In real estate, your money is made when you buy. We have all heard it before and you know what it’s true. This is especially true when buying property to fix and flip. If you don’t get a low enough price, you will be lucky to break even and you certainly won’t be making much money. So how do you know what to offer? It all comes down to the numbers.
When I look at a deal or advise a client on how to look at a deal, I look at it from a lending prospective and a profit prospective. Whichever method is the lowest is what I want to pay. In the past this would be your maximum allowable offer or MAO. Keep in mind that because there are fewer deals it may make since to pay more than the old standard MAO. Let’s go through the formulas:
*There are variables which I will not be covering in this article. For these examples we are assuming we know how to determine the true after repaired value or ARV and the cost to rehab.
Max Loan Method
If you plan to use hard money you should first run the numbers as a hard money lender would. This is the easier of the two methods. Often times this will be the only method you use to analyze a deal since it can be done so quickly. This assumes you are trying to buy and fix the home with none of your own money (other than your holding costs of course). The basic model is simple; 70% of ARV minus repairs. If you want to bring zero money to closing you also need to account for closing costs. For us it is 4 points plus about $1,500 in other fees. So the formula is 70% of ARV – Repairs – Closing costs = your offer.
When a deal looks good after running your quick numbers, its time to dig a little deeper and determine what your profit should be based on the price you want to pay. Or better yet, figure out a profit you would like to earn and come up with you offer. The formula looks like this:
ARV – profit – closing costs to buy – repairs – holdings costs – concessions – realtor fees – closing costs to sell = your offer.
Sound confusing? Let’s break it down.
ARV – after repaired value or what you think it will sell for once repaired
Profit – This should be taken off the top first. Most people run their numbers to determine what their profit should be. That is backwards, you should use your profit to determine what your offer should be. I can’t really help you with this one. What is a project of this size worth in dollars to you? $20k, $30k, more?
Closing costs to buy – What is it going to cost you to buy the property? If you are using hard money you need to budget for the points and fees as well as traditional third party closing fees. If you are paying cash you will only budget for the third party closing fees (county fees, title closing fee). With hard money you should expect 4 points plus about $1,500 to cover everything.
Repairs – The money it is going to take you to rehab the property
Holdings costs – Here is where a lot of investors get tripped up. I start by determining an amount of time that I will hold the property, probably 4 – 6 months. Then add ALL costs related to holding the property. These include: loan interest, HOA dues, insurance, taxes, and utilities. Taxes and insurance will not be paid out each month but they need to be accounted for since they were either already paid or will be due when you sell the house.
Concessions – People disagree with me on this and I really don’t know why. Even appraisers will push back when I ask that they adjust for concessions. Concessions are what you give back to the buyer at closing. It could be for closing costs, unfinished repairs or something else. The fact is concessions are very common and they do reduce your net profit.
Realtor fees – what is the commission you are willing to pay your listing agent (unless you are the listing agent)
Closing costs to sell – Title fees and other closing costs. You can budget around 1% of the sale price to cover these.
Let’s go through an example. Let’s say a house has an ARV of $200,000 and needs $30,000 in repairs. I use a loan amount of $140,000 since this is 70% of the ARV. I want to make $30,000 so my offer is $108,400 or less.
– $30,000 Profit
– $7,100 Closing Cost to buy ($140,000 * 4% + $1,500)
– $30,000 Repairs
– $10,500 Holding costs for 5 months (loan interest, insurance, taxes, utilities)
– $4,000 Concessions (2%)
– $8,000 Realtor Fees (4%)
– $2,000 Closing Costs to sell
= 108,400 Your offer
You may have noticed that using the Profit Method is really close to 70% of ARV minus repairs (using that formula your price would have been $110,000. Either method should work but by breaking it down like we did above you will have a great sense of what your profit is going to be when you are done. In a perfect world you would want you MOA to be the lower of these two methods.
I have included a worksheet on our website under Free Resources that you can use to run your numbers. www.pinefinancialgroup.com I recommend always looking at deals by hand and always using a pen. Spreadsheets are too easy to manipulate and you will find yourself adjusting the numbers to “make a deal work”. A pencil with an eraser is the same way.
Use this formula and make a lot offers and you are sure to make money in this business.