Almost every house flipper out there will tell you that they are in the business of real estate. I disagree. You are actually in the business of construction. How can I say this? Well let’s compare the two industries. In real estate, you are either involved in the selling of someone else’s land or you are a landlord. If you are acting as an agent for someone – YOU DO NOT OWN THE PROPERTY. You are merely acting on behalf of the owner. As a landlord, you do own the property. But, your financial position is to hold the property for an extended period of time and receive rents for use of the property.
In new home construction, a contractor takes on a project with the goal of turning materials and labor into a home that is sold to a customer. There are generally two types of contractors. The first is the traditional image of a contractor building a home based on a signed contract, i.e. there is no selling involved. The second type of a contractor builds what is referred to as a ‘SPEC’ house. With a spec house, the contractor is building a home with maximum appeal to the widest audience. They engage an agent to conduct the sale.
Of the four types of businesses I described above, which one most closely resembles a house flipper? Let’s see:
- Real Estate Broker/Agent – nope, in house flipping, the business (owner) owns the real estate
- Landlord – nope, the goal is to sell the real estate not have a tenant
- New Home Contractor – nope, not a new house and no up-front signed contract with a buyer
- Spec House Builder – this is the closest to what a house flipper is, except he isn’t building a new home, he is fully restoring or remodeling an existing house.
So, based on this, a house flipper is closer to being a contractor than a real estate agent or landlord.
Using this understanding, then the same business dynamics of spec house builders should be used to flip a house. So let’s explore the spec house builder’s business dynamics.
Buy Right, Not Necessarily Low
In spec house construction, the contractor’s goal is to maximize value and generate the widest appeal to potential buyers. He does this by purchasing a lot that immediately generates several of the positive attributes for potential buyers including:
- Good Schools
- Easy Access to Primary Travel Routes
- Proximity to Shopping and Services (Medical, Transportation Repair, Salon, Restaurants)
- Safe Neighborhood
- Neighborhood Amenities (community recreation facilities, pool, children activities)
By associating with these positive attributes, a minor issue in construction or inconvenient floor plan can be tolerated by a buyer in exchange for these benefits. These types of positive attributes can bring upwards of $10,000 in an additional sales contract price at time of sale. When people are looking for a home, this is how they start especially those families with young children.
The second attribute of a spec house builder is determining the best floor plan. Traditional layouts work well and are more inclusive to potential buyers than your modern or unorthodox floor plans. As with real estate sales, proper bedroom and bathroom combinations bring the most potential buyers. The spec house builder rarely has less than 3 bedrooms and 2 full baths. It just makes sense to stick with what works and sells. Too many bathrooms and the cost of renovation or remodeling can be prohibitive. So stick with what works – three or four bedrooms and at least 2 full baths.
A whole article can be written related to the proper purchasing process. But for the sake of staying focused on the business dynamics of how spec house construction works, let’s assume you purchased a house that fulfills the above attributes. In addition, you purchased at the appropriate discount and negotiated fairly for the following attributes:
- House Floor Plan
- Lot Dimensions and Footprint
- Age of Home
- Structural Integrity – never buy without having inspected the property
- Exterior Amenities (garage, shed, storage, deck/patio, driveway materials, walkways, fencing, landscape, foliage)
Notice I didn’t include interior amenities. This is because most likely these will be updated to increase the appeal to potential buyers. So never pay for something you are not going to retain.
In the overall scheme of things, it is worth paying a few thousand dollars more to produce the maximum appeal to potential buyers. So what is an appropriate spread between the buy and sell price? Here are a few rules of thumb:
- Never pay more than 65% of the tax records value; if more, let it go. There will be others!
- If the house is more than 25 years of age, decrease the price by 15% automatically. The reason for this is because the construction materials used then are no longer available or have changed significantly in quality or form. For example, windows are made completely different today than 25 years ago. Many replacements are not the same size. The same goes with bathroom fixtures, kitchen cabinets, plumbing and electrical wiring.
- If you live in a high specific humidity zone such as the Southeastern US, discount the home at least 5% more to account for moisture and pest control issues.
- If the mechanical system including ductwork is more than 15 years old, expect to replace the entire system. For most homes that are less than 2000 square feet, you are looking at $14,000 to $17,000 of costs.
Overall, the lowest risk for the house flipper is purchasing the home for less than 50% of tax record value. For every 10 years of age in excess of 25 years of age, adjust the maximum percentage downward 7%. So for example, if the house is 34 years old, then the lowest risk percentage is 43% of tax record value. Basically, try to buy the house for the value of the land and the studs in the house.
For every experienced and sophisticated house flipper, there are one to two new entries in this business. The new entries just want to make a deal so they can have a chance at making money. The more experienced flippers hope you overpay because you will not be here next year. Besides, for the experienced guys it is OK, there are plenty of opportunities to go around.
Now back to the spec house builder. The contractor keeps it simple and cost effective to bring him the maximum profit. So how does the spec house builder do this? He uses several tools to maximize value during construction.
There are no tricks. Simple straight forward rules, PLAN AHEAD! I’ve never seen a real estimate worksheet from a house flipper related to his project. OK, I saw one guy with 10 lines of group costs. This included a kitchen estimate, bathroom estimate, painting, flooring and so on. I don’t even think it qualified as 2nd grade math.
This is inadequate for true success. You need a real estimate worksheet. I plan to have one available here (by May 15th 2015) on the website in pdf format for free and in a spreadsheet format for $1.99. There are several reasons why you need this document. First and foremost, it identifies where you go wrong and what you do right. Secondly, the estimate acts as a budget for the project. If you miss-estimate, make notes in your estimate worksheet as to why. This benefits you in the future.
Next, implement cost accounting in your accounting software. I have written several articles on how to do this in the construction industry standards section of this site. The following are the three primary articles to fully implement a good accounting process for contractors:
- Implement Cost Accounting in Construction – File Structure
- Implement Cost Accounting in Construction – Document Flow System
- Implement Cost Accounting in Construction – Processing Documents
When data is entered into the accounting software and assigned to the respective project, it is assigned a phase group similar to the groups in the estimate. Now you can compare actual against the estimated amount. If the discrepancy is significant, you can pull the accounting detail and see the one or two items that generated the difference. This is referred to as the feedback loop method used in business. Basically you learn from your mistakes or experience to make continuous improvements.
If you desire to learn more than read the following construction articles:
Now let’s talk about maximizing value. The planning part allows you to generate an initial overall cost to complete this project. With this information you can get an idea of the final margin from the project. Naturally you want to generate the maximum number of dollars of profit. But I caution you here. Sometimes it is wiser to spend a few more dollars to increase the appeal and reduce the selling time frame. In general, it will cost around $1,500 to $2,000 per month to hold a project during the sales period. So if you know that spending another $700 or $1,000 broadens the appeal and increases the marketability of the home; it is a wise idea to take that step.
Other methods to increase value include spending some money to increase the value of the home. As an example, my understanding is that more bedrooms add more value. Effectively, a bedroom has the least amount of costs because there are NO costs associated with plumbing, additional electrical wiring, installation of fixtures or more expensive flooring (carpet is generally the least expensive flooring material). Effectively, bedrooms are the best dollar expenditure against value derivative.
Now that you have maximized the opportunity, it is time to sell.
Take advantage of your great work. Think about it for just a moment. If your house is in immaculate condition, ready to move in, and has all the positive attributes as discussed above; it means that no other house is going to come close. Basically you have the best house on the market. I guarantee you that every woman that sees it will buckle at their knees. You know how this works; they’ll be begging their husbands to purchase your house over any other even if it is $10,000 higher. So, make the price $10,000 higher. You earned the right.
Remember what business is about, buy low, sell high. You did the work, reap the benefit. Even if it takes an extra 30 days to sell, the additional value is well worth the time value of money. I have another article on this site that explains this business principle in regard to flipping real estate: House Flipping – Proper Inventory Turnover Rate.
Summary – Flipping Houses Business Dynamics
In the overall scheme of things, you are in business for the long haul. Flipping real estate is not in the real estate industry, it is actually more like a ‘Spec House’ builder than any other business. So take advantage of the construction industry standards and set up your house flipping operation to provide a continuous information feedback loop to continuously increase profitability with each house flip. Learn from the information on how to buy potential projects in the better neighborhoods, buy at the appropriate price; maximize value by using estimates and complying with industry standards. Finally, sell the house at maximum price. By doing each of these steps, you’ll end up earning the most amount of profit over the long haul. These are the business dynamics of flipping real estate. 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. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.