% – $24,000
$136,000 = $200,000 * 80% – $24,000