If you are considering buying a home as an investment, you may need a different strategy for your offer and ask: How much should I offer on an investment property? It really depends on many factors, but the rule of thumb is: investors should pay 70% of the after-rehab value (ARV) minus the costs of repairs. And, in following this rule of thumb, investors will, on average, realize a 10% net profit margin.
To make it easier to understand, I’ll start with some basic rules in real estate investing. Specifically, I’ll cover each of the following topics:
- Investment Property Gross versus Net Profit
- Additional Costs to Calculate Net Profit
- How Much to Offer on an Investment Property
- A Comprehensive Example
- Advanced Deal Analyzer
- Final Thoughts
Investment Property Gross versus Net Profit
While sometimes entertaining to watch, fix-and-flip television shows do a tremendous disservice to new real estate investors. In these shows, the “investors” typically explain their profits in broad strokes. For example, someone may say that they:
- Purchased a house for $50,000
- Renovated it for $25,000
- Sold it for $100,000
- Made a profit of $25,000
While this math works, these numbers fail to fully account for the costs associated with a house flip, that is, they calculate the property’s gross profit, not it’s net profit.
So, what’s the difference between gross and net profit?
- Gross profit: This represents a business’s profit after subtracting its cost of goods sold from its revenue. From a real estate perspective, that translates to after-rehab sales price minus A) purchase price, and B) direct rehab costs.
- Net profit: As opposed to gross profit, this represents a business’s profit after subtracting all costs from its revenue. When looking at a house flip, this means the after-rehab sales price minus A) purchase price, B) direct rehab costs, and C) all other costs.
In other words, gross profit ignores in its calculation the all other costs category of a real estate transaction. And, while ignoring these additional costs may make for good TV, it can significantly impact the profitability of a deal.
If, in analyzing a deal, you only factor in the gross profit, a profitable deal on paper may become an unprofitable one in execution due to the failure to account for all the costs an investor will face.
Additional Costs to Calculate Net Profit
After outlining the pitfalls of projecting a deal’s gross profit instead of its net profit, the next question becomes: okay, what makes up this list of additional costs? Or, in accounting terms, how do I calculate net profit?
As stated, gross profit only includes deductions for the “big ticket items,” that is, purchase price and direct rehab costs. To arrive at net profit, you need to deduct all of the following additional expenses. And, while this list doesn’t include all possible additional costs, it represents the major items investors fail to consider in calculating a deal’s profitability. As such, if investors include all of the below items in their initial analyses, they’ll have a much clearer picture of a deal’s actual profitability.
- Real estate agent commissions: While convention differs state-by-state, the seller generally pays the real estate agent commissions for both the seller’s and buyer’s agents out of sales proceeds. And, though negotiation room exists for commission percentages, the national average commission falls between 5 to 6% of sales price. This means that, if you sell a property for $100,000 and fail to account these commissions, you’ve already taken a $5,000 to $6,000 bite out of your projected profit.
NOTE: House flippers can become licensed real estate agents, eliminating the seller portion of this commission, but this process takes both time and money.
Loan interest costs
While some house flippers have the cash to self-finance a flip, that is, not take out a loan, many investors do not have this luxury. Instead, most investors take out a hard money loan to purchase a property to rehab and sell. As such, during the loan’s outstanding period, investors need to pay interest costs on that loan. Depending on the size of the loan, its rate, and the length of the rehab period, this potentially constitutes several thousand to tens of thousands in holding costs that need to be factored into a property’s net profit.
Utilities
During the entire rehab process, investors need to pay to have a property’s utilities (e.g. water/sewer, electric, gas) activated. In addition to actually needing these utilities to complete work, some municipalities mandate that utilities remain on in residential properties. Either way, investors need to account for six months to a year (depending on projected flip timeline) in utility payments, which could range from several hundred to several thousand dollars, depending on the size of the property and local utility rates.
Builder’s risk insurance
This type of policy insures against any casualty damages to the property during the actual construction process. And, just as it would be crazy not to insure a stabilized property, failing to insure a property during the construction period exposes an investor to a tremendous amount of risk. If the property burns down, or a ceiling collapses, or a water main breaks and floods the property, or any other number of potential casualties, builder’s risk insurance covers the costs of repairs (above your stated deductible). On the other hand, if any of the above happened to an uninsured house, the investor could be out tens of thousands of dollars in repairs.
Liability insurance
This insurance protects investors in case they’re sued. For example, if someone slips and falls at the property during the construction period, that person could sue the owner. If a successful suit, the owner would then be on the hook for the assessed damages, which would need to be paid out of pocket if not covered by liability insurance. And, depending on both the size of the damages and the legal structure of the deal, this could mean someone going after your personal assets, too (e.g. primary residence, retirement accounts, etc).
Property taxes
During the holding / rehab period of a flip, investors still need to pay property taxes on the house. While property tax rates vary by locality, municipalities charge them based on a tax-assessed value and the local property tax rate. For example, if the town assesses your home at a $100,000 value and has a local property tax rate of 1.5%, that means you’d need to pay $1,500 ($100,000 tax-assessed value times 1.5% property tax rate) in property taxes if you own the property for a year.
HOA costs
If your property includes homeowner’s association, or HOA fees, you’ll need to pay those during the entire holding period, which can add hundreds to thousands of dollars in expenses, depending on the duration of the rehab period and the monthly HOA amount.
On-going maintenance
In addition to the actual rehab costs, house flippers need to account for the costs of ongoing maintenance. While unexpected maintenance expenses can always arise (e.g. a water heater system needs to be replaced, HVAC system breaks, etc), landscaping constitutes an expected – and required – on-going maintenance expense. While flippers don’t need to pay a ton of money for top-notch landscaping, they need to ensure the landscaping remains good enough to A) avoid municipal fines, and B) appeal to potential buyers.
Staging costs
With fix-and-flip deals, investors typically look to sell a renovated property to someone who actually wants to live there (or who wants to lease to people who actually want to live there). Either way, after the rehab, the property needs to look like a habitable home. And, nowadays, that means that investors likely need to hire a staging company to actually stage the home during the sales process, that is, add furniture and decorations that make it look like a home. That way, when potential buyers tour the place, they can picture themselves living there. And, like all services, home staging costs money, further cutting into a deal’s profitability.
Transfer taxes and fees
If you’ve ever purchased a home, you’ve likely been surprised at how many line items a settlement statement actually has on it. Several of these line items deal specifically with the administrative transfer of the property’s deed – or title – from the seller to the buyer. Once again, these numbers vary by municipality, but investors will inevitably need to pay several hundred to several thousand dollars in transfer taxes and fees associated with the sale of a property.
Capital gains taxes
Uncle Sam always wants his piece. This means that, if you sell your fix-and-flip house for a profit – or gain, in tax parlance – you’ll need to pay a portion of that profit in capital gains taxes to the IRS (and potentially your state tax authority). And, while a full discussion on capital gains is beyond the scope of this article, the important takeaway for investors is that A) they will need to pay a capital gains tax on a profitable deal, and B) that capital gains tax rate will depend on how long they’ve held the property (less than a year means you’ll pay your higher, ordinary income rates, while holding for longer than a year qualifies for more favorable, long-term capital gains rates of 0% to 20%).
NOTE: Real estate investors can defer (that is, delay) paying capital gains taxes on the sale of a property by executing a Section 1031, or “like-kind,” exchange. However, this has several key parameters that need to be followed and, as such, should be discussed with a CPA.
Clearly, house flippers face far more expenses than simply purchase price and direct rehab costs. And, a failure to account for these additional costs can drastically undermine a deal’s profitability.
Bottom line, gross profit can help you quickly compare multiple deals, but net profit tells you how much cash you’ll keep after a deal.
How Much to Offer on an Investment Property
Now we’ve covered the importance of net profit, how much should I actually offer on an investment property?
Great question! And, as a result of both my The Investor's Edge and personal experiences, I’ve analyzed hundreds of fix-and-flip deals, providing me the experience to form a solid rule of thumb for how much to offer on an investment property. Here it is:
When buying an investment property to flip, investors should pay 70% of the after-rehab value (ARV) minus the costs of repairs. And, in following this rule of thumb, investors will, on average, realize a 10% net profit margin.
A Comprehensive Example
Okay, so how does that actually work?
Let’s say that, in analyzing a deal, you project a property’s ARV at $100,000 after putting $20,000 in rehab costs into it. Here’s how I would calculate my offering price:
- Determine 70% of the ARV: $100,000 ARV x 70% = $70,000
- Subtract the projected rehab costs from the above number: $70,000 – $20,000 rehab costs = $50,000
- Determine your approximate net profit: $100,000 ARV x 10% net profit margin = $10,000 net profit
Now that you know the above numbers, if you offer more than $50,000 on this deal, you’ll begin cutting into your projected net profit of $10,000 on the sale. And, if you offer more than $60,000, you’ll end up taking a loss.
As with all rules of thumb, this one must be adjusted for the specifics of every deal. However, in my experience with hundreds of fix-and-flip deals, I’ve come to fully embrace the merits of this rule.
Advanced Deal Analyzer Helps You Make Good Offers
If you’re an investor looking for more exact deal calculations than the above rule of thumb, I highly recommend taking a look at The Investor's Edge’s Advanced Deal Analyzer (ADA), a house flipping calculator we’ve created that incorporates the vast experience and technical expertise our team possesses.
Specifically, the ADA is our proprietary house flip calculator. It lets investors enter a property’s purchase price and projected repair costs to immediately determine A) whether or not a deal will be profitable, B) the deal’s actual net profit, and C) how much money you can qualify for on a particular deal.
This tool provides investors a level of efficiency that eliminates hours of time sorting through potential deals trying to figure out whether or not they’ll be profitable. Simply put, our ADA tells you if it makes sense to pursue a deal.
And, here are some of the other benefits provided by our ADA house flip calculator:
Know how much to offer
The ADA quickly tells how much you should offer on a given property – and whether the initial asking price makes sense. This calculation lets investors determine whether they’ll need to negotiate with a seller in order to qualify for a hard money loan.
Maximize your profit
When you enter your projected rehab costs into the ADA, you’ll see whether completing this rehab will successfully bring the property in line with its neighborhood sales comps. In other words, the ADA will let you know if you’re underestimating your rehab budget – and, if necessary, how much you’ll need to increase it.
Save time and money
Stop chasing bad deals! Every time you pursue a bad deal, you waste your time and the money. In addition to the direct costs of pursuing a bad deal, you also forfeit the opportunity cost of a profitable deal you could be pursuing. The ADA gives you the deal insights to, as quickly as possible, eliminate unprofitable deals so you can focus on the solid ones you should be pursuing.
No math
Let’s face it, we’re not all math wizards. And, when you rely on complicated spreadsheets and your own calculations, the potential for mathematical errors increases significantly. With our ADA, you can be 100% confident in the outputs, as the system correctly completes its underlying mathematical computations – the same way, every time.
Eliminate the wait
With the ADA, you don’t need to wait to determine whether or not a deal will be profitable. As soon as you enter a potential deal’s basic information, you’ll know whether or not to spend more of your time reviewing comps, soliciting contractor bids, or applying for a hard money loan.
No hidden costs
As illustrated above, one of the major mistakes new investors make involves projecting profitability via gross profit instead of net profit. With the ADA, you’ll receive 100% disclosure of all costs, which will let you know if a deal remains profitable after accounting for all loan, holding, and selling costs.
Final Thoughts
Every house flip has its own unique characteristics and considerations. But, at the end of the day, when investors search for potential properties to flip, they need to focus on a deal’s net profit, not its gross profit.
By including all of the costs associated with a potential flip, investors arm themselves with the knowledge to make an appropriate offer on an investment property. On the other hand, a failure to account for all these costs converts a deal from a well-calculated risk to an outright gamble, with an investor hoping things work out, not proactively taking the steps to actually make a deal work.
Learn how you can make money flipping properties with us by attending our next webinar.
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