House flipping requires diligent homework on the part of the investor, and the first step is to research the housing market to understand the prevailing rates for home values in the area.
When mapping the viability of a flip, investors use a calculation to determine the “after repair value” (ARV) of the home. The ARV is the price the home should sell for after the renovations, based on market standards.
There is a general rule for looking for a profitable reversal called the 70% rule. The rule states that the goal is to obtain housing for 70% or less of ARV. Since the purchase price of the home will be the biggest investment, buyers should carefully analyze the market to understand what a realistic selling price will be. When buyers can secure a property at a lower purchase price, they are more likely to make a better profit. Without considering the ARV of the house, the path to profit becomes murky, jeopardizing the investor’s goals.
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Before you buy the house, consider the condition of the property and any renovations or repairs that will need to be done. As best they can, buyers should budget for relevant material, labor, and inspection costs. To help understand what renovations are needed, investors can also perform a cost per square foot analysis.
After listing the renovations to be done, calculate if the cost per square foot is comparable to that of other homes of similar condition on the market. Home-flippers shouldn’t do so many renovations that the property is well outside of what the market will accept. Buyers should really know the bones of the house before undertaking the investment, as any renovations will reduce projected profits.
Before a single repair is made, the new owner incurs several costs when closing the house. These closing costs include the transfer of the title of the house, the closing costs of the transaction, the insurance and any other costs that one assumes when acquiring the property. Closing costs can add up to an additional 3-6% on top of the purchase price of the home.
Buying a property comes with other recurring costs such as taxes, insurance and utility bills, all of which should be considered a pre-purchase. Even if someone buying a house to flip doesn’t plan to stay there long term, they are accepting ownership and must ensure that all expenses are paid and essential utilities are operational. As long as the flipper can expect to have the house before selling, it pays to plot the sum of these expenses, commonly referred to as shipping costs.
Unforeseen obstacles frequently crop up for house flippers. Pinball machines should prepare for delays and accept some degree of the unknown, including but not limited to the discovery of structural issues, an unexpected bidding war, and construction and shipping delays affecting timelines of renovation.
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Inflation hits almost every possible input for buyers, with higher costs for labor, appliances and other materials likely to drive more expensive renovations across the board. While soaring inflation is not a permanent phenomenon, it is a challenge whose end date is unpredictable.
Rising interest rates also have a direct impact on financing a home purchase, and the more rates rise throughout the year, the more they will reduce profits. When buying a property to flip, buyers should consider alternative financing options, such as hard money loans for short-term financing. These types of loans come with a higher premium for borrowing costs.
The near horizon for the house flip largely depends on market conditions, and if the current imbalance in housing supply and demand persists, house prices will continue to rise. Until broader changes occur in U.S. housing markets, potential buyers could be left out of the process.
It is important to remember that market conditions are not permanent and savvy buyers should research the market to find an environment that suits their financial goals. If the conditions look right and the analysis holds true, there may indeed be a path to profit.
David Mount is a director of the Wise Investor Group of Robert W. Baird & Co. in Reston, Virginia. Baird does not provide tax, legal or real estate advice and does not provide or service mortgages.