During my recent vacation, I had the chance to watch one of those reality shows about flipping real estate. These two partners in Texas bought a house, fixed it up, and then sold the house. The show illustrated that they made $52,000 from the deal. Really? I have yet to see a deal like that in my accounting experience. I have done the accounting for over 45 deals with 7 different business operations. Not a single deal came even close. So I’m going to illustrate for you the truth about this industry, I’ll identify the best deal and the worse. I’ll also calculate the average so that you can truly assess whether or not you want to get involved in this industry.
Business is a risk reward concept. The more risk involved, the more reward earned by the risk taker. There are several risks in this business. At the end of the day, you have to sell the house in order to reap any financial reward, if a reward exists. The current market (2017) indicators are that most homes sit on the market for more than 90 days before closing. The best scenario is to get the house sold as fast as possible, and the only way to do this is for the house to be in tip top shape. In effect, when the potential buyer sees the house, the house is in better or more modern condition than the others they peruse. Naturally, other factors come into play, location, schools, community issues, etc.; all have a bearing on the final decision. So for the house flipper, the only way to have the best opportunity at the sale is for the home to be in better condition than the others on the market. This means a few more dollars out of pocket to get it this way, but also, to maintain the home while the house is on the market.
So, let’s take a look at the best deal that I have seen in accounting during the last 13 years:
Initial Purchase Price of Home $65,000
Closing Costs to Purchase 3,059
Total Initial Purchase Price 68,059
Fix up Costs 22,963
Total Cash Investment 91,022
Contract Price on Sale of Home $128,021 ($21 related to a real estate tax issue)
Closing Costs & Incentives 13,048
Adjusted Sales Price 114,973 (Contract Price less Closing Costs)
Actual Profit $23,951 (Adjusted Sales Price less Cash Investment)
This deal may not look great, but it is a reflection of the dollars earned on the dollars invested. The house took 116 days from start to closing. So the return on the investment equals 82.8% on an annual basis. This was the best dollar for dollar deal out of the 47 deals with the bookkeeping I did. If every deal was like this one, wow, I wouldn’t stay an accountant.
There were some hidden costs, first off there’s the cost of money. Secondly, there are operating costs for the office, transportation, signage, and general accounting (my fees). So although this one looks great, a more realistic return on the investment is closer to 72% or so. I would still take this every day.
But not every deal turned out this way. So let’s take a look at the worse deal in the portfolio:
Initial Purchase Price of Home $105,000
Closing Costs to Purchase 303
Total Initial Purchase Price 105,303
Fix up Costs 46,887
Total Cash Investment 152,190
Contract Price on Sale of Home $158,500
Closing Costs & Incentives 16,022
Adjusted Sales Price 142,478 (Contract Price less Closing Costs)
Actual Profit/(Loss) $(9,712) (Adjusted Sales Price less Cash Investment)
This house took 297 days from start to finish. So the cost of money is not included. Other costs not included were taxes paid during the holding period, operational costs of the house, utilities, community fees, and grass cutting. So a more realistic loss is about $13,000. Total cash out of $152,190 and a loss of $13,000 equates to a 10.5% annual loss on the investment.
This clearly identifies that the downside risk factor is relatively low or minimal. It substantiates the risk component we often hear about in real estate. But here, the case is straight forward because the client used their own money. Had they used somebody else’s money, the percentage loss would be significantly higher, possibly off the charts (only as a percentage issue).
This took some time, but I calculated the overall average for the deals I have in my portfolio of completed transactions. So here is the average:
Initial Purchase Price Average $99,602
Closing Costs Average 5,562
Average Initial Purchase Average 105,164
Average Fix Up Costs 26,094
Total Average Cash Out (Invested) 131,258
Average Contract Price 162,147
Closing Costs Average 16,594
Average Adjusted Sales Price 145,553 (Contract Price Less Closing Costs)
Average Earnings Per House Flipped $14,295 (Adjusted Sales Price Less Cash Out)
The average holding period per home was 131 days. Based on the return on the investment formula, the average return on the investment was 30.34%. This does not include the cost of capital. If you are in a position to be able to borrow funds, assuming a 7% borrowing rate because of the nature of the business, I would estimate the return at 23%.
Although this looks impressive, it really doesn’t add up to becoming a multimillionaire. Allow me to explain. If you borrow money to purchase the homes, then there is usually a deed of trust filed for the property which adds to the closing costs, reducing the overall return. In addition to cost of capital, the costs associated with house maintenance and association issues are not included above. Furthermore, operational costs for transportation, office operations, marketing, etc. are not included in the final bottom line. Assuming that you can turn one house a month, your average annual gross margin would equal 12 * $14,295 or $171,540. With some other assumptions, I can calculate your net income to within $5,000 either way. So here is my math:
Average Annual Gross Margin $171,540 (12 houses * $14,295/ea)
Cost of Capital 39,572 (Carry about 4.3 houses in the portfolio at all times)
Deed Transaction Costs 2,400 ($200 each)
Transportation Costs 8,650 (One truck, fuel, insurance, depreciation, etc)
Office Operations 16,800 (small office rental, utilities, communications)
Marketing 6,000 ($500 per house)
Actual Profit $92,618
Taxes & Licenses 31,490 (Self-Employment, Income Taxes, Revenue Tax, Licenses)
ACTUAL TAKE HOME PAY $61,128 $5,094 PER HOUSE SOLD
So you can see from this simple illustration that the actual value earned by the house flipper per house is not so great after all. The above is based on the average and I have to assume based on the number of deals that this will come true overall for anyone flipping houses. Can you become some multimillionaire? I don’t think so.
So let’s go back to the show that I watched. The two partners bought the house for $88,000 (not too far off from my average), spent $35,000 fixing it up (more than my average), and sold the house for $175,000. So the show claims that they made $52,000 off this deal. You see the show didn’t include the closing costs, if it averages my formula above, then another $22,000 should be subtracted. But since they acted as their own broker, I’ll add back $10,500 for commission savings. So now after closing costs are included, their actual gross margin is $40,500. From this they have to subtract the cost of capital or the loan they received and then office operations. In addition, you have the transportation costs etc. If their costs are similar to what I calculated above, the final net profit from the house will approximate $22,900. I’m pretty confident that this is a more accurate reflection of what that deal did for them.
So is this a good business? Overall I would say it is OK, not the greatest, but the downside risk is minimal. The real core issue is the learning curve for somebody new. I suggest using phase accounting to provide the feedback knowledge. It is possible to do more than 12 houses per year, but most of the clients I dealt with were only capable of 9 to 11 per year. So for someone to process that many homes, you’ll have to work extremely hard to sell 12 houses per year. In addition, this has weekend work involved, working with subcontractors etc. You decide based on your personal situation. But from the information above you can see the real financial truth in flipping houses.
Good luck and send me a note in the comments section below letting me know how you are doing in this industry. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.