Understanding the true costs behind the scenes when flipping houses is vital to staying in business and making sure you stay profitable and in business. These costs aren’t accounted for on TV because they don’t fit the narrative of, “Look how profitable flipping houses is!”
Not so fast! No, Sale Price – Purchase Price – Rehab Cost does NOT equal Profit!
Closing Costs and Commissions
You need to account for the hidden costs involved in purchasing, holding, and selling the house. Closing costs and commissions will vary slightly depending on the deal you negotiate with your agent, but for me, I typically use 5%.
The reason for that is, closing costs are about 1.5% on the purchase and sale and I like to budget an additional 2.5% for agent commissions on the sale. The reason this is an equation used to generate your MAO in seconds is because it’s impossible to be accurate down to the dollar. If your decision comes down to a few hundred or thousand dollars the deal is too tight anyways.
Carrying + Holding Costs
The next variable in the equation is subtracting the carrying costs/ holding costs assuming that most of us aren’t buying these properties with our own cash, we are going to have a hard money loan.
When calculating holding costs, this is what I do. Let’s say for example your hard money loan was for $500,000. If your rate is 10% that means 10% annually.
Which means 10% of $500,000 annually is $50,000. Divide that by 12 months and your monthly payment will be about $4,166. That is your carrying/holding costs each month. So if it takes you 4 months to renovate your house and another 2 months to market and sell, that would be $4,166 * 6 months would be $24,996.
Lastly, don’t forget to calculate the points. The way hard money lenders charge you is not only the interest rate, but also ‘points’ which is a fancy way of saying ‘percentage’ – the difference is that points are charged upfront regardless of the hold time. Let’s say for example, the hard money lender charged you 10% interest + 2 points, that is an additional $10,000 (2% of $500,000).
This is why it is so important to move fast! Time is money!
Being accurate down to the dollar is not important. I just want to be close so I use a lot of math so I can move faster and if I’m off by a few thousand it doesn’t matter! Your hard money lender rates can vary which is why I wrote How to choose a hard money lender.
Target Profit Expectations
Depending on how you are funding a deal, you need to keep in mind how many ‘hands’ are in the mix and what margins you need in order to make the deal make sense for everyone.
Once you’ve identified the ARV or what I like to call, my ceiling. You subtract all of the things that we just discussed.
However, if you stopped there, you would be buying the property at your break even, because you haven’t built In your profit margin yet! So the last thing that you have to do is build In your expectations for your target profit.
For houses we buy in Maryland, we generally like to be at a net profit of 10%-15% of the all in investment. So essentially, what you need to do is find the ARV, subtract all of the other expenses as well as your target profits, which will bring you all the way down to the purchase price, which Is what I like to call my floor. This price Is what we refer to as your maximum allowable offer, this Is the MOST that you are willing to pay for the house.
I use a Deal analyzer calculator to help me make these calculations even faster! Bigger Pockets offers one here that you can sign up for!
As you can see, there are a lot of costs to flipping a house. To calculate your offer in seconds the 70% rule works a lot of the time. This is because your total costs not including your rehab cost typically adds up to around 30% of the ARV.
Overall, the whole name of the game is knowing the absolute most you can pay for a property based on what you project it will be worth for you in the future and your projected potential profit as an investor, anytime you can purchase the deal for under your MAO I would consider it to be a good deal assuming every part of your equation was done properly and accurately.