Fix and Flip Module 2 - Digging Deeper
Fixing and Flipping houses is much more detailed than just finding any old house fixing it up and then selling it. That is the concept, but you must know the bones of the concept to be successful in the business of financing these properties.
The hardest part is finding the right property and that is a lot of work. You must be familiar with costs of improvements, be able to inspect the property thoroughly and make sure that there are no hidden surprises. The biggest problems pop out when least expected and can kill the deal and drastically reduce your ROI (return on investment).
You must do your homework, what can this house sell for? Remember that it is not what the listing prices for like houses in the area, it’s the sold prices that will provide you with an accurate figure. Sometimes it’s best to have a realtor friend or have full access to mls. Days on market will show how hot the neighborhood is, are people moving in at a fast clip, or do the houses sit on the market for a long time. You want properties to move quickly, sitting on the market costs you money. Take a look at the sales prices and see if they are rising for similar houses in the area, All houses being reviewed must be in the same area, be like houses in square footage and lot size. Your final review should be you driving the neighborhood and driving by the comps and other neighborhood amenities.
Next you have to see where the work can be done to get the biggest bang. Wifes by houses, and since the largest buying segment is couples, that is what you need to focus on when you are looking at renovations. Focus on kitchens and baths, curb appeal, neutral bright colors to enhance the room size, sensible trimming and for the husband a manly garage and backyard. But you must fit within the budget so plan correctly.
Once you have all your information, now it’s time to figure out the budget. Investors needs to make a profit! There are downpayments, closing costs, mortgage payments, renovation money and reserves. Obtaining financing for the project requires a minimum 10% down of the purchase price. Closing costs will run somewhere around 7-10 % depending on where the property is (States differ in closing costs, and some are considered high closing costs states).
- Note – the down payment will come back when the property is sold
The other money needed is the money to start the renovations. Money for renovations is given in draws. Typically three draws will occur during the renovation. Once ⅓ of the work is complete the borrower will request an inspection from the lender. The inspector will review the work completed and report back to the lender who will then release the funds to start the second stage of renovations. The money laid out for renovations will be reimbursed through the financing.
Lenders require that the borrower realize a profit. As part of their underwriting guidelines their maximum funding amount will not exceed 65-70% of the ARV. This leaves between 30-35% gross profit. Now remember out of this there will be costs as we discussed for the purchase, interest only payments for the financing, closing costs for the sale of the property which will include real estate commissions.
Let’s take a look at an example:
$40,000 in Repairs
$295.000 Sales Price
20% down on the purchase ($36,000)
7% Closing Costs ($10,600)
$14,000 for first round of renovations
Reserves for Payments and Shortages –
$180,000 purchase with 20% down results in a mortgage amount of $144,000
Interest Only Payment on $144,000 @ 10% interest = $1200
12 months reserves for payments – $14.400
Shortage or Surprise Reserve for Misc = $10,000
Closing Costs on Sale – 2% Costs + 4% Realtor
Lookin at the above example we can see a couple of things. First we can total up the money needed to do a flip, $36,000 for down payment, $10,600 for initial closing costs, $14,000 for first round of renovations, $14,400 for mortgage payment reserves, shortage and emergency funds of $10,000 which all totals $85,000.
Now we look at the profit to be made. Let’s say that the property took 3 months to be renovated and then took 4 months to sell and close. That would leave us with 6 months of mortgage payments. The lender will lend up to 65% of the ARV. The ARV value is $300,000 and we times that by 65% which equals $195,000 total loan amount. Which means that the entire amount of renovations can be funded.
Now let’s figure out the ROI, which is the most important aspect of the entire transaction. We have a sales price of $295,000, and remember that the original down payment will be reflected in the monies received from the closing.
Sales Price: $295,000
Closing Costs: $5,900
Real Estate Commission @ 4% : $11,800
Mortgage Payments @ $1200 for 5 months = $6,000
Mortgage Payoff at closing – $144,000
Balance = 127,300
Original Downpayment – $36,000
Original Closing Costs – $ $10,600
ROI (Balance) = $80,700
THe result shows a good return on investment. But these numbers can change based on economic factors resulting in prolonged market time to sell, or even finding that the property may need additional work that was overlooked. Without risk there is no reward.
With competition, certain lenders have been raising LTV’s and reducing ROI requirements. Yes, the competition is fierce in finding the right properties to flip but the borrower must be careful to ensure that they still realize an acceptable profit, They must be aware of miscellaneous costs that may pop up and cut into their profit.
When a borrower runs into an unforeseen problem that will cut sharply into their profit, and they are working with minimum excess cash, they may walk away from the deal. This is not your problem, and you still earned your money on the deal when it closed. But, if you want to set yourself aside from the rest of the industry and be a true professional, you should discuss with the client that the margins are real low, and what could be the result. If something does go wrong, that client will be out of business so you may have closed one deal with them but you may have missed out on 10 future deals. Express your concerns lightly so that the borrower understands and if they still want to proceed there is nothing you can do. If you are dealing with an experienced investor, especially one that has the means to handle a situation if it arises, you can mention in passing and include that the borrower is experienced and has the means to handle the situation. Investors may work lower margins when they work 2 or properties at a time, and turn a hign multiple of houses per year.
This module is to help you understand the process of the purchase of the property, determining budget and the return on investment. As a commercial lending expert, you must understand the process from the borrower’s end, and also from the lender’s side of things. The fix and flip industry has exploded and lenders and investors have sprouted up all over. The great thing on the lenders side is that rates have dropped and guidelines have eased. For the borrower to enjoy much of the lower rates and higher LTV’s means experience, the more experience the more favorable the deal. Repeat business is important to a lender, it builds trust.
In the next module we will look at how the properties are found, and other flip options.
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