House Flipping: Basic Rules to Stay Profitable
With the rise of television shows showcasing house flipping, it has gained popularity in recent years. These shows paint a pretty picture of the financial gain that house flipping has to offer, and everyone wants to get in on it. How profitable is house flipping in reality though? In this article we will cover what house flipping is, and the basic rules to follow to ensure a solid return.
What is House Flipping?
Before exploring the financial benefits that house flipping has to offer, we first need to understand what house flipping is. At its core, house flipping is when a real estate investor purchases a house, performs renovations, and sells it for a profit. A home must be purchased with the goal of selling it as soon as possible to qualify as a “flip”. The period between the purchase and the sale is generally between a few months and a year, depending on the amount of construction required.
When you intend to purchase a property, perform renovations, and resell the property in a short window of time, this is often referred to as a “fix and flip”. Although there are other ways to flip properties, this article will be looking exclusively at these “fix and flip” opportunities.
What is the 70% rule?
When discussing what type of profits house flipping can offer, there is one important rule to understand before beginning — the 70% rule.
When looking through real estate listings, flippers can get assistance from the 70% rule. In essence, it states that investors should not spend more than 70% of a property’s after-repair worth.
The 70% rule formula
The 70% rule is a simple calculation:
After-repair value (ARV) * 0.70 − Estimated repair costs = Maximum buying price
The 70% rule in practice
Viewing a formula is not always the best way to understand a topic, so let’s view an example. After estimating a property’s after-repair value (ARV) and determining repair costs, you can use the 70% rule to estimate the maximum amount you should spend to ensure a profit.
For this example, we will estimate the repair costs to be $35,000 and the ARV to be $250,000. With the estimated costs now calculated, we will plug that into the formula and get our maximum buying price to ensure we protect our profitability.
$250,000 * 0.70 — $35,000 = $140,000 [ARV * 70% — Estimated repair costs]
By using this simple formula, we can increase our chances of profitability by sticking to a maximum buying price of $140,000 for the property.
In the above example, by using the 70% rule, we have an estimated profit of $75,000, or a 42.8% ROI.
Things to consider when using the 70% rule
The ARV may change while under renovation
The main goal is to acquire a property, renovate it, and flip it as soon as possible. However, flipping homes can become messy and unearth problems you were not expecting. These problems can cause your estimated timeline to increase months longer than previously expected. In these months, the housing market can change shape and cause your ARV to change as well, for better or worse.
For this reason, the 70% rule is all the more important to follow. In the event your flip gets delayed by several months or your repair budget goes up due to unforeseen issues, the 70% rule allows for enough cushion to ensure you will still turn a profit.
The estimated cost of repairs can be tricky
Calculating the cost of home repairs and renovations is one of the difficulties of house flipping. If you’re new to flipping homes, it’s crucial to collaborate with a contractor and a home inspector to acquire a clear image of the construction a home needs and an estimate of its associated costs.
Although working with a contractor and home inspector can uncover many issues, it is better to be made aware of them as early in the process as possible. If an uncovered electrical issue arises down the line, it could increase your repair cost by up to $10,000, greatly diminishing your profits. It is vital to be conservative with your estimates by accounting for unforeseen contingencies. For many professional house flippers, a 5% to 10% increase in budget is built in for these contingencies. For less experienced flippers, this number should be even higher.
What all is included in the estimated cost of repairs?
At first, it may be easy to forget about some of the estimated costs associated with flipping a property. After working with a contractor and home inspector you may feel confident that you arrived at a solid estimate. However, you also need to factor in fees such as insurance, taxes, closing costs, and realtor fees. These costs will vary from neighborhood to neighborhood, and company to company, but an estimated range for closing costs can be anywhere from 2% to 5%.
Finding properties that meet the 70% rule
Adhering to the 70% rule will greatly increase the likelihood that your flip will be a success. But finding flip-ready properties that meet the 70% rule isn’t always an easy task. Here are some things to consider during your search.
Consider the value of surrounding properties
No matter how nice a property is, location will play a major role in determining its value. When it comes to house flipping, your ARV will rarely exceed comparable properties in the area. With this in mind, it is often beneficial to find lower cost properties in otherwise higher priced neighborhoods or cities.
Focus on properties in need of cost-effective repairs
Not every fixer upper is made equal. An outdated kitchen and bathroom may turn many buyers away, but cosmetic issues are far cheaper to fix than structural or electrical ones. Properties that only need a quick face lift can often present the best flip opportunities, with minor kitchen/bathroom remodels and landscaping being the most cost-effective options.
The Bottom Line
House flipping can be extremely lucrative if done properly. The profit margins differ based on the area, property value, market conditions, and time of year. Your return also depends heavily on other factors, such as how much of the work you plan to do yourself as opposed to hiring out. Results vary greatly, but the average return on a residential house flip is roughly $67,000.
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