The Flip Formula


17 comments

I’ve had countless newbie investors ask me how I decide whether or not to take on a flip project. For the most part, what they’re asking is, “How do you know if (financially) the numbers work out in your favor?”

Most investors have some quantitative analysis technique for determining whether to pursue a project or not. Some use analysis techniques that require spreadsheets and/or complex formulas; other don’t use any formulas, but just go off a gut feeling they may have for the property or the location. While I’m certainly not a fan of the “gut feeling” method, I’m also not a huge fan of the complex analysis method either. While this may surprise some people (especially those that know my tendency to sit in front of large spreadsheets for hours on end), one of the main goals of my financial analysis is to be able to do it in my head in less than 10 seconds while standing in the property I’m considering.

Certainly the whole analysis can’t be done in 10 seconds, but most of it can be. The goal of my analysis is to determine what’s the highest price I can pay for a property and still make my desired profit. If I can purchase the property for that amount (or less!), I’ll take the deal. If not, I’ll pass.

So, what’s my formula for the maximum purchase price (MPP) of a flip property? Here it is:

MPP = Sales Price – Fixed Costs – Desired Profit – Rehab Costs, where

Sales Price equals the conservative estimate of what I can sell the property for (not necessarily the price I’ll list it for!).

Fixed Costs equal all the costs, fees, and commissions that I can expect to pay during the project.

Desired Profit is the minimum amount of money I want to make off the project when it’s complete.

Rehab Costs are the material and labor costs required to rehab the property into resale condition.

As an example, let's say that I have a property I'm considering purchasing. I believe I can easily resell it in rehabbed condition for $100,000. Additionally, I know my fixed costs to be about $17,000 (see here for my personal breakdown of fixed costs), my desired minimum profit is $15,000, and I've estimated the rehab costs to be about $18,000.

In this case (this is the actual analysis from The Red Garage House, btw), my maximum purchase price is:

MPP = $100,000 - $17,000 - $15,000 - $18,000

MPP = $50,000

So, if I can purchase this property for $50K or less, I'll jump on the deal.

In the actual case of The Red Garage House, I purchased the property for $45,000, making it a deal I was very happy to pursue. In fact, see here for the full financial details and results of this project...I ultimately was able to purchase the property for $45K, rehab it on budget, keep my holding costs down, and sell it for $105K -- I made over $28K in profit on this rehab.

Btw, a very important -- and too often overlooked -- aspect of this type of financial analysis is understanding your fixed costs per project. In this article I discuss fixed costs and how to determine yours.






{ 17 comments… read them below or add one }

1 David, Real Estate Visionary August 5, 2010 at 12:23 pm

Very similar to MAO – Maximum allowable offer = ARV (After Repair Value) X70% minus repairs.

2 J Scott August 5, 2010 at 5:13 pm

Hey David -

For properties in the $150-400K range, The Flip Formula will generally return about the same number as the “70% Rule”, like you said.

But, for lower-end properties and higher-end properties where the fixed costs are disproportionate to the sales price, you run the risk of ending up with too little profit if you go by the 70% Rule.

Plus, The Flip Formula will provide results that are more accurate without too much more effort. But, I agree that the 70% Rule is a good first approximation as well.

3 GB October 14, 2012 at 9:45 pm

J Scott,
Are you factoring your personal time on site in the labor cost and if yes, how much per hour? Also, I recently retired with a chunk of money that sits in the Bank at basically “0″ interest, so – why not use it to do the whole deal and avoid the schmoozing and fees and interest? I am assuming I can FLIP it in good time and not get stuck without cash for the next deal, but – if its rentable the return should be 5% plus some tax shelter to bolster the return to 6%. Your thoughts?

4 J Scott October 15, 2012 at 9:41 am

GB -

I have a full-time project manager who handles all the day-to-day issues of the rehab, so I generally spend very little time at any property. In fact, I probably only see a property two or three times before it’s renovated and ready to be put on the market. Because my project manager is a full-time employee (as opposed to a contractor), his salary is expensed as business overhead as opposed to being included in the labor cost for the project.

As for how I pay for projects, I generally pay all-cash and rarely get loans these days. I like to assume worst-case situation, so I’ll factor loan costs into the first-pass analysis, but in the end, I generally save a few thousand dollars by paying cash and not borrowing.

5 Deb December 18, 2012 at 4:55 pm

Hi there,

Can you please tell me what your PM’s job scope is and what you pay him salary wise? Why did you decide to put him on payroll as opposed to contracting him out? Have you ever use a fund control to handle your projects? Last question – who are the employees you have on payroll? Trying to scale but don’t want any unnecessary overhead and would sure appreciate your feedback!

6 J Scott December 18, 2012 at 6:41 pm

Hi Deb,

My PM makes a monthly salary and then gets a percentage of the profits on each project. The monthly salary evens out his cash flow, and the percentage of the profits ensures that our interests are aligned (we’re both interested in maximizing profit). If you want more details, feel free to send me a private email and I’m happy to give more detail…just don’t want to post information publicly about how much my employees make.

The reason he is an employee vs a contractor is that the scope of his job requires him to be an employee per IRS regulation. I control his tasks, I define his hours, I provide his tools, he doesn’t do work for anyone else, etc — these are all things that indicate he is an employee and not an independent contractor. Besides my wife and myself (the company owners), our PM is our only employee.

Not sure what “fund control” is…can you elaborate?

7 Jason March 12, 2013 at 12:33 pm

Hello,

I have zero experience flipping, but am debating weather or not to get into it (we are in Maryland). I have approximately $50K in cash and access to a $200K credit line (as my house is paid off) and we are thinking about flipping properties with a final Sales Price in the neighborhood of $100K to $175K My question has to do with your statement that the Desired Profit is “the minimum amount of money I want to make off the project when it’s complete”. How you determine that minimum amount of money you want to make? This seems fairly arbitrary to me. The 70% rule seems like a straightforward way to easily come up with an offer price (if your rehab estimates are somewhat close to reality). For starters, should I use the 70% rule (or maybe 80% rule) and go from there, because I have no earthly clue how to decide what “I want to make” (other than “as much as I possibly can”).

Thanks so much,

Jason

8 J Scott March 12, 2013 at 4:31 pm

Hi Jason,

Yes, profit targets are pretty arbitrary, but you have to ask yourself what your time is worth and how much you want to earn on your investment. Many investors are looking to make about 15-20% return on a typical rehab project. So, let’s say you buy a property for $100K, put $50K into rehab, have $20K in fixed costs and then resell for $200K — your profit is $30K ($200K – $50K – $20K). If your total investment was $160K (purchase plus rehab plus about half of the fixed costs), your return on investment is:

$30K / $160K = 18.75%

Btw, the reason I only count about half the fixed costs in the investment is that about half the fixed costs are part of the sale and don’t actually come out of your pocket.

Also, some people will calculate their return based off the sale price, not the investment amount. In this case, your “return” would be:

$30K / $200K = 15%

So, for a lot of investors, this would be a reasonable deal. But, you need to decide what’s right for you, for your risk tolerance and for your time.

9 Jason March 15, 2013 at 8:48 am

Okay, that makes sense to me.

Thanks so much for your time,

Jason

10 Ryan m April 15, 2013 at 2:46 pm

Hey Jason
My dad and I are looking to do some flipping. I wanted to know if you hire a real estate agent or if you sell by yourself. If you do hire a agent how do you determine who you choose because I’ve been doing research for agents around my area and don’t know how to decide on who to choose because most of them are expierneced. Also my last question would having friends and family be much easier to have help to keep costs down?

11 J Scott April 15, 2013 at 3:08 pm

Hey Ryan,

In Atlanta, we list our own houses because we know the market better than 99% of the agents and my wife knows most of the buyers agents in the area. In other markets where we flip, we have an agent who lists for us, because we don’t know the area nearly as well, and we don’t have the network. Whether you should do it yourself or not should come down to whether you think you can do a better job than a great listing agent (or not).

12 Jeffrey June 7, 2013 at 1:12 pm

Hello Jason

At what point do you market your flips?
Do you ever market early?

Thanks Jeffrey

13 J Scott June 7, 2013 at 1:26 pm

Hi Jeffrey,

We VERY RARELY ever market before the house is completely renovated, cleaned and staged. The exceptions are when we know the buyer’s agent very well (and he assures us his clients can see past the construction) or when there’s only one opportunity to win over a potential buyer before he moves onto another deal. Even in those cases, we’re very skeptical about showing early.

Remember, you only get one chance to make a first impression, and MOST buyers won’t be able to imagine what a finished product will look like if the product isn’t already finished.

14 Justin December 16, 2013 at 10:11 am

Question Mr. Scott, if the house value is on the lower end, 50-80k, possible duplexes 1800-2000sqft, what is a good ARV since 70% is too high for low end?
Also I saw on your site that some of your flips are being rented out, how long do you wait before making the decision to rent/hold? Do you do 6, 12, or 18 month leases?
Btw, great blog, almost finished the education page, will be moving to the blog. This should be an HGTV show

15 J Scott December 16, 2013 at 3:20 pm

Justin -

I don’t quite understand your question about the duplexes. You say that the house value is $50-80K and then ask what a good ARV is. House value and ARV are the same if the property is in good condition. Perhaps you can clarify what information you’re looking for?

As for renting, we’ve only ever rented two properties — the very first property we rehabbed (which was a mistake) and a current property that we have a project manager living in (just because our project manager needed a place to live). Typically, we don’t like renting out properties, especially after a full rehab. I’ve rather lose a little bit of money on a project than rent it out and have to do another rehab after the tenants move out.

16 birke December 21, 2013 at 3:59 am

JS
Found a house on Zillow for 50k sold by an agent. It’s estimated at 118k if it was in good condition. From the pictures it doesn’t look too bad. It’s in a great neighborhood and I’ve found comps that sold recently for about 110k. I have absolutely no money and no credit. I have no experience. I’ve never owned a home. It looks like a deal that could possibly be flipped/assigned/wholesaled to a contractor/investor. I’m trying to figure out if i should jump in. Should I first look for investors to flip the house to? Do you do any wholesaling?

Thanks

17 J Scott December 21, 2013 at 2:57 pm

birke -

Before you do anything, you’ll want to accurately determine the ARV (resale value) and the estimated rehab costs. Sound like you have a reasonable idea of the ARV, but without a good estimate for the rehab costs (to get it to that ARV), it’s impossible to know if it’s a deal. If you can’t do the estimate yourself, you’ll want to visit the property, put together a scope of work and then get at least one contractor to give you an estimate for the rehab. Once you have those numbers, you can plug them into the Flip Formula to determine if $50K is a good price or not.

For more information, I discuss the entire process — beginning to end — in my books…

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