For those of you who have been following my blog or podcast for a while, you are probably well aware of the importance I place on being able to properly evaluate properties prior to your purchase. In fact, I would say that this is the single most important (and essential) skill every house flipper must have before starting in this business.
So far I’ve covered some of the basic ways to evaluate properties. And that’s great if you are just getting started. But for you who might want a bit more “meat on the bone” this post is going to cover a bit more. Specifically, our method for evaluating houses and what we are looking for with each one we buy.Everything I do when evaluating a deal (or perhaps I should say everything my team does :-)) is based on the annualized return of the total capital invested for the deal.
Do I worry about the capital cost from the beginning? No. Because that can vary. As you probably know, I’m big into systems, and having every single person we work with contacting us to find out our capital investment plans on each deal prior to them making an offer for us — well, that is just insane!
Besides, the way I look at, I am always going to try to get the best possible price for a house, and I’m also going to always try to get the best financing possible. But in my mind those two things are not really related.
Let me give you an example of what I mean.
Financing your Gas
Let’s say you are buying gas at a gas station and it is right next to another gas station. One is selling gas for $3.00 a gallon and the other is selling gas for $3.25 per gallon. Other than price everything else is EXACTLY the same!
Now, are you ever going to pay $3.25 when you don’t have to? Of course not!
But let’s say you recently got a credit card that offered you 6% interest instead of 13%. Would you think ‘Hey! If I can finance this gas I may as well pay $3.25’? No way! You would take the $3.00 gas and you would take the cheaper financing as well. Right!?
Just like gas, there is a “going rate” for investment properties. The difference is that the price might change based on several factors, some of which are set by yourself. We all have this “going rate” in mind. For me, as an example, the rate adjusts based off of the market, how much cash we have on hand, and if we have private money lenders waiting to invest. It also changes based on supply.This isn’t as much of a factor right now since we are able to take on any deal that makes sense to us, but there have been times in the past where, if I was presented with several deals at a time and I couldn’t afford them all, I would have just gone for the deals that offered the best potential results and passed on the more expensive ones.
Looking for the Return
So, back to the financing side of things. You do, of course, have to have an idea of what you are spending for capital. Its important to take that into account. But if you change the way you evaluate properties for every single deal, based on the financing you have on that particular day, then you are going to have a really tough time scaling your business.
Perhaps if I explain exactly what I do you will have a better understanding of what I’m talking about. 🙂
So, like I said earlier, everything I do is based off of the annualized return of the total capital invested. For example, I’m currently looking for an annualized return of 40% on the total capital invested for a given property. So, if I think we can flip a property in four months (from our purchase to selling to our end buyer) I would look for a return of around 13% to 14% on the total capital invested on that deal.
If you are able to turn the capital in 4 months, and then do that again 2 more times over the course of a year, your annualized return is right around the 40% mark.
For a larger project that might take closer to 6 months we would expect to make closer to 20% because we could only turn that capital 2 times in a year to reach the 40% annualized goal. And to take that one step farther, if we had a one year long project, then we’d seek out 40% on just that single transaction.
So, that is all fine and dandy if it’s just me and my own capital in the deal. What happens when I start working with hard money lenders?
Looking for Leverage
I know that I will be paying my lenders anywhere from 10% to 12%. That 12% annualized works out to 1% per month (1 point x 12 months = 12%) which, on a deal where I hold the property for 4 months, ends up being around 4%. Since you also need to add on another couple points from the hard money lender (usually around 2%) that brings you up to 6% for that 4 month deal. Annualized that 6% for 4 months comes in around 18%.
So, if I’m paying and annualized 12% to 18% on my capital, and I am making about 40% annualized, am I going to be okay? You betcha!
And even if I do a 50/50 equity split with my investor, I’m still going to be just fine.
If we hit our target of 40% annualized on the entire deal, then we would both get 20% annualized return on the total capital invested in the deal.At first you might think “That’s great. You’re making 20% on your capital“, but since in this situation I’m working with a lender, I’m actually making 20% on their capital. If that is the case, then what is the return on my own capital?
Well, actually it is infinite.
The less of my own capital I have invested in the deal, the higher my returns are! I’m essentially getting paid for my time and expertise, which is what makes this a HUGE win-win. The lender wins because they don’t have to know or do much of anything. And it’s a win for me because I’m making money without investing much (if any) of my own capital.
Finding the Offer Number
So, how do we actually come up with this offer number?
Well, I am somewhat embarrassed to say that I whenever I have tried to show people how I calculate it I have bombed miserably! It turns out I just have this strange way of coming up with the offer price (or maximum offer price), but when my brother Derrick was working for me he created a nifty spreadsheet calculator that works really good to figure this out.
And since I think you guys are so awesome, I’m just going to give this calculator to you for free. Just click on this link to download the file:
What it basically boils down to is this:
Take your total purchase price (or offer price) and add repairs and any holding costs (taxes, insurance, utilities, etc.,) and your end goal is to make 13% on the total capital invested (assuming you think you can turn this deal in 4 months or less). Please note that this percentage is not based on the end sales price, but on what you have put into the property before you close.
So, for example, if you purchase a property for $175,000 and your total expenses, including rehab and holding costs, are projected to be $25,000, then $200,000 is the total cash invested for that project. If you are shooting for a 13% return in less than 4 months, then you are aiming to make $26,000 (not including the cost of capital).
If all goes according to plan your share of that profit would never be less than $13,000 (assuming you never pay more than 20% annualized of 50% of total profit). If you were paying 12% to a private money lender, then they would get $8,000 out of that total profit and yours would be closer to $18,000. If you are paying a hard money lender, then add an additional $4,000 to cover their fees (around 2%) for a total of $14,000 profit.
Really, in any scenario, you are doing pretty good. Just make sure you know your values, repair estimates and the costs involved.
Now, like I mentioned before, I am currently shooting for about 40% annualized in today’s market. But there were times in the past when this was closer to 50%.
That was for a couple reasons.
Part of it had to do with the market, and part of it had to do with the fact that I could get deals like that. Another factor was that I didn’t have as much of my own capital to put in to deals so I didn’t want to spend more for a house and then not be able to buy one the next day. 🙂
If the market starts to decline, then you may want to adjust and plan on potential depreciation. I will also increase the margin if I’m buying a house that I think is a higher risk. Higher risk could be something that is really old, a deal that is lacking super solid comps, the days to market are a little longer, or for whatever reason the buyer pool might not be as strong.On the “flip side”, if I do happen to come across a fairly new property that only needs some cosmetic repairs like new carpet and paint, and the property is in very high demand and looks flippable in 3 months or less, I may push those numbers just a bit because my risk is much less and, with faster turn around, my annualized return will probably be higher.
Hopefully I haven’t confused you more than I’ve helped you! But I will tell you one thing for sure: once you begin to understand the “velocity of money” and returns, it will completely change the way you look at investing.
Once you realize you can make 20% annualized return on almost any capital you are able to raise, this game starts to get a WHOLE lot of fun! 🙂
Need Help with House Flipping?
This sort of information can be a little overwhelming or confusing if you are just getting in to House Flipping. Lately I’ve been getting a lot of emails and messages asking if I can help with real estate investing and in response I’ve decided to start a group for those who would like a bit of assistance and accountability with their house flipping endeavors.
If you have been keeping up with our posts, podcasts and newsletters, you probably know by now that I am going to be starting a House Flipping Mastermind group in February. To help explain what this all means, I will be having a free webinar next week to share the reason I wanted to create this mastermind group.
I’ll also share some information about the house flipping process, but ultimately this all boils down to my desire to help people develop the education, skills and social accountability necessary to take action and move their businesses forward.
If you would like to get details on the webinar or mastermind, then please click here to enter in your name and email. It would be fantastic to see you there!