Get the Numbers Right
The most common mistake I see new real estate investors make is miscalculating costs, values, and rents.
If you take nothing else from this article, take this lesson to heart: Learn how to accurately calculate cash flow and house flipping profits because it’s not intuitive. It’s how investors lose money.
IRepairs & Carrying Costs
When you flip houses or buy rental properties to renovate, you need to know exactly how much repairs will cost. It sounds easy on the surface; after all, contractors give you a written price quote, right?
The problem is that contractors are notoriously difficult to work with, and renovations rarely go as smoothly as planned. Often, contractors over-promise and under-deliver, in terms of both costs and timeline.
For your first investment property, stick with relatively minor cosmetic repairs. Then, budget an enormous cost overrun reserve to handle the inevitable hiccups. Just don’t tell the contractor about it, or they’ll find an excuse to spend it.
Get at least three quotes from licensed contractors, and be extremely clear about the repairs you want. When you leave room for interpretation, you leave room for contractors to charge you extra later.
And don’t forget that renovation costs themselves are only the beginning. It also costs money to own the property while it sits vacant undergoing repairs. These carrying costs, or “soft costs,” include the mortgage, utilities, taxes, insurance, and permits.
For your first deal, budget 50% extra as a reserve for renovation costs, plus a 50% cushion for your estimated carrying costs. By managing your contractors attentively, you can avoid spending any of it, but as a new investor, you should budget for mistakes when working with contractors.
Pro Tip: Before you start the process of finding a contractor, check out HomeAdvisor. They’ve run background checks and found the best contractors in your area for you to choose from. Pick a few from their list and have each give you a quote for the work to be done.
After-Repair Value (ARV)
Just as new investors usually underestimate costs, they also often overestimate the after-repair value (ARV) of their property.
Do your own research on Trulia or Zillow to get a sense of comparable renovated property values. Then, visit a few comparable homes that are currently for sale. Walk through them and get a gut-level sense of how completed properties are priced in the neighborhood.
As a novice investor, your opinion alone won’t cut it, so also get three expert opinions on the ARV range for a given property before buying it. First, ask your real estate agent’s opinion, and ask that they be conservative in their value range. Then, find an experienced investor operating in your market and ask their opinion. Finally, review the lender’s appraiser for their opinion.
When you have those three ARV range opinions, take the low end of the range as your working ARV. This is not the time or place for optimism; you need to know your minimum profit from flipping the property and make sure it isn’t negative.
If you’re keeping the property as a rental, you need an accurate estimate of the after-repair rent. Go through the same process as estimating the ARV, but this time for rent.
If you’re local, don’t skip walking through neighborhood properties currently listed for rent. There’s no substitute for seeing how local comps look with your own eyes. You want to develop a sense for the local rental market, as well as what level of finish and amenities renters expect.
Ongoing Rental Expenses
Repeat after me: Your cash flow is not the rent minus the mortgage.
Another set of numbers that new investors get wrong is ongoing rental expenses. As a general rule of thumb, expect your non-mortgage expenses to average about 50% of the rent. For example, according to the 50% Rule, if the rent is $1,200, your ongoing non-mortgage expenses will average $600. If your mortgage is $500, that leaves you with an average monthly cash flow of $100 – a far cry from the $700 that many novice investors expect.
Non-mortgage expenses include:
Major repairs and capital expenditures (CapEx)
Property management costs
Accounting, bookkeeping, and legal costs
Don’t exclude property management costs because you plan to manage the property yourself. Not everyone has the time or temperament required to manage rentals well. Even if you have it today, that doesn’t mean you’ll have it next year. Besides, managing rentals is a labor expense, whether you’re doing the labor or someone else is. Be financially prepared to hire a property manager by including these costs in your cash flow calculations now.
Don’t rely exclusively on the 50% Rule for your actual calculation, however. It’s a broad rule of thumb, and you need to calculate each expense for any given property before buying.