Fix and Flip Basics - How Do They Differ From Rehabs?

What Is a Fix and Flip?

The general philosophy behind a fix and flip is to, “Put lipstick on a pig” and get the property sold to another buyer who either finishes the full-scale rehabilitation of the property or lives in it as-is.  Consequently, the buyer profile for the property can consist of wholesale buyers who generally pay cash or low-end retail buyers that qualify for government-backed loans.  Many investors characterize this process as “prehabbing” the property, or knocking off the rough edges of a rehab job to allow potential purchasers a quick look at the property’s potential.

A prehab generally benefits mainly from the following quick fixes:

1. Straightforward Clean Up – It is amazing how much easier it is for a buyer to imagine a property’s potential if the previous slob’s trash, grit, and grime are polished up and made presentable.  This task alone will account for a significant portion of the value add in an average fix and flip
2. Exterior Work – The lawn should be trimmed, weeds pulled, and the outside appearance in general should be tidied up.  The costs for this type of work are nominal and generally involve some simple trash haul off or a trip to the dump
3. Inside Work – The principle here is that of, “Addition by subtraction.”  In other words, remove stinky carpet, junky appliances, or anything else that will keep your buyer from imagining what the place will look like after some elbow grease is put into the project

Buyers should end up seeing the potential of the project instead of the items you saw through when you initially purchased the project with a prehab strategy in mind.

Should You Use Your Money or Someone Else’s?

One of the beautiful truisms about real estate is that it is a highly acceptable form of collateral for lenders of all stripes.  Regardless of what fiat-based transactions do real estate has fundamental, intrinsic value because it provides utility to the occupant.  Consequently, the degree of leverage attainable for a real estate purchase is very high when it is compared with other income-producing asset classes.  Leverage is a double-edged sword.  You can amplify risks, but you can also amplify losses by using borrowed money to capitalize a transaction.  You, as the skilled investor, know how to force appreciation on a project.  Given that you know what you are doing it is generally optimal to borrow money to minimize the amount of cash you have in the project to increase your returns using whatever set of metrics that you deem as appropriate.

Cash-on-cash returns are traditionally used for simple fix and flip investments because they are easily done on the back of an envelope.  Other time value of money calculations yield results that are close to the cash-on-cash return because the duration of the project is generally fairly short.  A cash-on-cash return is calculated as follows:

Cash-on-cash = Annual before tax cash flow / total cash invested

So if an investor placed $30k into a $100k rehabilitation project to get it ready to sell as a prehab, and later realized a $15k “profit” then the cash-on-cash return would be $15k/$30k, or 50%.  Note that this definition does not account for the time value of money or the risk associated with the cash flows.  Additionally, the cash-on-cash return is higher than it would be if the investor needed to invest all $100k for the rehabilitation to make a marginally higher $25k profit.  In that case the cash-on-cash return would be $25k/$100k, or 25%.  The basic idea behind a prehab strategy is to carve out the returns that are low hanging fruit on the project and to leave the end buyer with some of the harder tasks to yield the remaining profit

Good Things To Look For in a Fix and Flip

Many of the common major value-adds for a fix and flip strategy were outlined above.  The idea is to either get the house to a stage where an end rehabber would want to buy it or where it is “FHA loanable.”  You should look for houses where the bulk of the gross profit between the acquisition price and the after-repaired value (ARV) is derived from fixing unsavory and easily fixable problems.  These problems include, but are not limited to:

1. Trashy houses
2. Poor landscaping
3. Smell problems
4. Unattractive or outdated appliances, fixtures, or other items

It is generally advantageous to have an ugly property in a desirable location so that holding costs don’t eat through all of the profits you calculated when underwriting the project.

Pitfalls and Things To Avoid in a Fix and Flip

You can change many things about a property, but the location is generally not one that is easy to fix.  Buying disasters in poor neighborhoods limits the upside potential for the project and will almost always lead to longer than expected holding costs and lower profits.  If nobody wants to live in the Taj Mahal you constructed in the middle of a war zone you just invested a lot of time and energy into something with no viable exit strategy.

Structural items like electrical, plumbing, foundation, etc. are also hard to sell to end buyers.  You can clean the house up and make it shinier than it once was, but it will still be hard to sell to an end buyer because the bank won’t loan on it or the wholesale buyer will discount the purchase price to account for the heavy lifting involved in fixing the major structural problems.  If the property contains these problems it is likely a better candidate for a full scale rehab than a fix and flip where the easy work can be done and passed along quickly to another investor.

Tips on Working With a Contractor

If you speak with any investor that has been in the game long enough they will likely have a horror story or two about working with unscrupulous contractors.  Contractors are notorious for a whole assortment of dirty tricks, even if the agreements are structured correctly.  When you manage any project you can get 2 of 3 categories optimized, but not the other one among:

1. Better
2. Faster
3. Most cost effective (“cheaper”)

In other words, if you tend toward the quality end of the scale and/or need a job done faster it is going to cost more.  You can get something in a very cost effective manner if you let the contractor work on it when he has spare bandwidth, but this increases your project duration and likely reduces your returns.  There is really no correct answer for which way to lean on this tradeoff.  Every project is different and the spread will determine your budget constraints and needs.

An ounce of research is worth two megatons of cure when it comes to dealing with contractors.  The trouble is that many investors are guarded with their best contractors if they are able to find them and are not really willing to share their gems with competitors.  Ask around and get several recommendations and bids on jobs to find out who will provide the best value for you.  Know ahead of time which two of the three items above are the most important to get your project done and make you money.

Placing carrots and sticks in agreements with contractors works fairly well at getting them to do what you want them to do.  A performance or success fee for hitting early dates is fine as long as you set the expectation that their work will be inspected and that the fee will not be payable for poor quality work.  A “tax” for work that misses dates where the penalty isn’t severe, but it hurts the contractor’s bottom line (e.g. $100/day) also serves as negative reinforcement for undesirable behavior.