In my previous post, I explained how you calculate return on investment for real estate investments or for that matter for any investment. The basic calculation was profit divided by investment. I encourage you to read that post first before this one. In this post, I assume you understand the basic ROI concept. I will also use a more complex example. Let's plunge into an example with some realistic numbers in place of the very simple ones from the last post.
Our objective in this exercise is to calculate how much we have to sell an investment property for in order to obtain a desired rate of return over a particular period of time. In simpler terminology, we are fixing up and flipping a house. To accomplish this, I have to give you some numbers. Here they are:
Purchase price of the house $350,000
Settlement costs on the purchase $10,000
Fix up costs $50,000
Loan amount at 80% of the purchase price at an annual interest rate of 8%
We intend to sell the house after six months with a 50% annual rate of return.
Settlement costs on the sale $20,000
Our objective is to determine the selling price of the house to get our 50% annual rate of return in a six month period. Let's start out with how much money we need to invest in the house. We need this information to know the dollar amount of the return we desire. To get the total amount invested in the house, we add the purchase price, the purchase settlement costs, and the fix up costs, which gives us $410,000. We can borrow 80% of the purchase price or $280,000. The bank typically won't finance the settlement and fix up costs. If we then subtract the loan amount from the total amount we have in the house, we get our investment of $120,000. That's our money in the deal.
Next, let's determine the profit we need to achieve our annual rate of return of 50%. Since we are holding the house for 6 months, our actual nominal rate of return is 50% divided by 2 or 25%. So we take the 25% times out investment of $120,000 to get $30,000, which is our desired profit.
Finally, we determine the selling price we must get. Add the original cost of the house including the purchase price, fix up costs,and purchase settlement costs. That gives us $410,000. To that we add 6 months interest on the loan, which is $11,200. The bank isn't loaning you the money for free. Then we add the settlement costs on the sale, which are $20,000. Finally, we add in our desired return on investment of $30,000. That gives us a desired selling price of $461,200.
Put simply, to achieve a 50% annual return on our invested funds, we need to sell the house for $461,200 in six months. If you don't follow the math exactly or would like to run your own scenarios, I have an Excel spreadsheet I will send you if you shoot me a message requesting it at fstitely2@gmail.com. I have no agenda in this. I ain't looking to sell you nothin'.
Let's have some more fun with these numbers. Let's start out with the selling price we need to break even. That's an easy number to get. We take our desired selling price of $461,200 and subtract the profit of $30,000. Our breakeven price is $431,200. If the price is above that, we make money. If the price is below, we lose money. In other words, we have to sell the house, that we bought for $350,000 and spent $50,000 fixing up, for $431,200. Or we lose money. If we are selling within six months, the house, that we paid $410,000 for after fix-up costs but before settlement costs, has to go up in price to $431,200 or we lose money. The breakeven number is an incredibly important piece of information to have before you plunge into this investment. If you haven't calculated that number, real estate investing isn't for you.
Now that you know how to set your objective and calculate breakeven, let's discuss the circumstances under which you can accomplish your profit objective by flipping a house. Let's start out with a sanity check. Why would somebody pay you $461,200 for a house you bought and fixed-up for $410,000. Why wouldn't someone just go out and buy another house for $350,000 and spend $50,000? What makes your house worth the $461,200 after six months or even the breakeven of $431,200? Few amateur house flippers ever ask themselves this question.
There are three circumstances under which you might achieve the return you desire. The first is that you are in the construction business. That means you are doing a lot of the work yourself or through your employees. You are paying wholesale for materials and labor. You aren't paying for the improvements what the average Rich Dad Poor Dad reader pays. You are paying $50,000 for improvements worth $90,000, assuming no other increase in the price of the underlying house. Are you in the construction business with access to great pricing? Most of you aren't.
The second circumstance is that you have identified a house that is significantly under-priced. Under-priced to the tune of $40,000. In other words, you paid $350,000 for a house that was really worth $390,000. How did you happen to have this magnificent foresight? You might have this foresight if you have been in the real estate business for a long time. You might be able to identify houses in neighborhoods about to become desirable. I have known a few people, who have done this, but damn few. Look in the mirror and be honest. Do you really have this sort of insight?
The final circumstance under which you might achieve our annual return of 50% is that the real estate market has gone truly crazy and there is a buying frenzy. The early 2000's are a perfect example of a real estate market gone crazy. You could buy a house from a builder that had not been built yet. Then you could sell it two weeks later for a good profit still before the house had been built.
Of course, you had better not get in on the end of the cycle. My business partner Paul and I have a saying. “The party is over when the fools arrive.” Fast forward from 2000 to 2006. When the music stopped, a lot of people had borrowed a lot of money on houses that were worth 60% of what they had paid a year earlier. They weren't underwater. They were completely under the riverbed. I had clients whose real estate investments went as follows: profit, profit, bankruptcy. Some of these people were real estate agents. So much for superior market knowledge.
Your ability to make money in a crazy market depends on your ability to recognize the beginning of the price run-up and then get out before the crash. Do you have that level of expertise? I don't. Pretty much no one does.
My intent isn't to tell you that real estate shouldn't be part of your investment portfolio. It should be. However, flipping houses isn't investment. It's speculation. If you're not real estate savvy, you are just gambling – with borrowed money in most cases. If you aren't doing the ROI calculations above and making realistic judgments, you aren't real estate savvy. Your real estate flips will be flops.
Our house is in mourning over the death of the baby panda at the National Zoo. The Zoo has had incredibly bad luck raising baby pandas. There are two possible explanations for this. The first is that the pandas are just another defective Chinese export product.
The second explanation is the lack of sex appeal of the female pandas at the National Zoo. Despite importing male panda studs, the zoo has resorted to artificial insemination. We can only imagine the conversations between the male pandas. “Dude, she's a double bagger. I'm not doing that.”
Maybe panda love works the same way as human love. They should spike the bamboo shooters the males drink. Get them liquored up. Then announce last call for alcohol. The females will probably look a lot more attractive then.
Thanks for reading. Next time, I plan a post on falling behind the times in marketing. As always, for real tax and accounting advice, please visit the main S&K web site at www.skcpas.com. Until next time, let's do it to them before they do it to us.
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