Although the title of this chapter is admittedly a bit daunting, be assured that the math is very easy to do. One of the great tricks of mathematics is to make things sound difficult so mathematicians can sound smarter.
The initial feasibility study is merely a fictional project where you will put in all the known variables. For instance, you would put in your available cash and the financing terms from the lender. The goal is to develop an ideal scenario of a project that meets your investment goals while considering your financial constraints. In technical jargon, this is a model. Once complete, the model allows endless scenarios allowing you to see the impact of unforeseen events. For example, the effect of the project going over schedule by three months, impact to returns if the building requires twice the budgeted repairs and the effects of any other scenario you can image. These various model runs make up a sensitivity analysis. This helps determine what events would have the biggest impact on our returns so you can keep on top of them.
Notice that you still have not even looked for a property yet. The model helps determine a reasonable estimate of the total project costs that you can afford. Then taking into account your return goals and profit expectations, the model will estimate the price range of the properties you need to shop plus the appropriate price discount below the surrounding properties. Remember you're flipping properties here - you need to buy at a discount or you're going to lose money. If you are planning to make profits by capital appreciation only (a rise in property value), you should consider a rental property instead.
Now before you begin to build your model, a few subjects need to be tackled. You need to determine your investment goals on the project. Then, gather information on the required project expenses. Finally, you must account for the time it will take to purchase, repair (if needed), and sell the property.
Riskier investments need to pay much higher than lower risk ones. For example, U.S. Treasuries are very low risk investments backed by the U.S. Government. Returns on treasuries are low with an average of around 2%. At the other end of the investment risk spectrum are stocks. Over the long haul, stocks tend to produce a 10% return. "Where does speculative real estate fall?" Well, if your project would return only 4-5% you would be better off buying treasuries or bonds. In the 10% return level, it would be better to buy stocks. So in order to make flipping a house worth your while, you need to see a higher return.
Why? First, real estate is typically highly leveraged which increases the chance of default. Once the property goes into foreclosure, all equity is lost (you're wiped out). Second, real estate is not liquid. Stocks and bonds trade online with a click of a button. Residential real estate typically takes around two to three months to sell in a normal market. Lastly, there is uncertainty to the home's value. Traded securities are valued at an exchange with publicly available data. In real estate - you will only find out what the property is worth when it sells. Hopefully the sales price was higher than your total project costs.
"What is a reasonable return for flipping?" To answer this question requires the use of the Weighted Average Cost of Capital formula known as the WACC. The WACC takes into account leverage and risk to calculate the required equity return, r(e).
r(e) = [r(p) - (LTV) * r(D)] / (1-LTV)
LTV is simply the loan to value ratio of the mortgage ;r(D) is the interest rate on the loan. The last variable r(p) is the real property return that is generally 8 percent. "Whoa, I thought you said real estate returns need to be higher than stocks? Shouldn't we be looking for a reasonable return between stocks and bonds? " If you purchase a home all cash and rent it out over ten years the eight percent return is probably reasonable. Speculators are looking for short-term gains with high leverage. Therefore, you need higher returns to justify our risk.
If you set the LTV to a typical 80 percent and the interest rate at 5 percent the WACC equation calculates the required equity return, r(e), at 20 percent.
r(e) = [0.08 - (0.80) *0.05] / (1 - 0.80) = 0.2 or 20 percent
Within the project model, it is important to estimate the expenses. Without an actual property to analyze, these numbers will be very rough approximations. However, you need to develop a realistic model to properly gauge what you can expect to pull off.
There are plenty of different types of property expenses. For the fundamentals, the expenses have been broken down into before and after the property purchase. The many expenses which will be unknown will be expressed in the percentage of the property cost - the price you negotiated before closing costs. In the pro forma section below we'll put all of this information in one place for you. Now, you just need to read and get a basic understanding.
Before you purchase a property, there are a few expenses you may incur. Since you are modeling a property, you should include most of the expenses to develop a robust and safe scenario. The expenses are:
Upon a quick glance of the list you will notice that most of these expenses are incurred during the due diligence period. The due diligence period is the time granted by the seller for the buyer to inspect the property prior to final purchase. How long the due diligence period is would be spelled out in a Letter of Intent or the sales contract, which could be anywhere from 30 to 90 days.
Property inspection is very important. You need to find a licensed and certified company to inspect the property for any potential issues. These issues can range anywhere from structural problems, insect infestation, mold, plumbing, electrical, and mechanical (heating and air conditioning). If the home is an older home you may want to ask them to check for lead paint, asbestos, and lead welding joints on copper drinking pipes. The inspector's job is to report these issues to you. Your job is to make sure you do not buy a money pit, so call around and get a few quotes to account for the fees in your model.
An environmental inspection is really only needed if the property is known to have underground storage tanks for fuel. The property inspection company may be able to handle the inspection, but if the tank has leaked fuel into the ground you have a serious problem. If you were still considering purchasing the property you would need to hire an environmental engineering company to assess the extent of the contamination. Here it gets trick since they are required to report the contamination to the state's environmental agency. The state agency will require the current owner to clean up the mess. You probably already guessed the seller is going to be weary. Cleanup of fuel leaks is very expensive and can easily run into the tens of thousands of dollars. Be sure to ask if the home has underground tanks. If so, be sure to have them checked for leaks. Call around and get some quotes if you are dealing with properties that have underground storage tanks (UST) with fuel. If nothing else, you have a rough idea of costs if you are able to take advantage of the situation. Otherwise, in the beginning it is best to stick to "clean" properties.
Closing costs are a toss-up as to whether you consider them before or after the purchase. Since you usually don't get the keys to the property until after the closing is complete (and you technically paid the closing costs), putting them in the before purchase category is not a crime. Getting our lingo inline for real estate analysis, the "before" expenses are considered acquisition costs. They are what you need to pay in addition to the purchase price of the property at closing. If you don't know, closing is where you formally sign documents and have the money transferred to the seller from your lender - it is usually a disaster since something always seems to get screwed up in the paperwork. Typical closing costs run 2 to 3 percent of the property purchase price.
"Whoa, that's pretty high. Why are closing costs so high?"" Closing costs are high, because there are a lot of that goes into them. Here is a list of some of the common items included;
After you purchase the property there are a few typical expenses that will need to be accounted for each month until you sell. The expenses are:
The mortgage payments should be self explanatory. Hopefully, you shopped around and have a good feeling for what the market will bear. From the amortization period, loan to value, and interest rate you will be able to calculate your anticipated mortgage payment. Many spreadsheet programs have payment functions included, so don't sweat the calculations.
Repairs and remodeling are where many new real estate speculators and investors make mistakes. Your goal is to sell the home in the shortest amount of time for a profit - not appear in a design magazine or television show. Repairs and remodeling should be kept to an absolute minimum. More than likely, the bank will not finance these activities and you will have to pay for them out of pocket. Focus on minor painting, cleaning, and some landscaping. Many folks have someone pressure clean the exterior of the property to include the roof. If it looks good - they leave it alone. If you need to express your creativity remember that your buyer may not appreciate what you have done and change it. Finally, shy away from major renovations that require significant structural changes to the property, such as, adding a bathroom or additional bedroom. For our preliminary model, do carry a small budget to cover some miscellaneous work. Costs will vary widely based on your location, but a budget of 5% of the purchase price is reasonable.
Landscaping for the model is the cost of keeping the lawn and plants in tip top shape. Call around to get a feel for what to budget. You could do it yourself to save a few bucks, but just make sure you can handle it and do it properly.
The prospective buyers would probably be a bit weary if you didn't have the electricity and water on. Plan on paying for the utilities for a few months until you sell the project. Many local utilities will have information online regarding what they bill, and some have statistics for various home sizes. Get a reasonable estimate together and add your utility expenses to the model.
Lastly, there are the expenses insurance, broker's fees, and taxes. You'll need property insurance for the project - in fact, your lender will insist. Again, simply calling around for a quote will get the data needed for the model. Real estate brokers fees. If you are smart you'll use a real estate broker to drudge through the posers and find you a buyer. Sure you can do it yourself, but you will probably take a bit longer which you will soon learn is perilous. Go ahead and put the 3% into the model. Taxes. If you blew the project schedule the tax man may be knocking on your door. Real estate taxes are also highly localized and require some research to ferret out. Luckily, most property appraiser sites are online and have the information available. Go ahead and put a line item for taxes in the model, just in case.
These are just some of the expenses that you could encounter, we could probably write a book solely on this subject if pressed. If you can think of any other expenses you'll incur such as accounting, go ahead and add them. Each project is unique, and in the early model you'll not get everything right. That is OK; you are only trying to get a basis of the types of projects to hunt. Let's carry on.
As in most things in life, timing is everything. Here is another area of great peril. Unrealistic time estimates create unrealistic schedules. You need to be realistic of what the schedule will be. Remember, time is money and every month you let slip by or did not account for will be another month of expenses; better known as loses. Furthermore, the longer you linger the higher the chances of getting punished by market forces and systemic risk.
Luckily, you are building a model. Here you can run different scenarios of scheduling without losing your shirt. A flipping project can easily be split into three distinct phases; acquisition, repair and renovations, and sale. The acquisition time is important to include, but you really haven't put money into the deal. Any slip-up's here is annoying but not game changing. A good estimate would be two months to find and close on a property. Longer if you're not out beating the pavement.
The clock really gets running when you purchase the property. You have just put a 20-percent cash wager on the table that you can pull this off. If the project delays, the expenses will begin to accumulate and the return will suffer. Not only are you losing hard cash with expenses, but the return is being diminished with the increase in time. "How?" It is time to introduce you (if you haven't met already) to the time value of money.
You probably remember a parent or grandparent discussing what they used to be able to buy with a dollar. No doubt it was significantly more than today. "Why?" Well, various factors are at play. Inflation, national debt, and a myriad of other things. The end result being that a dollar today is worth more than a dollar at some point in the future. "How much less?" It really depends on your expectations and what you are modeling. You need to determine the appropriate discount rate, which is merely a percent discount you choose. For instance, if you just wanted to look at the dollar and how it would depreciate, you could use the average interest rate for the dollar as the discount rate.
Let's look at some simple numbers. How much would $100,000 be worth in a year if the average inflation is 2-percent?
$100,000 x 0.02 = $2,000
$100,000 - $2,000 = $98,000
In a simplified calculation to see what a $100,000 would be worth in a year, you simply have to subtract the 2-percent inflation from the initial amount. So, at the end of a year your $100,000 is only worth $98,000 - it's present value.
Because real life calculations are a bit more complicated, you can use the present value formula (also known as present worth), which is simply:
P = F/(1+i)n
This formula makes it a bit easier to push out the time horizon. Figure what $100,000 would be worth in five years. Instead of an interest rate, you will use yearly average inflation, 2-percent, as a discount rate. Since the calculation is in years, n will be simply 5. Time to crunch the numbers.
P = 100,000/(1+0.02)5]
P = $90,573
Hopefully this was a bit of an eye opener. For investment purposes, money loses value with time. Instead of "time is money", the phrase should be "time costs money" for clarity. In the next few sections this concept will be introduced into your model.
The net present value is simply the sum of the future cash flows minus the purchase price. You take the time series of your cash flows and discount them (expenses out and income) - then add them up. Now you have the present value. Subtract the purchase price and you have the net present value. Let's look at the formula.
NPV = sum[Fn/(1+i)n + + Ft/(1+i)t] - Project Costs
If you look closely you should see a striking resemblance between the NPV and present value formulas. The variable F is the value of the expenses or cash flow for that particular period of time. If your project is expected to last under a year, you use months. Each period of time is represented by the variable, n. The second month in the project would have n equal to 2, and so forth. The starting period for your project, n equal to one, should be when you purchase the property. Any expenses from inspections or other due diligence activities can just be added to the purchase price to represent total project costs.
The variable, i makes a dramatic transformation. Instead of representing inflation rates or interest, it now represents your opportunity cost of capital. The opportunity cost of capital is merely our return expectations for the project. Remember back in Section 3.1 when you figured the return a speculative housing investment should have to compensate you for your risk? For a highly leveraged property the required return would be 20-percent annually; the opportunity cost of capital. As you gain experience, you'll find a return rate that you are comfortable with. Perhaps 15-percent is sufficient - it is your money, you get to set the hurdle rate. Just remember you are working in months, so you need to adjust your required return to the project period. For instance, a five month project would multiply a 20-percent yearly hurdle by (5/12). If you wish to require the project to make the hurdle (20-percent overall) then just divide the hurdle by the project months (i.e. 20-percent / 5 months).
The final item that you compute before summing the present values is the sales price, Ft. The letter, t is the period the sale takes place. Hopefully sooner than later. "How do I figure the sales price?" Expectations on the sales price will be covered a bit later. For now you are just trying to understand the logic of the computation.
Now for a few refinements before jumping into an example. First, your main concern is the return on your cash investment; the equity. More than likely you utilized financing such as a mortgage to purchase the property. To simply model the mortgage you would input the monthly payments as expenses and subtract the payoff balance from the sale. Now you see the return on your equity in the project. Second, the project should be less than a year in duration with six months or less being ideal. Your calculations are going to be for a brief period with little to crunch - lucky you (take a look what rental investors have to do).
Time to take the NPV formula for a spin. Now imagine you bought a fixer-upper with a total project cost of $100,000. The bank required 20-percent equity, which you put on the table: $20,000. Closing costs are 3-percent, $3,000. You did no major renovations, just some paint and yard clean up over two weekends and week nights - you spent $500. Monthly expenses run around $700 with the mortgage. Five months from purchase, you flip this property for $135,000. Closing costs, fees, and expenses add up to $6,000. Time to put all of this information in a table.
Now for a little shortcut. Instead of computing the present value of each month, you can use the net present value function in your spreadsheet of choice. Take a few moments to find out how to do this on your spreadsheet - it's the NPV function in Excel. For the opportunity cost of capital, i, the 20-percent return was divided by five. You could divide the yearly opportunity cost by twelve and be correct for a monthly value. However, it is probably better to consider each project as being required to hit the return over the project life. There are really no hard set rules, again, your money you decide what works best for you.
When you compute the NPV for the totals, the result should be around $14,200. "What does this mean?" The positive result means that the project's return exceeds your investment requirements - a good thing. A good rule of thumb is only consider projects that produce a zero or positive NPV value. Remember, a NPV value of zero means the project meets your opportunity cost requirement. "How does the NPV translate into a return percentage?" That's where the NPV's cousin, the internal rate of return, IRR comes in.
The IRR is the value of i, the opportunity cost of capital, that will cause the NPV to calculate to a zero value. A complex iteration that is easily handled in a spreadsheet with a single command. The IRR is a handy way to visualize a percentage of return. Remember, if your project is month to month the IRR value is monthly.
Looking back at the example, the IRR calculates to a project return of 17-percent per month. "Does that mean I would make 90-percent profit" Potentially, remember you are still only modeling a potential project. Reality has a way of dampening things. If the investment hurdle for the project was 20-percent over five months, you would check to make sure the IRR exceeded (20-percent divided by 5 months) 4-percent per month.
Where the real value of NPV and the IRR calculation come in is when you change the time schedule. Messing around with the pro forma values such as time is called stress testing or sensitivity testing. Imagine your project went sideways and couldn't sell for twelve months - not the quick flip you had hoped for. Keeping all of the numbers the same and extending the sale out has some immediate obvious impacts. First, the mortgage payments and expenses pile up since you must pay them each month. Second, and less obvious is the impact of the time value of money. Running the NPV calculation, you find the result is a NPV of around $9,140. The project still exceeds our investment goal, but notice the NPV value has dropped by $5,060 from your initial calculation of $14,200. That is roughly a 36-precent loss in project value by extending the project out from 5-months to one year. The IRR has also dropped from the initial 90-percent to 53-percent.
"So what if the project slips, those returns are still great" The end result is not the point. The point is that the project has lost almost half its value in a very short period of time. So you need to really be on top of making sure you have a realistic schedule. The project model is showing that you lose about 5% of return for each month the project does not sell. This is very valuable insight when it comes to negotiations.
The pro forma is nothing more than laying out the NPV calculations you had done before so others can understand the project and assumptions. For example, instead of one category for expenses you break into closing costs, sales costs, mortgage payments, utilities, etc. The goal of the pro forma is to explain to the lenders and/or partners how the project will make a profit. Take a look at the pro forma for the example project:
|Category||Month 1||Month 2||Month 3||Month 4||Month 5|
|Renovations / Repairs||($500)||-||-||-|
|Equity Cash Flow||($26,700)||($1,200)||($700)||($700)||$129,000|
|Cash Flow to Equity||($26,700)||($1,200)||($700)||($700)||$49,000|
The pro forma is easily done in a spread sheet. The math is mostly arithmetic with the exception of the NPV and IRR functions. Each expense and revenue has been broken out and placed into one of three logical categories; acquisition, expenses, and sale. Next, the money spent or received is placed in the time period where it is expected to occur. Ongoing expenses such as the mortgage payments occur each month, while onetime events such as the acquisition and sale take place in only one period. Looking at the pro forma a lender would have a reasonably good idea of the projects expenses and sales expectations. They would be able to determine if your assumptions are reasonable. You, on the other hand, have a invaluable feasibility tool.
Per the example pro forma you can see the project returns are reasonable and meet the investment hurdles. Since you are not considering leverage at this point the OCC, occupational cost of capital, can be as low as 10-percent for the project. Remember unleveraged real estate returns are generally expected to be around 8-percent. With a positive NPV and a reasonable IRR for the project period, the project seems to be good so far.
Equity returns. This is where you see if you and any potential partners make any money. In the example you are the only partner in the deal so the equity cash flow is from and to your bank account. If you had partners or hard money lenders you would model the returns to each in this section. With multiple equity lenders and partners, the equity returns become known as a waterfall distribution. As income comes into the project, it is taken up by each layer of lender and partner. Generally you are at the bottom taking whatever is left (if any) or dividing it further between partners.
In the equity returns the total required equity for the project is around $29,300. This is higher than the $20,000 required for the property purchase. "Why?" Typically, the lender will only lend on the property itself and may not allow any further monies. If so, you need to supply the cash for the closing costs, renovations, and expenses. On the bright side, if you have been realistic in the sales price expectations, the project will return a healthy $19,700 profit. Not bad for a few months of work. "Why is the NPV and IRR for the equity returns higher than for the project" This leads us into the next subject - leverage.
Leverage allows you to make higher returns than if you utilize all cash. To illustrate, if the project was an all cash deal your total required equity would be $109,300. With the sale of the property you will net $19,700 in profits. Ignoring the time value of money for simplicity, the ratio of profit to equity is around 18-percent. Granted the actual profit would be a bit higher, since you would not have to pay any loan fees or mortgage payments. With leverage, you are only putting $29,300 into the project and borrowing the balance of the money. So in effect your $29,300 is leveraging a $109,700 project. Better yet, you will receive close to the same profit amount as if you put in all cash; $19,700. However, your simple ratio of profit to equity is now 67-percent, which is a much higher return. The use of leverage has increase the projects profit potential by a factor of almost four. As discussed earlier though, leverage can turn against you if you are not careful.
In summary, the pro forma can be thought of as your business plan for the project. Up to this point you have only modeled a hypothetical project. In fact you haven't even looked at physical real estate at all. You have been building a model of a project that is a realist representation of the project you should be looking for. If $30,000 is all that could be invested into a project, the model has shown we are limited to properties under $100,000. So you have now filtered out wasting time looking at properties over $100,000. You also learned that you need to sell the home for $35,000 more than what you paid for it - a 35% increase in price. As you will learn in the Site Selection section, property values don't appreciate that fast in general. Therefore, your search is further narrowed to finding properties in neighborhoods with an average value around $135,000 with a sales price around $100,000.
"That seems like a no brainer without all of the analysis hoopla. Why not just look for heavily discounted property of at least 35-percent?" Easy. First, you didn't know that you needed to find a house discounted by 35-percent until you ran the preliminary numbers. The model is to help you save time on what to look for. Instead of aimlessly wasting time on projects you don't have a chance on financing, you have spoke with financiers and other professionals to develop a realistic model of the project you can handle. Armed with this knowledge, you can now go out and focus on finding successful projects without the distractions. Once you locate a few properties you can use the model to pro forma each of them to select the best project to pursue of the bunch. Since you already have your model, you would simply plug in the actual values of each project to see the results.
Finally, be sure to run a few scenarios with your pro forma where you increase the project time to a year or more. Find out how long do you have before you start losing money or use up any cash reserves (savings to most of us). Play around with the renovation costs. Be sure and look up what the renovation value adds to the property, there are many sites out there with good data. Typically the renovation adds less than a fraction of its cost to the property's value. To be really safe you can add a contingency line to the expenses, which is just a placeholder for unknown expenses that is usually 3 to 5-percent of the project costs. All in all, be honest with your input, run some stress tests, and you will discover the ideal projects for you to chase.
Time to look for a project.