There are a lot of amateurs these days trying to get in the game. Flipping homes is the “dream” occupation because watching the reality TV programs on Bravo and HGTV make it look like the easiest way to make the big bucks with no downside.
As a realtor who has worked through many up-and-down markets, let me caution you: It’s not as simple as it looks. There are many considerations here. Before spending your money or borrowing against the equity in your home, be well-educated about the many factors that determine your final outcome.
The flipper’s secret is annualized return. Even after figuring your rehab costs, your closing costs, your proposed selling price and the possible rise and decline in the market, the time you are either paying for borrowed capital or tying up your personal invested capital is very important.
If you put out $200,000 in cash and borrow $500,000 at 5 percent interest, planning to finish your project in six months, but it really takes 12 months, your annualized return is cut in half.
If you anticipated a profit of $100,000 in six months, your return on investment declined by 50 percent and is still subject to tax reporting based on ordinary earned income.
Of course, there is no guarantee on any profit, and a loss could turn you bankrupt if you are not otherwise well covered. There is no guarantee that the market will remain stable, and there is always a chance, even if you have strong comparable sales to prove the value of your beautiful, newly remodeled masterpiece, that the market will no longer be as strong of a seller’s market.
There could easily be an increase in interest rates, or an economic hiccup that causes a decrease in activity and an increase in unsold inventory, price reductions and days on the market. Have you factored all these possibilities into your equation?
Remember these unknowns:
1. Will the cost of materials and labor hold, and will the bids you get be reliable?
2. Will unanticipated things come up once you open up walls; ask for city permits; and comply with soil and retaining wall requirements, drainage issues and retrofit nuances?
3. Are you being optimistic or realistic about the time required to obtain city approvals and homeowner association approvals, as well as possible obstructions from neighbors, the coastal commission, neighborhood review boards or natural causes such as rain?
4. Are you factoring declines in sale prices based on previous sales per square foot in case there is a shift in the market?
5. Are you adequately and realistically looking at adjustments for a busy street, a fixer-upper next door, unsightly power lines obstructing a view, high power transformers nearby, a less desirable school district, a home with low ceilings, a poor floor plan or with poor natural light, or a home that lacks a backyard or adequate parking?
6. By the time you are on the market, could there be an oversupply of homes in your price range with a limited number of buyers?
7. If you run short on cash, will you have adequate reserves so you can move forward without needing to scramble for new investors after the fact?
The bottom line: Don’t believe everything you see on TV, and know this is serious business with little room for error. The key is to buy right from the beginning. Be location-conscious. Be realistic about your costs. And make good use of your time. Wasting six months to draw plans and obtain permits could be your kiss of death before you even start.
As you figure your pro forma analysis, keep cost reserves, and always anticipate your cost at 10 percent higher than you project. If it doesn’t pencil out this way, don’t be optimistic and say, “Somehow it will come together.” That’s going to crush your spirit.