Basic Financial Dynamics
The bulk of house flips are valued at less than $200,000. In a good flip, the house is purchased for about 60 cents on the dollar against fair market value and about 12 to 15 cents on the dollar is needed to fix it up and another 3 cents is needed to hold the property in the interim. So in general, a good flip will have no more than 83 cents on the dollar invested. Your best flips are less than 75 cents on the dollar and your poorer performing flips are closer to 93 cents on the dollar.
So let’s do some math for a $185,000 home (the fair market value). In a distressed sale the home is sold to a house flipper for 60 cents on the dollar or $111,000. Closing costs run $1,300. Next the house flipper invests another $27,000 for restoration and renovation work. The project takes four months start to finish which requires an additional $5,100 in operating costs (utilities, taxes, homeowner association fees and interest on the debt). Total investment is $144,400. At closing the house flipper yields $3,400 in allowances and pays $11,100 in real estate broker fees.
Total cost of the project is $158,900 and he gets a check for the difference of $26,100.
For the house flipper he has to have $144,400 in cash to make the deal work. In general, banks do not lend money for flipping real estate. There are exceptions but for the most part; it doesn’t happen. Most house flippers use a combination of their own money and private money. Every one of them wishes they would have access to more capital.
Now I’ve explained the basic financial deal so let’s explore the private investment side of the equation.
Financing the Deal
Both of the clients I had demanded a 1% per month interest payment on any outstanding balance. In the example above, the financier charges $1,444 per month for the loan or any portion of a month for the loan. In a typical flip, the house is held for a period of four months. So in effect the financier would earn $5,776 in interest.
In addition, the financier charges a 1% loan origination fee and requires the closing costs at purchase to be paid by the house flipper out of the fronted proceeds. This eliminates costs for the financier. So in this case, there is an additional $1,444 for the loan.
Now for the best part; both of the lenders required a cut of the profit from the house. One of the guys took 50% of the net while the other took a 7% royalty at closing. Allow me to explain in more detail.
In this scenario, the lending party wanted half of the profit generated. In this case he would receive $13,050 for his 50% of the profit at closing. There were a multitude of problems associated with the arrangement. The house flipper didn’t control his costs of restoration/renovation and therefore over time I noticed the overall profits started to decrease. My gut feeling was that he would load the costs via receipts from other projects into this deal to reduce the profit and basically force the client to cover costs in other projects. The only way to prevent this was to cut all checks from the lender and this was a paperwork nightmare.
The other client used a much better method.
In this arrangement, the lender basically used two numbers. The first is the SALES PRICE not the actual sale value once the deal was complete, but the listed price from the real estate broker. In our example above this is the $185,000 price. The second number is the actual purchase price without any closing costs. Here, the purchase price is $111,000. The difference is assessed a 7% royalty fee at final closing. The fee for this deal was $5,180 [($185,000 – $111,000)*7%]. This kept the deal simple and straightforward. It was impossible for the house flipper to pack extra expenses in the deal. Best part was it didn’t matter how much the house was sold for at the end of the day, the royalty was still the same.
It would appear that the 50% cut formula would be more lucrative but in realty the royalty program was by far simpler and there was no need for verification or monitoring of the house flipper. There were some deals whereby there wasn’t a profit from the sale; so the lender made zero in those cases.
Using the royalty program above, this financier earned $1,444 for the loan origination fee, $5,776 in interest and an additional $5,180 for the royalty. Total income is $12,400 for a $144,400 loan for 4 months. This is a whopping 25.76% return on the investment.
There are a lot of advantages to this relationship.
Advantages of Financing Deals
Naturally your first concern is risk. How do I protect my investment? The best tool is a Deed of Trust with a well written note attached. Deeds of Trust are basic documents but you’ll need to modify the paragraphs addressing notification and process associated with service and foreclosure. Each state is slightly different in what is allowed and good legal assistance in drafting your basic model is required.
The second method to reduce risk is in the process of disbursing funds. The flipper will want the $27,000 of renovation money up front. This is a definite NO-NO. Your note should have a draw process built into the relationship whereby you can monitor the work on the house and set draw points related to releasing funds. This protects your primary asset which is the house as collateral. The following is an example of a draw scheduled used by a client:
- House demo is complete, exterior doors/windows are set with proper locking mechanisms, interior framing completed and passing a County Inspection – 15% of budget
- Electrical, plumbing, HVAC rough-ins completed and inspected; walls up and primed – 20% of budget
- Kitchen cabinets and countertops installed – 25% of budget
- Flooring, tiling, house trimmed out, final painting is completed – 25% of budget
- Appliances installed, yard work completed, final certificate of occupancy issued – 15% of budget
Any cost overruns were the responsibility of the house flipper. At initial purchase closing, the only proceeds advanced were the expected holding costs. Remember, the house flipper pays the interest each month back to the lender which is one of the operating costs involved. The final interest installment is paid at final closing.
The key to the disbursement process is to protect the asset’s value related to the fair market value. Naturally it is impossible to sell a gutted house; the only buyers are other house flippers. This is why disbursements are issued at certain completion points to minimize the downside risk for holding real estate.
Other advantages include:
- You don’t have to find the deal.
- You don’t do the work!
- There is a large market to purchase the collateral in case of default.
- Just sit back and collect the money.
The best part is that all the real risk is on the house flipper. I have recorded over 40 deals – The Financial Truth about Flipping Houses – and discovered the average profit per deal was a mere 10% of the sales price. This is the final net profit not the gross profit you hear so much about on TV and from the house flippers.
As the financing guy you earn $12,400 from the deal, the house flipper earns about $18,500 from the deal. He does all the physical work, the daily inspections and has to carry the insurance. You would merely show up to the site four or five times to inspect progress before issuing additional draws. Your money is guaranteed, the flipper’s money and corresponding profit is all at risk.
Which one is smarter?
The Really Smart Way to Do This
This is all about risk reduction and stress reduction for you as a financier. One of my clients set up an LLC and let a few real estate agents know he had money. The house flippers were calling within a few days (6 in four days called). He sent over the contracts and the process for each of the six to make sure they each understood how this was going to work.
Once the house flipper understood the arrangement the client would forward the following types of contracts and documents:
- A letter of mutual understanding between the house flipper and the LLC
- A Process Agreement identifying required documents and initial forms of information needed and how to e-mail the information to the LLC
- Formula for Financing and Line of Credit draw process
- Required Closing Documents
- Attorney Contact Information
- List of Required Insurance with the LLC listed as coinsured
- Copy of a typical Real Estate Broker agreement and the expected information for each of the required elements
- The Draw Agreement and the corresponding indicators and requirements to receive a draw on the project
When the house flipper discovered a house to buy the flipper would forward an information package to the LLC and explain the expected purchase price, closing costs, restoration budget, expected fair market value and listing price. The address was provided and the links to the county tax assessment were included. My client spent an hour researching the house and the expected sales price. If the standards of cost points were met; he would contract the deal. The contract stipulated the maximum purchase price, budget and corresponding line of credit for the restoration work and the budget for holding the house during restoration.
Once both parties approved an offer was made by the LLC to purchase the home in the LLC’s name. Once purchased the title for the property was held by the LLC which is 100% owned by the financier. The house flipper engages the respective subs and material suppliers to restore the house. At each of the respective draw points, the financier inspected to verify the work is progressing as identified in the budget and draw schedule. Once done he would issue a check to the house flipper. Notice how the value of the home stays with the financier so if at any point the flipper fails to do their job or comply with the contract, the LLC simply throws them off the job site and engages another contractor to finish the house.
At closing, all the money comes into the account of the LLC which simply issues a check to the house flipper for their respective profit. A complete deal cycle and you move onto the next deal.
In general the financier fronted around $450,000 and carried about 3 deals on the books at all times. He spent about 2 hours per day on the paperwork, inspections and communications. After one year, he had earned a little over $132,000 on his $450,000 investment and spent around 500 hours of work with managing the business.
Over time he got much better at this and charged a 9% royalty for house flippers that had less than 5 projects completed with him. Once they completed 5 projects he reduced the royalty to 7%. He was very good at making sure their proceeds were in their hands once the house flipper requested an inspection. He noticed that the only thing that matter to the house flipper was having cash in his hand.
In one deal the house was sold for fair market value but the total costs in the project equaled the fair market value. The house flipper walked away with zero but my client still earned his money on the deal. It did create some jealously from the house flipper but my client reminded him that the risk was strictly his as set forth in all the contracts and documents. 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 services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.