Minimum Bottom Line Profit Should Be > 7%!
After Income Taxes Are Paid!
With a typical business operation, turning the inventory over as often as possible has several benefits. First, it generally reduces overall costs, secondly, it generates greater profits and third, by increasing the profitability, the company has a greater return on equity. As a basic business principle, this seems all well and good, but does turning the inventory over in the house flipping business as fast as possible generate the same benefits?
Immediately, every reader will say, well yes, it should. I’m going to say, NO. Here is why:
First, this particular industry isn’t about increasing the speed of selling product. This isn’t production and sale of a homogeneous product like consumer goods. There isn’t a large market of buyers with very little price differential like in selling gasoline. Face it, you can indeed sell the real estate faster, but you pay a significant price to reduce the selling time period by 30 days and a huge price reduction to sell it 60 days sooner. The buyers are trying to find a product that can meet their particular needs.
Secondly, the cost to get the product to market increases per unit at a much faster rate than standard homogeneous products or services. You and I both know that if you expedite the renovation process, the subcontractors charge more money per function because of the emergency request.
Finally, the time value of money is relatively inexpensive in comparison to the cost and losses associated with a rushed sale. I’ve seen this all too often. Sellers reduce the price $10,000 in order to save 30 days of time. In your typical house flip, the cost of money for 30 days runs around $1,500 to $1,750. Thus, you are willing to forego $10,000 when waiting will earn you $8,250 more (additional sales value less cost of capital).
Business is about maximizing profits. Sometimes, a little more capital investment and lower turnover rates generate significantly improved bottom line differences. This article is going to explain this business discipline and illustrate via a mathematical presentation why it is better to manage the turnover rate than to just accelerate the process.
Set the Conditions
It is difficult to compare one house flipper to another as each has different markets, flip various size and value in homes, and have different business acumen. To make this work, I am going to use a basic set of common variables to work with. So here we go:
- The fair market value of the home is $200,000; it is a 3 bedroom, 2 full baths, 1500 square feet w/a garage and decent sized lot. There is a shed out back for lawn tools and storage.
- Normal market conditions dictate a 90 day market period from date of listing to date of contract signature; an additional 30 days exists to close on the house.
- The purchase price is $100,000 and renovations are $50,000; closing costs run $15,000; so our gross profit is $35,000.
- The project is capitalized via two sources; first is a private mortgage lender who loans $100,000 at a 1% per month fee and a 5% share of gross profit off the house. The remaining balance is funded as a personal capital investment by you for $50,000. The closing costs are paid out of proceeds from the sale.
- The normal turnover time period is 120 days, 60 for renovation and 60 to sell and close. Therefore, to sell the home and close in 60 days, you discount the price 4% to $192,000.
- In order to do this full time, you do this exact same project 9 times a year.
- Your overhead costs are $15,500 (transportation, communication, technology, general business insurance, professional fees, office supplies); you operate out of your home.
Now let’s look at this from the financial statement point of view:
Sales (9 units at $192,000/ea) $1,728,000
Closing Costs ($15,000/ea)(Note ‘B’) (135,000)
Adjusted Sales Volume 1,593,000
Purchase Price 900,000
Renovation Costs ($50,000/ea) 450,000
Gross Profit 243,000
Costs of Capital Interest (Note ‘A’) 36,000
Costs of Capital Profit Sharing at 5% 12,150 ($243,000*.05)
Adjusted Gross Profit to House Flipper 194,850
Net Profit to House Flipper $179,350
With a 120 day turnover period, the house flipper needs to have an investment of $150,000 of his money to turn 9 projects per year. This is calculated as follows: 9 projects per year at $50,000 each divided by a factor of 3 (120 days is 1/3 of a year).
(A) To process 9 units per year, the house flipper needs $300,000 borrowed at all times to work 3 houses in various points of construction. If turnover time is 120 days, then $100,000 will cover 3 projects per year. To complete 9 projects a factor of 3 is applied. Since the holding period per project is 120 days, then 4 months of interest is required at 1% per month; total of $4,000 per project. For 9 projects, the house flipper will expend $36,000 which is $3,000 per month for 12 months.
(B) Closing costs include the use of a real estate broker, legal fees, and allowances to the buyer
Seems reasonable overall, would you agree? Now let’s change the turnover rate to a longer time period of 6 months. The additional 60 days allows for more renovation time and a longer selling period.
Longer Turnover Rate (180 Days)
The conditions are the same as above except that you have a lower turnover rate (longer time period) and you get some benefits from this. Here are the new modified conditions:
- Because you have more time to renovate the house, you get better prices from your subcontractors. This saves you 4% overall on $50,000 which equates to $2,000 per house. I can easily defend a 7 to 9% savings, but I’m going to be conservative here and use a 4% savings.
- Since the house is on the market for 60 days longer, you should get fair market value for the home and easily get a contract for $200,000 each. I would actually argue that you could list the house for $205,000 since your house will be in pristine condition, but again, I’ll stick to the FMV as identified above.
To compare apples to apples, now let’s look at the annual financial profit and loss with 9 homes sold:
Sales (9 units at $200,000/ea) $1,800,000
Closing Costs ($15,000/ea) (135,000)
Adjusted Sales Volume 1,665,000
Purchase Price 900,000
Renovation Costs ($48,000/ea)(Note ‘A’) 432,000
Additional Holding Costs (Note ‘B’) 8,100
Gross Profit 324,900
Costs of Capital Interest (Note ‘C’) 54,000
Costs of Capital Profit Sharing at 5% 16,245
Adjusted Gross Profit to House Flipper 254,655
Net Profit to House Flipper $239,155
(A) Remember, you get a 4% savings because you have more time to better negotiate and reduce your price with your subcontractors; in addition you take advantage of sales for certain flooring and appliances.
(B) Because of the additional 60 days involved, your costs of carrying the property increases related to additional utilities, property taxes and lawn maintenance; I estimate $450 per month. Therefore, 9 projects times $450 times 2 months each equals $8,100.
(C) The extended capital period requires $2,000 more per project for a total of $18,000; therefore total costs of interest is $54,000 ($36,000 plus $18,000)
Notice that you make $59,805 more than the higher turnover rate of 120 days. Amazing if you ask me, this goes against the higher turnover rate advocated by every business entrepreneur out there! How is this possible?
- More time allows for a better sales price on the house
- More time reduces the costs of renovations because you can negotiate from a position of power instead of demanding speed with the subs
What is wrong here? Well, there is a trick to this. You as the house flipper have to have more capital invested because the houses sit in your inventory for a longer period of time. How much more? With the shorter turnover period of 120 days, you needed $150,000 of capital invested($50,000 per house) because you carried 3 houses at any given moment. In this longer turnover period, you will have to carry 4.5 houses on average at all times. This means an additional $75,000 of capital on your behalf.
Think about this for a moment, an additional $75,000 of additional capital allows you to earn an additional $59,805 per year in income. That’s a whopping 79.74% return on your investment! This is a no brainer folks.
In summation, a longer turnover period i.e. lower turnover rate in this industry actually MAKES YOU MORE MONEY! It does require a higher capital investment though. But it is well worth the investment. Now this doesn’t mean you can go out there and extend the turnover period even longer because there are some drawbacks to an extended turnover period. As you go beyond a reasonable time period, you have to have even more capital and you get less net profit because the costs of capital and holding costs creep into and take away profit. So there is a reasonable turnover rate and honestly, 180 days is reasonable. None of this is going to do you any good unless you manage the projects well and sell the house at fair market value. Act on Knowledge.