Flips: Rules for Making Money

[Moises R Cosme]

This post is a simple rundown of our thought process for evaluating opportunities. I will describe the rules we apply; explain why they are important and how we apply them. It is important to note that these rules have been developed as we have completed projects, I made a decision to move away from being a full time real estate agent to being a full time investor about 16 months ago. That decision was difficult because I built an exceptionally good business as an Agent. Since becoming a full-time investor, I have devoted more time to creating a system, everything described below is a product of that.

As you read through this post and others, you will notice that everything is very patterned. Everyone in my life finds my idiosyncratic behavior somewhat frustrating so I apologize in advance to anyone that gets bored. Lastly, anyone reading is welcome to provide feedback, as stated in the description I take feedback good, bad or indifferent; I have no ego about any of this, writing about my process for all of these things helps me to think through the things I do and evaluate them. In that sense publishing these things is academic and therapeutic.

Rules:

1. The potential investment must have an after-rehab value that results in combined loan to value (CLTV) ratio of 75% or less

2. No properties built prior to 1900 and preferably nothing prior to 1940

3. Renovate in ‘home’ markets only

4. Purchases outside of my home markets MUST be cheap enough that they can be sold 'as is' for a profit

5. Set the resale list price prior to the purchase & stick to it!!!

Rationale for the rules:

1. The potential investment must have an after rehab combined loan to value (CLTV) ratio of 75% or less. Two reasons, (a) hard money lenders will apply a strict 75% CLTV on any money they lend; they do this to ensure they have enough equity to protect their loan and (b) in the event we fail to sell the property, we will be able to refinance the property without having to invest additional cash into it and will on paper have an equity position in the asset.

2. Properties built prior to 1940 tend to have fieldstone or some other porous type of foundation, foundation problems are a nightmare even if they are minor, so I try to stay away from old houses. I have had success with old houses in the past, but overall, they are more trouble than they are worth. Old properties are also extremely expensive to renovate, particularly since most towns force full code compliance when you renovate more than 50% of the structure (I have no idea how HGTV people do it). Building standards are dramatically different today, than they were when folks used horsehair for insulation!!! Needless to say renovating an old house is much more difficult and expensive in real life than it is on TV.

3. I still have a strong pipeline of Buyer clients (I hand them off to Agents on my team, supervise the transactions and keep a portion of the fees) and they buy in a few towns in my immediate vicinity. I know these towns well, I know what Buyers are looking for, I know the neighborhoods, and the loan programs. I have had success in other towns, but each town has a learning curve. I make the best use of my time by renovating exclusively in my home markets.

4. In order to make a business out of being an investor, I felt I needed to give myself the opportunity to do at least 1 deal a month; Massachusetts is extremely competitive, so in order to meet my target I have to look outside of my home markets for deals. The evaluation is stricter for out of home market assets, I force our acquisitions group to negotiate exceptional deals; as a rule, we will not buy outside of our home market if we cannot reasonably expect to resell the property ‘as is’ at a markup.

5. We have had two break-even projects in the last 18 months, in each case we deviated from our initial list price. There are two negative things that happen when you fail to set a hard list price at the outset of the project, the first is a lack of discipline, the second is recency bias that obfuscates critical factors. If you change the list price after the project is complete, you will blow your renovation budget – in our case, it happens 100% of the time. Each time we allowed ourselves to change the list price we initially started with; it releases us from the discipline of sticking to the budget. Since we spend a lot of time evaluating the comps up front without the pressure of having spent any money, the decisions we make are objective.

How we apply them:

We have two spreadsheets for each project, the first is a project evaluator, the second is a project tracker. The project evaluator follows this formula, expected resale value minus costs. In order to generate the expected resale value, I find at least 2 comparable sales within a half mile in the past 90 to 120 days. A comparable sale is a property that is within 30 years of the age of our proposed purchase, within 200 square feet, the same style, lesser or equal bedroom count, lesser or equal bathroom count and similar acreage. I lean on my acquisitions team to drill down on these numbers, I generate a report myself and compare it to what they come up with, we then talk through it in detail if there are discrepancies. In general, we should be coming up with a similar list of comparable sales. I also sit down with my acquisitions team and go through a rough renovation budget line by line, that way we arrive a renovation budget figure that we believe we will be able to stick to. The project evaluator has a line by line rundown of expected closing costs, that we adjust based on the specifics of the deal. It also has a stand alone after rehab value calculation to make sure we are within our rule for CLTV. Lastly, we are adding a function to our project evaluator that will allow us to compare costs for the different lenders we work with; the differences are likely to be relatively minor, but I would rather the extra money be in my pocket than theirs.

The project tracker is the sheet that tracks the project after acquisition. The evaluator is what we want to do, the project tracker is what happens. We have a routine where I sit down with my acquisitions team and compare the expectation against the result, all of the rules that we now follow have been devised as a result of mistakes or inefficiencies we found when we evaluated our results. Separating the sheets is a practical solution, since every project has a lot of information at both stages. If you try to stick everything on one sheet, you will get lost. Separating the project into two stages allows us to really focus on each section individually, we take our time and really drill down – this process has kept us from making a lot of bad purchases.

We search multiple channels for property on a daily basis, we created a filter that keeps out any properties built prior to 1900; not seeing them means we are never tempted to look at them, no matter how cheap they look. If we see something that is interesting built prior to 1940, its typically an active debate between me and my team – the potential must be overwhelming for us to purchase something built prior to 1940.

We are slaves to our project evaluator, if we identify a project outside of our home market the entire evaluation is based on purchasing the property at a steep discount so that we can still make money without renovating the house. There are two driving factors for this rule: (1) having buyers in my back pocket makes everything easier and cheaper (I save the Buyer Agent fee) and (2) I do not have to ingratiate myself with that town’s home inspector. Home inspectors are wired to be skeptical; their entire job is focused on catching you cutting corners. By staying in my home markets, I avoid having to convince a new inspector that me and my guys do good work. Sticking to this rule saves time, aggravation and money.

Attempting to evaluate the list price after the project is complete is difficult emotionally. Most projects take two to three months to complete, that means that every day I am on site with our team members pulling things down, putting them back together, designing etc. Every single day I am on site I love the project more and more, as a result I start to value it disproportionate to the market (they see a kitchen, I see a puzzle that I have carefully curated with my money and time). This lack of objectivity skews decision making and has made me overlook key details. Last Summer we purchased a small ranch in a great neighborhood for a great price, we set a list price of $409,000 at the beginning of the project. During our renovation, another house on the street that was virtually identical sold for $445,000 very quickly, so we bumped up our list price. To our credit we did not go nuts, we listed the property for $424,999, we ultimately sold the property at $420,000. Our property was inferior to the other property on the street because that house’s backyard was on the water!! Had we gone to market at $409,000 we would have probably created a little more interest in the property and maybe had more buyers competing. The project was profitable, so I am grateful for that, but this error led to a hard and fast rule.

I expect that we will continue to refine our process. We have had strong results. It is reasonable to expect that a bad market or unexpected costs will hurt our results, everything I describe above is designed to mitigate our losses. My perspective is that profits will be there, but the key is to design a system that minimizes or hopefully eliminates losses.