One of the things that we’ve seen increase substantially over the past couple of years is the number of people doing fix up and flips again. With a good economy (in many parts of the country), and rising home values, this area of real estate investing is back en vogue.
What is Gross Profit
Of course anytime you have an activity pick up like this, you also get a lot of people getting into the game who might not really know what they are doing, and will get burned. You can spot these rookies a mile away when they talk about gross profit when looking at a flip. Gross profit is simply the difference between the purchase price and the after-rehab value (ARV), minus the estimated rehab cost. Unfortunately, this number by itself doesn’t tell you everything you need to know about the potential profitability of a deal.
In addition to rehab expenses, here are some of the other costs you need to account for in the acquisition: closing expenses, lender points, title insurance, and tax stamps. During the rehab, you will have carrying expenses, such as loan interest, utilities, property taxes, and lawn care. And then when you sell the property, you will have at least a couple percent in realtor fees, plus more closing costs. You may even have some help for the buyers’ closing costs. If you add up all of these costs, your gross profit will quickly be reduced to a much different Net Profit figure. It is this Net Profit that you want to pay attention to, because that is how much you will actually make on the deal.
So for example, let’s say you’ve got a property that costs $84k, has $25k in rehab, and an ARV of $140k. The gross profit on this deal is $31k. Sounds pretty healthy, right? Well, let’s see.
On the purchase side, using typical costs, you may have $1,500 in closing fees, $1,000 tax stamp, $1,200 in title insurance, and $3,500 in points. In carrying costs, you may have another $6,000 in interest, $1,000 in property taxes, $1,200 in utilities and $400 in lawn care. Then, when you sell, you might have $7,000 in realtor commissions, $2,000 in buyer assistance, and $1,000 in closing costs. Keep in mind that while all of these numbers are round estimates, most, if not all of these are expenses you will have on your rehab. The total: $22,800.
Where things get skinny
If you subtract this from your gross profit, you are now down to a $8,200 net profit. If you have a couple extra months in carrying cost, or a couple thousand in additional repair expenses, which happens often, you could quickly end up actually making nothing on this deal. This is why you should never use Gross Profit in your decision making. A big gross profit does not necessarily mean a big payday when it comes to a fix up and flip, and tying up $20k or $30k for six months to make $1k or $2k is not a winning strategy. Evaluate the deal using all of the expenses listed above, in addition to the actual rehab expense, to come up with the Net Profit, and then decide if the deal makes sense to do.