There’s a rush you feel when someone comes to you with a ‘great deal’. It’s human nature. The first impression gets your adrenaline pumping. Your heart wants you to jump right in. That’s when your mind needs to calm things down. Is it really that good?
The money you take in (revenue) comes from one number – the sale price of the real estate, or the rental cash flow. It’s obvious this is important when you’re doing the research.
The money that goes out (expense) is another story. Expenses flow out of your wallet in lots of chunks – some big, some small. They all have one thing in common -they reduce your profits. In many cases it’s not as obvious and the revenue number. Costs pop up even in the case of experienced investors that nobody predicted or could have planned.
That’s why it’s very important to take your time and analyze your costs. If you are new at real estate investing, talk to other investors. Learn what costs they incurred. See which costs surprised them (it happens a lot). Look for trends, especially for your investing area.
If you are an experienced investor, keep track of your costs and review them. Don’t just compile them for tax purposes. After each job, take a look at what you could do to reduce the costs for the next job. And maybe help some of the newbies out?
Let’s take the example of flipping a residential home. Costs can be broken down into 5 areas. Keep these costs in mind when analyzing a deal. High costs can destroy what at first glance appeared to be a good deal:
1. Acquisition Costs
The costs to purchase the property. The obvious one is the price you negotiate to actually buy the property. However, you should also consider the advertising costs to find the property, the closing costs and costs to create an entity (LLC for example) to own the property.
2. Ongoing Costs
The biggest portion of these costs will probably be your financing or interest costs or the loan on the property. Taking on an investment partner may mean your cost is in the form of equity you pay to your investor when you sell the property. Other ongoing costs would include property taxes, insurance, utility bills and interest on money borrowed for the rehab.
3. Rehab Costs
All the costs of construction. These are some of the most difficult costs to predict. Contractors, materials, permits, and other costs associated with remodeling can easily succumb to ‘scope creep’. As you move further into the project, it is easy to find new problems that nobody saw coming. Besides obtaining multiple bids from companies, make sure to add in a certain percentage over and above your estimate to handle contingencies.
4. Sales Cost
These are your realtor commissions (if you are not already licensed or don’t want to sell on your own), staging, marketing other than the realtor costs if any, and seller-paid closing costs.
Please remember we are not accountants and are not giving you tax advice here. The tax system was not set up to favor house flippers. Buying and selling a home in less than a year means you pay short-term capital gains on the profits. These taxes can really eat into what you take home. It’s very easy to ignore the taxes if you flip a house from June to August and don’t have to pay taxes until the following April. Furthermore, with larger profits, there can be penalties in waiting until the end of the year to pay.