When you’re looking at a deal, it’s really easy to get excited about the raw numbers. In fact, if the basic numbers—how much the property will sell for minus how much it will cost to get it ready to sell—aren’t great, run!
In this case, we were looking at a house that would sell for about $375,000. We could buy it for $225,000 and it would take about another $65,000 for renovation, based on our average cost per square foot on a house in this market. That leaves about $85,000 in gross profit. Not bad for six months work. Right?
That gross profit number means that we should take a closer look, not that this is a good deal. It’s really easy to forget about the other costs, which can add up faster than Usain Bolt can run the 100 meters.
For example, we haven’t talked about contingency costs yet. I’ve been renovating houses for a long, long time—literally since I was in grade school. Projects seldom come in on or below budget. There’s always something unexpected that you can’t predict before you open a wall and find an electrical circuit completed with a coat hanger. Now you have to fix that, and that means bringing the whole project up to code.
Contingency costs are money you set aside to pay for such unknowns. We typically set aside about 10% of our renovation budget or $7,500 in this case. If we have to spend it, we’re not in any trouble. If we don’t, we have that much more money in our pockets at the end of the project. Allowing for contingencies brings our probable profit down to $76,800. We are still looking pretty, at least on paper.
Closing costs are the legal fees, taxes, and title insurance premiums you pay when you close the deal. You usually have to pay something at both acquisition and sale, but the seller often pays the bulk of these expenses.
I guesstimate about 1% of the purchase price and 2-4% of the sale price. That works out to $2,250 at purchase and $7,500 (2%) at sale for a total of $9,750. Our estimated profit is now down to $67,500.
Carol is a Realtor®, and her broker gives us a nice break on the sale commission. The seller always pays the commissions in Texas, with a very few exceptions. That said we still have to pay the selling agent their full commission.
Even though there are class action lawsuits against the National Association of Realtors® alleging price fixing, the “standard” commission in Texas is still 6% of the sale price. That number is negotiable, but as one friend of mine pointed out, “You tip a waiter 20% to get your order right. Why would you stiff someone who is actually making you money?”
Six percent of the sale price is $22,500. Our $85,000 gross profit is now down to $44,500. But we’re nowhere near done whittling away.
Money isn’t free. Since we had all of our personal, corporate, and private money tied up on other projects, our only option to do this deal would be a hard money lender. We have plenty of reserves, but it’s a very bad business practice to dip into your reserves to finance a project, no matter what Kiyosaki implies with his “pay yourself first” philosophy.
A hard money lender falls in the gap between bank loans and private money. They are bricks-and-mortar lenders who take on risky opportunities banks shy away from. They charge higher fees and interest rates that banks or private money, so they are definitely not the best way to go about financing a project. We have used hard money when the deal would support it, but only to avoid missing out.
Most hard money lenders in this market want 4% in origination fees and around 14% APR on the note. On this project, that brings the total cost of money to at least $33,000. With our potential profit down to $11,550, our lender would make almost three times what we would, and we would still have to come up with the renovation costs up front and wait for the hard money lender to “reimburse” us for them.
At this point, it’s hardly worth looking at taxes, which run about a thousand a month and utilities which average about $225 per month over the course of our projects, not counting deposits. Insurance on this project would cost about $700 for six month. Our total expected profit is about $3,500.
Would you work six months for $3,500? But wait! There are four of us. That’s $875, or less than $150 per month! And that’s the best case scenario.
Once again, this little exercise shows that the only thing worse than no deal is a bad deal.
But what if we had not already been fully committed? Then it would have been a much better deal for us, just above our threshold for a project of this scope.
But what if we had used only our own money? The same thing. You always have to pay yourself for your money. That’s an opportunity cost. If you weren’t using your own money for one of your projects, you could loan it to someone else or maybe find a project with a better return.Hermann says please like and share!