With so many moving parts with any real estate investment, how do you actually calculate profit?
It’s a bit easier if you’re on the lending side because you’re usually earning a set interest rate…but it’s more difficult when you’re figuring things out for a fix & flip, BRRR deal, or even a rental!
Before the deal happens, there’s a lot of estimating that you have to do, but let’s start with the basics.
Profit = Revenue – Cost.
Easy enough!
But what are those things, say in a fix & flip deal? The revenue is your after repair value, or what you estimate you’ll be able to sell the property for when everything is said and done.
Then your costs include:
- Property purchase price
- Rehab costs
- Interest rate
- Origination
- Loan servicing fees
- Title fees
- Inspections
- Other loan costs
So you’ll take your ARV, subtract all of those estimated costs, and you’ll get your answer.
Easy to say, but actually mastering the estimation of these numbers is a foundational skill in real estate investing!
In fact, the skill to quickly and accurately estimate revenue and costs will allow you to get into good deals and move on from bad deals…so incredibly important!
But let’s dive a little deeper.
How to Calculate After Repair Value
Establishing the after repair value is the first step in figuring out if a property is going to have the type of profit that you’re looking for.
Over my twenty years working as a real estate investor, I’ve developed a strategy that works very well…and it’s the same strategy that all of our borrowers at The Investor's Edge use as well.
You’re going to look for three recently sold and three active on the market properties that are comparable to what your property will be and look like after the rehab!
You might think to only look at the currently active properties…the problem is that no one has actually paid that price yet! It happens all the time that a property was listed for $250k but actually sells for $235k. The active properties give you an idea of what’s happening, but you’ll still need the recently sold properties to actually tell you what people are paying for a property similar to yours.
Why so many?
If you can only find one or two comparables, you’ll sometimes run into these problems:
- Estimate too high – perhaps that property happens to sell for more because two families really wanted to move into that area and they bid each other up. Perhaps at that exact time it was the only one of its kind on the market. If you use that comp, you run the chance of expecting a much higher resale value than is reasonable.
- Estimate too low – Maybe that one recently sold property was a father selling to a son or a friend selling to a friend as a favor. While you should always be conservative in your values, an artificially low price might keep you away from a deal that could have been profitable.
- Not enough volume – is there actual demand in the area? If there aren’t any recently sold, but there are several on the market, that’s a bad indicator. Holding your property for a long time once you’re ready to sell gets very expensive very fast—especially with the interest on a hard money loan.
When you find six comparable properties, you’re going to be pretty sure that you’ve got a great value to go on.
Which of those six do you use?
The LOWEST one.
Except for extenuating circumstances (like the buddy or family pricing I mentioned above), I always use and tell others to use the lowest price.
Borrowers will come to me and say, “I found 3 recently sold properties which sold for $200k, $218k, and $225k…I’ll take the average of those and use $214k as my projected resale value.”
Or even worse, they’ll get too optimistic and take the highest price!
So then here’s my question.
We have evidence that recently a property similar to yours sold for $200k…so isn’t is very possible that it will happen again?
If you’re planning on a $25k profit, but now you’ve lost $14k (you thought $214k but got $200k) because you didn’t do your valuations properly…you’re best case scenario is now only $11k.
For 6 months of work, for the risk involved, and the likelihood of other unexpected costs, that’s just not a great deal.
To find your 6 properties, the best way is to head over to Realtor.com or Zillow.com. Of course you can find the “for sale” properties, but they also show you recently sold properties in the area as well.
½ Mile Rule
My general rule of thumb is that you’re only looking for comparable properties within a ½ mile radius of yours. Once you start getting much further away than that, you’ll get too many differences in the property to make a good comparison.
This does exclude a lot of rural properties, as well as higher-end luxury homes. But that makes sense, right? If it’s a rural area, how can you possibly know the true value of your investment property if no one else is buying or selling nearby?
Or think about a luxury home in a small gated neighborhood…there might only be 10 houses like it in the whole neighborhood. You’re never going to get a truly accurate estimate on the value of that property because you’re not going to find multiple properties that are actually similar to that one. You’d likely have to look miles and miles away.
No Natural or Artificial Barriers
This is a cousin of the ½ mile rule, but it’s true regardless of how far away other comps might be.
If you think about it, you’ll recognize this everywhere.
Perhaps one builder built on one street, and then another built just one street over. If one builder has a great reputation and their houses are always amazing, they might be worth more than if the other builder just stinks and is famous for terrible houses.
Or perhaps one of your comps happens to be right on a river, or has a pretty view that bumps its value by an extra $15k.
Another example: there’s a famous street in Salt Lake City that all the real estate investors know. The houses can be exactly the same on both sides, but on one side they’re worth $50k more for almost no reason at all. It’s the craziest thing.
So when you’re figuring your comps, make sure to understand the area. If you live nearby, make sure to go check it out. You’ll notice things…like if part of the neighborhood goes right against a busy street, that’s going to cut into the value. If another part is quiet and has a beautiful park right up against it, that’s going to raise the value.
Other factors to look for:
- Crime – ½ mile radius can see big differences in crime levels.
- Schools (might not be a big difference in a ½ mile radius, but it pays to make sure)
- Boarded up houses – if your property is right next to one but your comp isn’t, that hurts your valuing.
- Graffiti
- Commute to work/commercial areas – So a ½ mile won’t make a big difference, but perhaps one comp requires a roundabout path with 7 turns while another has a straight shot to a busy road.
- Train tracks – for obvious reasons!
Adjusting for Differences
Things can get a little tricky here, and make sure that you’re not adjusting ALL of your comps. If you can’t find a single comp that’s close to yours, I’d skip that deal. Adjusting the price difference (in my opinion) is more to validate the other comparables you find.
Let me explain.
So let’s say that you find two great comps and they’re both listed for $215k.
Then the only other comp you can find is listed for $235k, but it has an extra bedroom.
Now you need to make some assumptions and know the area well.
Does an extra bedroom typically add about $20k in value in that area? Does a comp with one fewer bedroom go for $20k less? What about two extra bedrooms over your comps? Will that list at $255k or so? It’s never going to be perfect because a fourth bedroom is typically less valuable than a second or third bedroom, but you can make some educated guesses.
Your goal is to validate that $215k price, not come up with a new valuation based on a less-than-perfect comp.
Of course you can do these same sorts of calculations with one extra or one fewer bathroom.
Another calculation that happens fairly often is if the beds/baths are the same, but one property has 200 more square feet.
In that case, the simplest thing to do is to figure out what the average square footage price is.
Look at your other comps. If the price per square foot is about $125, then you can do 200 x $125 and get a $25,000 difference in price. But now you have to consider that square footage isn’t created equal.
Since the square footage won’t be in a bed or bath, you likely can’t expect a full $25,000 difference in price. Perhaps $20k.
The main point is this:
Do as little guessing as possible, and look at tons of properties in the area until you start getting a feel for how much square footage, bathrooms, beds, lots size, etc., play into the price. Then if you have to guess, don’t use your guess as a main valuation—use it to validate the other prices you found.
Be Conservative
This is my plea to you:
Don’t invent numbers that look good to make the deal happen! This happens way more often than you’d think because people are convinced that their property will sell for more.
I’ll get comps at $220k and then a borrower lists their after repair value at $230k. All this does is serve to give them a false sense of how much profit they can get. And really, it’s just shooting themselves in the foot because they’re going to move ahead with deals that don’t work.
I’m going to say something that might sound obvious, but only the most successful investors actually understand:
It’s better to lose a deal here or there because you’re too conservative, then to get into bad deals because you’re too optimistic with your values.
It’s hard to let a deal that’s almost good go in the heat of the moment. But it’s even harder dealing with your losses later.
Common Sense
Another observation:
Just use common sense with your values!
If you see a killer deal, but then find out it’s next door to train tracks, don’t think it’s going to fetch full price….
Or if your deal is next to a Burger King…
Or if you think that because you’ll do a good job of the rehab that you can add $20k to the value…
I had a recent investor bring a deal to us. All the numbers looked great. On paper, it seemed like an incredible deal where the investor was going to profit $50k or more.
Then we pulled up pictures of the property, and it was instantly obvious this was a terrible deal.
The front door was literally ten feet from a 45 mph street. And I mean literally. You couldn’t park perpendicular to the house because your car would be in traffic.
Most people wouldn’t take that house if it was free…so first, how can you even value that property, and second, who’s buying it?
That’s what I mean by common sense. I hear so many rationalizations…oh that won’t matter because THIS…or I’m going to get more money for my property because of THIS.
You need to be cold and rational. In fact, pretend that you’re evaluating someone else’s deal. If a friend brought this deal to you for your opinion, what would you say? If it wasn’t your money and your profit on the line, would you still get into the deal?
If you follow those guidelines, you’ll do a lot better when figuring out what a good deal looks like for you.
How to Estimate Rehab
So here’s how the process goes:
- Look at pictures and maybe a quick walk through
- Get a rough estimate using price per square foot estimates
- Make an offer and get the property under contract
- Meet contractor and formalize a bid
- Sign an agreement with the contractor
Rough Estimate
So the first thing you’re going to do is to make a down & dirty estimate. Your goal here is to get close enough that you can at least make an offer.
Is this going to be 100% accurate? Never.
Will it be close enough that you can make an offer and put it under contract? Absolutely!
At this point it’s about speed and efficiency. Most new real estate investors don’t realize you’re going to have to place 25-50 offers per deal that you actually end up flipping!
So even if you place one offer per week, that means you won’t get a deal for almost a year! That’s why I teach you should be making a minimum of 10 offers per month, and even better, an offer a day.
You can’t do that if you’re going to get hung up on your rough estimates. You can finalize the numbers later. If the rough estimates look like you’re going to get a decent profit, place an offer. Later you’ll walk through with a contractor, and if it doesn’t’ pan out, you’re well within your right to still walk away.
Here are the rough numbers I use to estimate rehab:
- Rental – $6 – $14 per square foot – $10 average
- Light – $10 – $18 per square foot – $14 average
- Medium – $19 – $33 per square foot – $26 average
- Heavy – $26-$48 – $37 average
A note on this…if your property is less than 850 square feet, then your estimate will be too low. This is because it’s not that much more expensive to paint a little more, or to have a bit more carpet or whatever. They’re already ordering materials and doing the labor, so it’s a little pricier per square foot to do such a small project.
The reverse is also true. For larger homes (over 2,400 square feet), your rehab bid will likely be overestimated!
For each of my projects, pretty much no matter what, I plan on these projects every time:
- Flooring
- Kitchen
- Bathroom
- Light package
- Door package
- Trim package
- Demolition
- Landscaping
Those are the cheapest repairs that bring the most bang for buck.
Finalizing Your Rehab Bid
When I first started out with real estate investing, I used to get what I call a “paper napkin” bid.
I would meet with a contractor, he’d look over the house, and then he’d write down his bid for the entire rehab in one number, usually on some scrap piece of paper or a napkin or whatever was lying around!
Okay, so it wasn’t literally a napkin, but it might as well have been.
The problem with bids like these (and a HUGE reason newbies fail and never do deals again) is that the contractor can add whatever they want to the price later and you have to pay it!
I’ve had contractors actually tell me that their bid didn’t include a toilet paper holder, the mirror in the bathroom, or grout.
And I’m like seriously? Any sane person would think those would be included when redoing a bathroom. It was so obvious to me that it would be included…but since it wasn’t laid out in the bid, I had to pay what he said.
At that point, I’m so far in, I’m not going to shut the whole thing down for a few hundred bucks here and there. Unfortunately, those “nickel and dimes” add up and pretty soon your profit is dust in the wind.
And even tougher is that a hard money lender has already set aside how much they’re going to lend you for the rehab…and you can’t keep coming back for more! So these extra costs aren’t coming from your loan—they come from your pocket.
So you know what I did?
I started walking around with a tape recorder and had him give me a bid for every…single…thing that needed to be fixed!
Eventually I started using a pen and paper so then I’d only have to check the tape recorder if I forgot to write something down.
Then I would go and type up that super-specific bid with each little project in its own line item and send it to the contractor! Let me tell you a little secret about contractors…they HATE paperwork!
They’d rather be swinging a hammer or knocking over a wall. I realized that if I line itemed everything out and had them just sign it, then I was happy because I had in writing exactly the price things would cost, and he would be happy that he didn’t have to put together a bid.
And of course, both parties do like knowing exactly what the expectations are, even if the contractor acts a bit put out at first for having to price every item.
I make ALL of our borrowers do this exact process. In fact, I have project managers for each borrower re-review ALL the pricing with the contractors so that this stuff is handled as well as possible!
Other Costs
So we’ve talked about rehab costs and the purchase price is already known from the beginning of your deal, so all that’s left are your other costs.
Some of these include:
- Interest
- Origination
- Property Tax
- Inspections
- Title Fees
- Insurance
And more.
I’m not going to get into all of those now because they differ so much with each deal and with each location.
However, you should ABSOLUTELY get all of these prices beforehand from your lender so that you can have as accurate an estimate about your profit as you can possibly get.
Rentals
Now, let’s say you’re doing a BRRR deal (Buy, Rehab, Rent, Refinance). In this case, profit is a little harder to figure out because it’s going to be an ongoing basis.
However, using the calculations I’ve shared with you in this article, you can know how much out of pocket you’re going to be up front. Then, make sure that you have a good idea of what you’re going to be netting each month on your rental.
The easy calculation is Profit = Rental Income – Expenses.
Those expenses include:
- Mortgage payment
- Insurance
- Property management (if applicable)
- Maintenance
- Vacancies
- Legal costs/consultations
Typically, I set aside around 10% of my rental income each month for these types of things.
So, if 90% of your rental income gives you a monthly cash flow number that makes the cost of doing the deal worth it, then great!
Just also remember that rental properties bring you more than monthly cash flow. You also make money on appreciation, tax benefits, and loan paydown. So even if the cash flow isn’t fantastic, it still might be worth to go through with the deal.
Conclusion
I hope this all makes sense so far!
Just remember the most important thing:
Don’t get caught up in your deal and fudge the numbers. Act with cold rationality by evaluating your costs and after repair values without bias. If that deal doesn’t work out, keep an abundance mindset—there will always be another deal that will come along later!
Take care, and good luck with your investing!
Learn how to make money flipping real estate with us by attending our next webinar.
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