Forget profits, use this instead

[Joshua Michael Hauman]

When considering real estate flips, there are a few ways you can look at profitability. Primarily how I evaluate a deal is off expected rate of return. Secondarily I focus on projected profit.

Risk assessment is crucial for me as well but since that is harder to quantify, I won’t describe that in this article. Before I got into real estate, I was a risk management analyst at KeyBank for 2 years, so I think I have a unique perspective on risk. If anyone is interested just leave a comment or DM me on that and I’d be glad to release a post on it.

Why I look at return on investment first is because it tells me more. Cash on cash return factors the cost and scale of deals in a way raw profit does not. For instance, I recently evaluated two potential flips - one with a $30,000 profit projection but requiring a $150,000 investment, the other a $45,000 profit with $270,000 spend.

Deal 1: 20% Return

Deal 2: 16.6% Return

ROI normalizes profit against total invested capital.

By targeting a minimum threshold return (I use 15%), my analysis builds in an acceptable risk/reward ratio. Setting profit goals alone leaves more to be desired- a $100k profit could still be a bad investment if achieving it requires $750k+ capital locked up for months. That would yield a 13.3% return which is under my threshold. Insisting on minimum returns ensures adequate compensation for my money and time as fix and flip is not passive by any means.

As a finance guy what I prefer even more is IRR. Internal rate of return. I like this metric the most as it factors for time value of money. Beyond accounting for investment sizes, IRR considers the element of time.

Take for example 2 deals all things equal, Flip A and Flip B. If Flip A takes 12 months and Flip B takes 6 months, Flip B's annualized return would be higher because capital is freed up quicker to redeploy elsewhere. Profit comparisons fail to capture this time value of money differentiation.

The bottom line is rates standardize investment decision making rather than lump sum profits. A rate of return makes assessing real estate deals simpler by baking in investment scale and in the case of IRR, time. I steer clear of fix and flips that don't meet target ROI thresholds, regardless of profit potential. Making return on capital the central evaluation metric improves my decision making and I hope using this will improve yours.

With Discipline,

Josh