Intro to "House Flipping; Calculate your Net Profit"
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Buy, renovate and resale; is it a good investment?
Renovating for profit, also known as flipping a house, involves buying a property, renovating it and selling it at higher price to make a profit. It is an activity that has been highly mediatized lately with TV shows dedicated to the subject, where successful transactions are exposed using simplified math. However, flipping houses is a risky activity that can be demanding with time and energy, without necessarily making big returns. That's why it is important to calculate its potential profitability before getting oneself in such a project.
On top of evaluating its net profitability, you always have to take into consideration the opportunity cost. A return that turns out to be equivalent to the stock market is not necessarily worth it. Investing your money in the stock market requires little personal effort, and it frees your time to work on other potential income. To avoid wasting time and money in a low yielding project, the first step is to know all the expenses involved.
Investments and expenses when flipping houses
The idea of renovating to cash a profit follows the market principle where you buy a good, improve it and resell it at higher price than its total cost. However, a real estate property is not a liquid asset, there is no incoming cash flow before the sale and its purchase requires a high investment.
The first major disbursement is the cash down on the mortgage balance. Banks will rarely finance 100% of the real estate value, but rather 80% to 95%, which signify a first deposit of at least five digits. In addition, there are other expenses related to its purchases such as the notary fee, the transfer tax and the inspection.
Only after covering these initial costs will the expenses start on the project renovations. There are two types of renovation expenses on the residential property: the cost of repairs and the cost of improvements.
The costs of improvements are expenses that will increase the durability and the value of the property. For example: a new roof, an air conditioner installation or a new floor; all these expenses are deductible from capital gain tax.
The costs of repairs are made to keep the assets already installed in good condition. It just maintains its structure and has little impact on its value and durability. We could think of plumbing repairs, painting the wall or cleaning the windows.
On top of these expenses, when you buy a house, you have to start making your monthly payments on your mortgage. A big amount of these payments goes to the interest portion first, which are not going to be recuperated from the resale, as opposed to the capital portion. Other monthly expenses will be required, such as electricity, insurance, energy and property taxes (municipal and scholar), that also won't be recuperated in the resale.
It is important to note that when you own a company, you can pass through all the current expenses (repairs, monthly expenses and interest) on the name of the company, and deduct them from the income tax. You will then benefit from a tax reduction.
Finally, the sale of the property is not going to be without costs: the realtor fees, the publicity and the taxes on the capital gain will reduce your profit. The capital gain is the profit you get from a resale. It is the difference between the selling price, less its related cost (realtor fees and publicity), and the purchase price including its related cost (notary, taxes, and inspection) and cost of improvements. Normally only half of the tax rate will be applied on the capital gain and it is possible to be exempt from it when living in the property.
House flipping and the return on investment
House flipping is an investment project where you provide an amount at the beginning and plan to recuperate a bigger one at the end. The amount invested is all the expenses enumerated earlier and the recuperated amount is the net profit on resale. If the strategy of profit originated from renovating a house, we hope to resell the real estate asset rapidly to minimize the drainage from interests and monthly expenses.
To measure its success, we need to make a parallel between the total investment and expenses with the net profit on resale based on the selling delay. By annualizing the rate of return, we find out what your investment really brought. You can then compare it with the rate of return of other investment opportunity to judge is worthiness.
Let's take an example where the total investment and expenses were $200,000.00 and the net selling profit is $250,000.00. If the process took 24 months, the annual percentage yield is 11.8%, which is a good return on investment. If the sale was done in 12 months, we are now talking about a return of 25%, which is much better, and in 6 months, the effective annual rate would be 56.3%, an incredible return.
It is important to bear in mind the time and effort you plan to put on managing the whole project. A rate of return of 10% can be interesting if you haven't done much effort. However, if you work many hours per week on this project, the 10% must include your salary, which necessarily lower the rate of return of your investment.
It is a sector of activity where you succeed by lowering the expenses and investing in key area (kitchen, bathroom, floor or windows for example). For this reason, you find many real estate agent, renovation experts and companies flipping houses. Real estate agents save on the transaction fees, professionals minimize cost of renovations and companies save on income tax by declaring all current expenses in their Financial Statement. The winning combination would be to regroup these three advantages in one organization.
Using the house flipping calculator
Before jumping on a house flipping project, the following calculator will help you judge its worthiness. Based on the selling price you expect and all the expenses, you will obtain the net profit and the rate of return of your investment. Always stay reasonable when you enter the selling price, because the average appreciation rate stays between 2% and 3% per year. This is the first step you should attempt before purchasing the residence.
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