Knowing how to evaluate your property before making a deal, is key to success in this business.
Very few in the industry (investors, realtors, appraisers, etc.), ever truly master this valuable skill. Believe it or not, after reading this post, you will probably understand this skill better than most appraisers!
You can “find” all the houses in the world but it won’t do you any good unless you properly evaluate them and make offers that ensure a House Flipping profit. In fact, if you don’t know how to properly evaluate and make offers on properties, you can run into A LOT of trouble.
There is a great deal of misinformation in sources such as house flipping shows on television. These shows often leave out expenses which can cost you BIG time if you don’t take them into account upon your initial property analysis.
Understanding how to accurately assess costs to ensure profit separates you from being a “speculator” — someone who is just buying a house in the hopes that it will go up in value — to a true “investor” — someone who understands expenses involved in real estate and doesn’t make wild guesses about the future.
The true investor takes calculated and accurate “risks” and understands precisely how to create a significant return on their investment.
We will cover these expenses and hidden costs in a series of blog posts. First and foremost, we are going to help you estimate the After Repair Value of your property with comparative properties by accurately estimating repair costs.
Let’s get down to it!
Determining the ARV (After Repaired Value)
ARV is an acronym commonly used amongst real estate investors. It stands for “After Repaired Value” and is what the property will be worth after repairs and upgrades have been completed.
Determining the amount of money the property will be worth once you finish rehabbing it, is always the first step in the deal evaluation process.
Once you know the amount people will pay for your property, you can determine all your other expenses, and calculate the optimal place to make a decent profit. If you don’t know your ARV, you have no place to work back from.
Beginning with the End.
Think of the ARV as the finished picture for a jigsaw puzzle. When you know what the puzzle is supposed to look like you can put the pieces in the correct places which creates a picture of profit.
We’ve told you why it’s Important, here is how to do it.
In order to accurately determine the ARV you will need to look at Comparables or “Comps.” Comps are recently sold (or up for sale) houses similar to your subject property, in the same general area. These are used to determine the “going rate” for houses in that area and are a really good indication of what your house will sell for.
To access data for comparable properties you can use a paid or free service such as Zillow or Redfin, but for the most accurate and detailed information we recommend the Multiple Listing Service, or MLS — a service which provides extensive detail on properties up for sale or recently sold.
In order to access the MLS, you will either need to work with an agent, become an agent yourself, or work with someone who can get you access to the MLS.
The first step with the MLS is to look for rehabbed “standard” sold comps which are similar to what your home will be like when it is sale ready. These comps are easy to spot. They will have upgrades, nice pictures and shine above other homes. These comps are what you consider most when determining your ARV.
Next, depending on how many “standard” sold comps you find, you may also want to take into consideration other recently sold comps, such as short sales or bank-owned properties (REOs) which have been renovated or are in good condition.
As a general rule look for homes that have the following criteria:
- Sold in the last 90 – 120 days.
- Are within ½ mile to ¾ mile from your subject property
- Are close in size, square footage, bed/bath count and age.
- Are in a similar neighborhood.
After looking at recently sold comps, expand your search to comps which are listed (up for sale) or pending (under contract with a buyer but has yet to close).
Listed properties are your competition, so if you see rehabbed houses that are not selling you know not to value your home for more than those listed.
Pending properties can give an idea of future values, but keep watching them and keep in mind that they may not sell for the stated price.
You want to focus primarily on properties that have been fixed up, but also pay attention to those in a similar condition to your subject property. If there are several comparable properties which have recently sold or are listed for less than your calculated offer, this can indicate you are overpaying and you may want to reduce your offer.
Extra Tip: You can also check tax records to see what other investors paid for the homes they purchased in that area.
Reminder: Don’t cross the tracks! Avoid using comps from a different city, school district, or across a major barrier such as a freeway, river or railroad tracks.
Also take into consideration swimming pools, garage size, lot size, views and other upgrades so you can adjust your value accordingly.
Finally, consider current market trends and seasonal price changes for indications on both the resale value of your property, and the best time to buy or sell.
Keeping all these important pointers in mind, realize there is no exact formula for value determination, you have to take each property on a case by case basis.
Estimating Repair Costs
The next step in being able to determine an offer price is to accurately estimate the cost of repairs. In my company, we have become so good at this with pictures, a description and the age and size of the house, we can guess the repair costs within 1-2% without ever seeing the house!
The “$20 per sq. ft.” rule is a guideline we use to give us an idea of what it will cost us to fix up a house. This rule comes from our experience that most houses requiring a full “standard” cosmetic rehab will cost around $20 per square foot.
What is a ‘standard’ cosmetic rehab?
A “standard” cosmetic rehab usually includes all new flooring (carpet and hard surface floors), paint (inside and outside), baseboards, electrical and plumbing fixtures, new kitchen/bathrooms (including cabinets, granite, appliances), blinds and window treatments, new doors and a little bit of landscaping.
For example, if you are buying a house that is around 1,500 sq. ft., you can plan on spending $30,000 for the rehab (1,500 x $20 = $30,000).
This rule assumes you are rehabbing an entry or mid-entry house. If you are rehabbing a higher-end house and using higher quality materials and finishes, you are going to adjust the rate closer to $25 or $30 per square foot. For your standard basic rehab, the $20 per sq. ft. rule is a solid and reliable estimate.
From this baseline, you can adjust cost up or down based on additional needs (or things you don’t need). Over time you will develop a better understanding of these expenses and can easily calculate the rehab costs, up or down. We will continue to revisit this topic in more detail in future posts as we discuss rehabbing and working with contractors.
Pro-Tip: You will probably only use this $20 per sq. ft. formula when you are coming up with your initial offer price. Once you get an “acceptance” on an offer, go through the property with a licensed contractor and for a detailed “scope of work” and repair estimate to ensure you didn’t miss anything major with your first estimate.
Understanding what your property can potentially sell for and accurately assessing repair costs are fundamental first steps to successfully turning a profit.
Look out for upcoming blog posts where we will address Hidden Costs and Closing Expenses and give you the best formulas to determine your offer on a property!
(Second and possibly, two more blog posts with what is below).
Step 3: Calculate for Closing and Holding Expenses
An area of expenses often overlooked is closing and holding costs. Following are a few of the holding and closing expenses you need to be aware of when calculating your offer on an investment property.
Purchase Closing Costs:
These are the closing costs you incur when you are buying the house. Traditionally most of the commissions and closing costs are paid for by the seller, so when buying a property your expenses will typically be less than when you sell the property. To cover all your bases, calculate for 0.5% of the purchase price when buying a house for buying closing costs.
Selling Closing Costs:
Closing costs can incur more expenses. If you are selling a house with an agent you can usually count on giving commission of 5 – 6% to the agent. Depending on the area and market your buyer may ask for concessions to help pay some of their expenses. This can range from 1 – 6% but is typically about 3%.
Additionally you will want to include 1% for closing costs such as title and escrow or attorney fees.
That lawn needs to be kept up!
Selling closing costs can add up if you are using an agent to sell your house and your buyer asks for concessions. Depending on the area and type of home we are dealing with, we typically account for 6%-10% of the sales price for closing costs.
Even more so than closing costs holding costs are typically something many people forget to take into consideration when buying an investment property. Holding costs can include, property taxes, insurance, utilities, maintenance such as lawn, HOA and or Mello-Roos, if any.
You will want to make sure you know what these expenses will be and depending on how long you intend to hold the property you will need to calculate for those expenses during this time.
If you are using your capital then you will not need to worry about financing costs, but if you are not “Daddy Warbucks” and have to use financing like the rest of us, then be sure to account for this. It can really add up!
If you have a private money lender you can expect to pay anywhere between an 8 – 12% annualized return on your capital. If you are using a hard money lender in today’s market, you can expect to pay right around 12% annualized with additional points and fees. (Points are just a fancy way of saying percentage points.)
Most hard money lenders will charge you 2 – 3 points (basically 2 – 3%) however this is not annualized so regardless of how long you borrow the money this is what you will be paying on the money you borrow. The fees vary but you may want to calculate for an extra “point”, or an extra 1%, for these expenses.
So for financing if you are paying a private lender 12% annualized, that would be the same as 1% for each month you borrow the money. If you plan on holding the property for 4 months you will need to calculate for 4% of however much capital you will be borrowing. If you are using hard money you will need to calculate for an additional 2 – 3% on top, so that would be around 3 – 7% for financing costs for a 4 month period.
For example, if you borrow $100,000 from a private lender, then for each month you are borrowing the money you would pay 1% or $1,000. If you hold the property for 4 months, then you would pay $4,000.
Or, as another example, if you borrow the same $100,000 for a hard money lender, then you would calculate around 2 – 3% right out the door, which is $2,000 – $3,000. Then, for each month you are borrowing the money you pay an additional 1% or $1,000. So, for the 4 months from the previous example, you would pay $6,000 – $7,000 for financing costs.
Still with me? I know it is a lot to take in at first. Trust me I have been there!
We will continue to go over this stuff and the more you hear it, and start to put it into practice, the more you will understand. In time it will all become second nature! We will go over financing costs in more detail later on, but just make sure you are calculating for this because it can REALLY add up!
Step 4: Determine Your Offer (and 2 Formulas You Can Use To Help You Do This!)
Much more complex than our formulas!
Once you have a better idea of how to determine your potential selling price (your ARV), and you can estimate your expenses, then it becomes time to come up with an offer price!
There are several formulas you can use to help you calculate what to offer on a property. I was going to cover 4 here but after reading through I realized it might be a little overwhelming if you are just getting started, so I am going to cover the 2 easiest and most basic ones here and we will get into the others later.
(ARV) – (Repair Costs) – (Closing and Holding Costs) – (Desired profit) = Offer Price
Simple enough, right? This is the most basic and most obvious formula, and probably the most accurate way to determine your offer price.
Basically it boils down to figuring out what can you sell the house for minus all of your expenses and desired profit. Then that gives you your offer price.
Your desired profit will of course just depend on you and how much you want to make. You want to be conservative and leave some room for error, but you will quickly realize that if you are too low on your offers your chances of buying many houses will be pretty low.
For the most part I would recommend your profit be based on a % vs just a standard number. You will understand why I say this much more in the weeks and months ahead but it has a lot to do with managing risk, returns on capital, and bigger picture thinking as you put together the pieces for your house flipping machine
Okay, once again I am getting ahead of myself! As a quick rule when first starting out you can just calculate 10% of your ARV for the profit. So if the ARV is $250,000 you can calculate a profit of $25,000.
Here is an example: You have a 2,000 sq. ft. home with an ARV of $220,000 which requires a standard rehab as well as a new HVAC and you are financing it all through private money lenders. Based on those numbers you would end up with the following:
- ARV = $220,000
- Repair Costs = ($20 / sq. ft x 2,000 sq. ft =) $40,000 + (new HVAC =) $5,000 = $45,000
- Closing and Holding Costs = 1% (purchasing closing) + 8% (selling closing) + $X (holding) + 1% / month (private money financing) = approximately $18,000
- Desired Profit = $22,000 (10% of ARV)
or $220,000 – $85,000 ($45,000 + $18,000 + $22,000) = $135,000 Offer Price.
Now that we’ve done it that way, let me show you a faster and easier way to calculate an offer for an investment property. You may sometimes hear this formula referred to as the “70% rule”. Here it is…
ARV x 70% – Repair Costs = Offer Price
Basically you are taking what the property should sell for when fixed up, subtracting what it will cost you to fix up, and then you are leaving 30% to cover closing and holding costs, as well as desired profit.
Let me give you an example …
If the fixed up or retail value of a house (ARV) is $200,000 and the repairs to bring the house up to that retail condition will cost $25,000 then this is how you would calculate your offer:
$200,000 (ARV) x 70% – $25,000 (Repairs) = $115,000
Pretty simple, right?
Now I want to be very clear here. This is not a one size fits all formula, and needs to be adjusted based on the scope of the project you are working on, how long it will take, the type of financing you get, your acquisition strategy and the market conditions at the time of your offer.
I have seen this same formula being used with 60% up to as high as 80% (or even up to 90%!) so keep that in mind. But if you are just starting out, you can be pretty “safe” using the 70% rule and adjusting from there.
When I originally started this post I wasn’t going to do this, but I decided it might be helpful to share a video that my friend Doug and I put together about 3 years ago. We created this to teach agents we were working with how to analyze deals.
First of all, the video quality is HORRIBLE! Keep in mind this was a long time ago when I was still new to the rehabbing process (up until then I had mostly done wholesale deals). But that caveat aside, I still think this video could provide a lot of value to a new investor.
I will definitely do a higher quality video in the future, but for now I think it serves our needs.
Note: In this video we used 75% to determine our offer price.
In Conclusion …
So now you have a pretty good idea how to determine a property’s ARV, you have an idea of how to estimate repairs, and you know what to expect for closing and holding costs. You even have some great formulas in your toolbox to help you calculate your offers!
I know it might seem a little overwhelming at first, but no one ever said flipping houses was a walk in the park. (And if someone told you that, they clearly hang out in the wrong kind of parks!)
Watch out below!
It reminds me of an analogy my web designer/consultant used a few weeks ago when I expressed feeling overwhelmed by all this online technology. There are so many moving parts and just too much to learn! (Basically I was having a bit of a break down and wanted to “throw in the towel” )
He said when someone first starts learning how to use and implement online and media technology it feels like a game of Tetris, but played in reverse. In the beginning all the pieces are falling super fast, such that it feels overwhelming and almost impossible to figure out where to put them as they come falling down! But as time goes on the game starts to slow down, and you begin to understand more clearly what each piece is for, and where it fits in the “puzzle”
Real Estate investing or any other worthwhile venture is the exactly the same!
At first it seems impossible to learn all you need to know, but over time your capacity starts to grow. Although you are taking on more than when you started, it actually feels like you are doing less.
It happened to me with real estate and it is beginning to happen to me again with becoming a “tech geek”. And, without a doubt, it WILL happen with you and house flipping if you stick with it and continue to push forward.
Okay! So, here is your assignment. Later this week I am going to post a detailed article to teach you more about where you can find these properties and how to make offers. In the meantime, I want you to do some “paper trading“. Go online (or drive by some houses in your neighborhood) and try to get a feel for what you would offer on these houses. Try to do this for at least 5 properties.
If you don’t have access to comps, then do your best coming up with an ARV on your own. But even if you don’t know the exact ARV just come up with a “pretend” ARV so you can practice using the formulas and rules I outlined in this post. Then, once you either find an agent or get access to comps, you can improve the specificity of your ARVs.
For now just make your best guess and try to plug in as many answers as you can.
My goal is that by next week, you will start to take REAL action and get some offers out.
Now, I’m not saying you are going to completely start dominating your market place and make $100k over the next 30 days! I just want you to get in the habit of doing the one thing that will create success in this business: MAKE OFFERS!
For many people it takes them years to get up to speed making offers, but once you get your feet wet in this area all of the additional coaching we do here will be amplified because you will see things differently. It might not make sense right now, but you can bet it will down the road!
If you have any questions about this process of evaluating properties, just put them in the comments below. This is a lot of information and it will take some time to learn and apply it, but with enough practice these “pieces” will seem like they are falling incredibly slow and you will know exactly where to put each one. And soon enough you will really start to create and build your own house flipping business.