Many potential real estate investors hesitate to make their first deals, concerned that it’ll just cost too much. Frankly, there’s a lot of confusion about how much – or little – initial capital you need to get started in real estate. As a result, new investors often ask me: Ryan, how much money should you spend flipping a house?
If analyzed correctly, investors can fund an entire house flip with lender’s money. That is, hard money loans can cover the purchase and rehab costs of a good deal. But, to find these deals, investors need to avoid the common mistake of underestimating their rehab, holding, and transaction costs.
In the rest of the article, I’ll dive into the details of how much money investors should spend flipping a house. Specifically, I’ll cover the following topics:
- An Overview of House Flipping
- Major Mistakes New Investors Make
- Estimating Flip Costs with the Advanced Deal Analyzer
- How to Develop a Rehab Budget
- Funding House Flip with Hard Money Loans
- Gap Financing Options
- Additional Considerations
- Final Thoughts
How Much Money Should You Spend Flipping A House? An Overview of House Flipping
Before discussing paying to flip a house, I want to provide a brief overview of the fix & flip real estate investing strategy. In a nutshell, house flippers buy a house in need of significant repairs, complete those repairs, and then sell the property for a profit. More precisely, these investors complete the following steps:
Deal Research and Analysis
Unfortunately, popular HGTV shows make it seem that a successful flip just takes a little rehab, and then “boom” – profit! In reality, successful flip deals begin far before you (or a contractor) swings a hammer.
First, investors must conduct significant research analyzing potential deals. This research centers on the house flipping profit formula:
- Final sales price
- Total costs (Purchase price PLUS rehab costs PLUS holding costs PLUS transaction costs)
- Deal profit or loss
The purchase typically comprises the largest portion of that middle line of costs. Simply put, if you pay too much for a property, you either cut into your profit margin or erase it completely. Generally, the rehab itself makes up the second largest portion of your total costs. Therefore, if you buy a home for a steal but still need a massive rehab budget, you can end up taking a loss. As a result, investors need to spend a ton of time analyzing potential deals, ensuring that the numbers work before actually purchasing a home to rehab.
Part of this analysis includes developing a detailed rehab plan, something you’ll need to oversee during the renovation period. Building a realistic, executable plan can make or break a deal, and investors typically build this plan during the due diligence phase after going under contract but before closing on the property.
Purchase a Distressed Property in Need of Renovations
Once investors run a potential deal’s numbers and confirm that it’ll be profitable, they must purchase the home. The whole purpose of house flipping revolves around renovating a distressed property. Accordingly, house flippers purchase distressed properties, typically at a significant discount.
When a property requires major repairs, it won’t qualify for traditional financing. That is, a bank won’t approve a conventional or government-backed mortgage for a home needing a full rehab. Due to this reality, house flippers function as problem solvers when they buy homes. Using cash or hard money loans (which I’ll discuss below), investors purchase properties that the homeowners couldn’t otherwise sell, as they wouldn’t qualify for traditional financing.
This provides a win-win situation. Win 1: investors find a good deal on a property to flip. Win 2: homeowners who need to convert their property equity into cash can do so, irrespective of renovation needs.
Conduct the Rehab
After closing on the home, investors need to conduct the rehab. For most investors, this means supervising the general contractor (GC) in a project management capacity. If you happen to be a contractor yourself, you can save costs by doing this yourself.
However, contractor-investors need to balance overall investing strategy considerations. Namely, if you focus on the day-to-day of rehabbing a property, you sacrifice your ability to find and pursue new deals. In other words, it may make more long-term sense to pay a GC rather than fulfill this role yourself, as you can focus on building your real estate portfolio instead of hammering nails.
Sell the Renovated Property
Lastly, investors need to sell the renovated property. Until this sale occurs, house flippers do not profit on a deal. With the net sale proceeds, investors A) pay off their hard money loan (unless using all cash), and B) pocket the difference as profit (excluding capital gains taxes).
This sale adds another element to the idea of house flippers as problem solvers. As outlined, distressed properties generally do not qualify for traditional financing. This means that people looking to buy their primary homes cannot purchase these homes with traditional mortgages. But, through the renovation process, house flippers bring these properties to a condition that will qualify for traditional financing, which helps investors put people into quality homes.
Major Mistakes New Investors Make
In any discussion of house flipping, I feel obliged to outline a major mistake that new investors make when getting started. During their first deal or two, most new investors significantly underestimate repair, holding, and transaction costs. These make up a large portion of a flip’s total costs, so underestimating these items can quickly move a deal from a solid profit to a loss.
By repair items, I mean the direct costs of the renovation (e.g. contractor payments, supplies, etc.). Detailed planning with your GC – which I’ll outline below – can prevent this sort of mistake. However, where many new investors really get themselves in trouble is budgeting for holding and transaction costs associated with a house flip.
When you own a property, even one you only plan on renovating and selling, you need to pay certain holding costs. Some of the more common ones include:
- Property taxes
- Utilities (e.g. gas, electric, water) – necessary for renovation work
- HOA fees (if in a HOA community)
- Loan interest
Additionally, as part of the property sale, house flippers must pay certain transaction-related costs. These costs add up and, if not accounted for, can cut into your profit margin. While not an all-inclusive list, some major transaction costs include:
- Real estate agent commissions
- Transfer taxes
- Title fees
Estimating Flip Costs with the Advanced Deal Analyzer
Recognizing how much new investors struggle with accurately forecasting holding and transaction costs for a flip, we built a tool to help. Do Hard Money’s Advanced Deal Analyzer (ADA) incorporates our team’s collective experience to help you determine a deal’s costs. With this tool, you just need to enter purchase price and the rehab budget. Then, the ADA software provides an item-by-item breakdown of all the associated holding and transaction costs for the deal.
With this detailed cost breakdown, you can immediately tell whether a deal makes sense to pursue. The ADA incorporates massive amounts of data to closely project a deal’s profitability (or loss). As a result, new investors gain a key advantage analyzing deals – the ability to incorporate hard-to-calculate holding and transaction costs into a house flip’s overall budget.
NOTE: All Do Hard Money members have access to our ADA tool.
How to Develop a Rehab Budget
Considering the above, the question remains: how much should the rehab itself cost? We recommend following the below steps to develop a detailed rehab budget.
First, you need to create a detailed scope of work. You should do this by walking the property with your GC. As you walk the property together, you’ll talk about everything that needs to be completed during the rehab process. And, you need to document each one of these items. As the investor, you are ultimately responsible for the deal’s budget and execution – not your contractor. Personally, I like to record these conversations on my phone, as I can use this as a reference when I’m building the below scope of work.
After completing the walkthrough, you’ll document every single item in what’s known as a scope of work form. This form includes a line-by-line description of every task to be completed, the quality of the associated materials, and – eventually – the cost per item.
NOTE: At Do Hard Money, we have detailed scope of work form templates. We also have project managers who support our investors through the entire process, as we understand developing and executing a rehab plan can be challenging.
After you’ve added the tasks and materials to the scope of work form, I recommend meeting with two contractors to have a pricing meeting. During these meetings, you’ll assign costs to each of the line items in the scope of work. The total cost for all of these items becomes your rehab budget. And, meeting with two contractors for pricing bids lets you solidify a primary and back-up contractor. This will give you flexibility during the rehab process in case one of the contractors A) doesn’t perform, or B) needs to back out due to unforeseen circumstances.
Additionally, meeting with two contractors confirms fair market pricing the project. You don’t want one contractor to significantly underbid and then request another $10,000 or $20,000 once the rehab begins. By getting two bids, you’ll have a clear picture of market pricing for the renovation.
With pricing confirmed, both you and the primary contractor will sign the scope of work form. That way, if you have any discrepancies in the future, this form will serve as the final arbiter. At this point of time, you have successfully developed a detailed rehab budget.
Funding House Flip with Hard Money Loans
If analyzed correctly, investors can flip a house with 100% financing. That is, you can buy, rehab, and sell a property without any of your own money. To do this, you’ll need to work with a hard money lender. These lenders provide loans based on the “hard asset,” that is, the property. They don’t concern themselves with the borrower’s income, credit, and debt-to-income (i.e. his or her “soft assets”). Instead, hard money lenders want to ensure that a property’s after-rehab value (ARV) will more than cover the loan balance. In other words, if a deal goes south, they depend entirely on the property to recoup their costs.
Every lender differs, but at Do Hard Money, we lend up to 70% of a property’s ARV. We conduct a two-step process in determining ARV appraisal—first done virtually, in-house and then we hire a local, licensed real estate agent to walk the property and submit their own values.
Assume that this appraisal determines ARV as $300,000. We would lend up to $210,000 ($300,000 ARV times 70%). If your A) purchase price, B) rehab/holding costs, and C) transaction-related costs total less than $210,000, you can use a hard money loan to buy a house with none of your own money.
Unfortunately, finding a deal this good can pose a challenge for investors. Most deals will require more cash than your hard money loan. But, this doesn’t mean that you need to use your money to bridge the gap. Instead, you need to find a creative solution to finance the difference between your total costs and your hard money loan, which I’ll discuss in the next section.
Gap Financing Options
Gap financing represents the money you need to get to make a deal happen. Generally, it’s the difference between the cash you commit to a deal and the required cash to A) secure financing, or B) complete the rehab. Similar to a hard money loan, gap financing is short-term in nature and typically requires higher interest rates than long-term mortgages. Here are a few of the more common options:
Credit Card Financing
Credit card companies want your money. If you’re a responsible borrower, these companies will provide you pretty good personal loan options. Say you have a $25,000 limit on your credit card, but you only use $2,000 of it every month, always paying it off on time. There’s a good chance the card company will offer you a relatively low interest personal loan for the difference between the credit you regularly tap and your limit. This can be an outstanding gap financing strategy.
Find a Business Partner
Alternatively, you can seek a business partner. Plenty of people A) want to invest in real estate, but B) don’t have the time or experience to do so. If someone has money to invest, you can potentially bring them on as a limited – or “money” – partner. These individuals provide funds, have no role in the day-to-day operations, and receive a return on their investment. Yes, you’ll need to sacrifice a portion of your returns. But, if it makes the difference between funding a deal or not, bringing on a partner can be a great option.
Home equity lines of credit, or HELOCs, are another great gap financing strategy. Typically, investors tap the equity in their primary residences. Assume you have $50,000 in equity in your property. A lender may not extend a HELOC for that entire amount, but even if you secure a $25,000 HELOC, this gives you a tremendous amount of gap financing flexibility. Additionally, with HELOCs, you only pay interest on the money you draw. Once you repay the outstanding balance, you don’t need to pay interest.
A business line of credit (LOC) functions similarly to a HELOC. However, rather than secure the credit against your primary residence, banks use your business’s operations to secure a business LOC. Obviously, this option only exists for investors with a business. But, if you have a successful business, a LOC secured by its operations can be an outstanding gap financing option.
In real estate investing, good judgement comes from experience, and experience comes from bad judgement. At Do Hard Money, we want to help you gain good judgement without needing to make a ton of mistakes along the way!
With any house flip, something inevitably goes wrong – regardless of your level of experience. Solid planning can avoid a ton of problems, but some unexpected issue always pops up (e.g. a water heater breaks, a contractor finds previously undiscovered structural damage during the rehab, etc.).
Don’t let these inevitable problems completely derail your deal. Instead, make sure that you always have an emergency fund! For every deal, you should have some money available in case of unexpected issues. This doesn’t need to be cash – available credit card or HELOC financing works, too. But, you need to have reliable, easy-to-access funds in case of an emergency.
As I’ve illustrated, you can find good deals that don’t require you to spend any of your own money. By understanding how to analyze deals and creatively using hard money and gap financing, investors can 100% finance a house flip.
Despite this, I’ve found that new investors still need about $5,000 to “get into the game,” that is, start their house flipping journeys. This money buys some initial tools, software, and subscriptions that provide a solid foundation for flipping houses – the items necessary for investing but not part of any particular deal.
How much you actually spend flipping a house ultimately comes down to the following items: A) purchase price, B) direct rehab costs, C) holding costs, D) transaction costs, and E) your financing.