Picking a rehab property is only the first step in the fix-and-flip process. If your goal is to generate a reasonable profit, rehabbers must also accurately gauge the property’s “After Repaired Value” (ARV) and the cost of needed repairs. Before making an offer on a property, rehabbers should already know ARV and repair costs since working backward from these numbers establishes the maximum price the rehabber can pay for the property that also ensures an adequate return on investment.
The three steps for pricing a fix-and-flip property are: 1) calculate ARV; 2) estimate repair costs; and 3) use these numbers to determine an appropriate offer price.
Step 1: Calculate ARV
Calculating the price home buyers will be willing to pay is the starting point of any fix-and-flip project. Without knowing ARV, there’s no way to determine if the financial risks associated with the project are even worth undertaking.
The ARV calculation starts by analyzing sales data for comparable properties (Comps). Comps are homes similar to the rehab property located in the same general area. Rehabbers working with a realtor have access to comps data through the Multiple Listing Service (MLS), which provides detailed descriptions of listed or recently sold homes. There are also free web sites such as Zillow and Trulia that provide online access to home sales data.
Comp data should focus on recently sold homes, not listings. This is because ARV should reflect actual sale prices, not the wishful thinking of homeowners marketing a property. Comp data should also look at similar properties; if your rehab property is a single-story ranch, for example, comps on two-story brick homes are not useful. The properties analyzed for comparison purposes should be comparable in size, age and square footage to the rehab property and have the same number of bedrooms/bathrooms. ARV should also take into account features unique to the rehab property such as in-ground swimming pools, oversized lots and other amenities that appeal to potential buyers.
The comp data should be recent (i.e. no more than 90 to 120 days old). Real estate values can change rapidly and using outdated comp data to derive ARV can result in significantly underpricing or overpricing a property. Another caveat is that comps should come from homes in the same neighborhood. School districts and commute times can have a big impact on home prices so comps from nearby properties should be weighted more heavily than data from distant neighborhoods.
If the initial search doesn’t yield a sufficient number of comparable properties, rehabbers can always expand the internet search to include home listings and pending sales. Keep in mind, however, that listed or pending prices often differ significantly from actual sales prices.
Step 2: Calculate Renovation Costs
The next step is to correctly estimate repair costs. Upgrades can range from simple cosmetic improvements such as new paint and carpeting to structural work. The most risky investments are usually properties requiring major structural repairs since these fixes are not only costly, but also invisible to home buyers. Upgrading kitchens or bathrooms can be smart investments, but rehabbers should heed the warning of the National Association of Home Builders, which cautions against remodeling investments that raise the asking price more than 15% above the median price of surrounding homes.
Many rehabbers use a budget repair sheet to estimate renovation costs. This spreadsheet tracks needed repairs in the different areas of the house. Rehabbers lacking construction experience may want to walk through the property with a general contractor, who can help estimate repair costs and assist in hiring skilled subcontractors to do the actual building, painting, plumbing and electrical work.
Step 3: Calculate Financing, Closing and Other Expenses
The third step in the process is to estimate financing costs, closing costs and monthly expenses for holding the property. Financing costs vary, depending on the lender, prevailing interest rates and the borrower’s creditworthiness, but most rehabbers should expect to pay 11-12% interest on their loan, plus another 2-3% in points and upfront fees.
Commissions and closing costs are usually paid by the seller, although there will be commission costs if the rehabber is working with a buyer’s agent. Those selling a property through a realtor can expect to pay a 5-6% commission on the sale. Closing costs, which typically include attorney’s fees, title and escrow costs, generally amount to 1-2% of the sale price.
An expense item frequently overlooked by rehabbers that can add up quickly is property carrying costs. These will include utilities, insurance, yard maintenance and property taxes. Depending on the type of property, rehabbers may also be on the hook for Home Owner’s Association or Condo fees.
The best way to control carrying expenses is to create a work schedule and make sure you’re your subcontractors stick to it. A subcontractor falling behind by a few days can create a cascade effect that delays the project by weeks and increases holding costs exponentially.
Once ARV, renovation, and financing/closing/holding costs are known, an offer price can be calculated that incorporates the rehabber’s targeted return on investment.
A simple formula for calculating offer price is:
Minus Renovation, Financing, Closing and Holding Costs
Minus Profit Target
Equals Offer Price
So, for example, if the property ARV is $210,000, repair costs are estimated at $30,000, closing, financing and holding costs will be $15,000 and the profit target is 12% of ARV ($25,200), the calculation is:
$210,000 – ($30,000 + $15,000 + $25,200) = $139,800
The maximum price offered for the property should be $139,800.
Rehabbers usually calculate target return on investment as a percentage of ARV. A 10% to 15% profit margin target is typical for most rehab projects.