4 Key Things You Need to Consider When Analyzing a House Flip Opportunity
House flipping is relatively simple real estate investing approach to understand. In short, an investor buys a property with the intention of reselling in a short period of time for a profit.
From the time period before the property is purchased until it is sold, you can do a lot to increase investment returns. This includes increasing the eventual sale price by making renovations and repairs, and possibly even adding square footage (“an addition”). You may also seek to minimize costs by making smart material purchases that suit the local buyer-pool’s expectations. Other strategies include finding a balance with sale pricing to achieve close to the maximum the market will bare with as few days on market as possible, and adding a loan to further drive returns on your out-of-pocket investment.
Where things get somewhat complex is determining which investment return metrics should be considered when analyzing an opportunity. Here’s a run-down of the investment return metrics to get acquainted with, and why it doesn’t hurt to consider all of them.
The 4 Key Considerations When Analyzing a House Flip Opportunity
- Net profit: The money in your pocket after the house is sold, lenders are repaid (principal and interest) and the investor’s initial capital contribution is deducted. Net profit is the numerator for the equations used to calculate the following two metrics.
- Return on invested capital (ROI): Net profit divided by the investor’s out-of-pocket cash. This metric is often looked at in two forms: actual and annualized. The actual form is determined by performing the calculation above. The annualized version is determined by dividing the actual form by the number of months a project takes (from acquisition to sale) and multiplying by 12.
- Profit margin: Also known as margin or net margin, the profit margin is the net profit divided by total project costs, which include the property purchase, construction costs, soft costs (architect, engineer, inspections, etc.), loan costs (initial fees and interest) and carrying costs. Some investors like to look at profit margin before factoring in debt, which allows them to get a general idea of the quality of a specific opportunity relative to others before factoring in their cost of capital via lending sources.
- Time: The three metrics mentioned above are neither good nor bad until the hold period for a project (time) is considered. Adding the element of time allows investors to weigh the opportunity cost of tying up capital against the returns a project produces. Converting absolute return metrics to an annualized form (see ROI above) allows investors to easily compare investment alternatives with varying profitability and hold periods.
All of these metrics and data points should be considered, because each sheds light on the same story, just at a different angle.
Here’s a quick example that illustrates the importance of considering time when making investing decisions. Say an investor considers a flip opportunity that provides a 20% return on invested capital, assuming an all-cash purchase (at the “project level” before debt and taxes). At first glance, this deal looks great—the investor has heard that 15-20% returns are excellent for local flippers.
However, upon further analysis, the investor realizes that the project will take 11 months, which is 5 months longer than typical project length for local flippers. That means the annualized return on invested capital is only slightly higher, at 22%, whereas, local flippers are earning closer to 45% annualized. The investor’s only loan options are hard money at 12% interest and 3 points (additional costs equal to 3% of the loan amount), which works out to an effective borrowing rate of close to 14%. After factoring in the loan, the investor’s total returns are low, both in terms of dollar profit and returns on actual invested capital.
Next time, the investor will know that prior to digging into what loans are available, they may want to consider only deals that produce an annualized return of 35-45%, or find a lower cost source of debt and adjust their return hurdle (minimum target).
From our experience, it’s always good to take a sharp look at the whole picture. That’s why we build our financial models to include multiple metrics and various levels of insights. Stay tuned for our house flipping financial model, which will show both actual and annualized metrics (in addition to all of the metrics above) as well as before-tax and after-tax perspectives.
As always, be curious and seek to understand the metrics and data points you might not know—it will make your financial analysis that much stronger.