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Control Your Money, Not Vice Versa

A few weeks ago, I wrote a post very similar to this - in fact, some aspects are identical - but I'm putting a slightly different twist on it to alter the perspective by a tad.  

Whenever I meet a real estate investor who likes to take the fix-n-flip approach, I always ask why they go that route rather than subscribe to a buy-n-hold approach.  There are different answers to that question, but they all seem to have a common thread running through all of them: "I need the money to go out and buy another house to flip."  Sure, most people have a limited supply of cash on hand, so that makes sense.  With that said, there are three options EVERY real estate investor should know about - but, usually, they only know about the first one.  Let me set this up:

Real-life example: the property in question costs $77,000 to acquire and $18,000 to rehab (total cash put out equals $95,000).  The property then can sell for $135,000.  Ready?

Traditional Fix-n-Flip
• $135,000 Sell price
• Get back total $95K put out (acquisition & rehab)
• $17,225 Profit (after costs of sale & short-term capital gains taxes)
• 18.1% ROI

Immediate Cash Out (0-6 months)*
• $135,000 Appraised Value
• Get back $77K
• Earn $435/mo in passive income
• 29% ROI in the first year
• No short-term capital gains taxes

Delayed Cash Out (Wait 6 months)**
• $135,000 Appraised Value
• Get back $101,250
• Earn $295/mo in passive income
• ROI is INFINITE – In 6 months, $6,250 in profit
• No short-term capital gains taxes

Any questions?  Sure, some of you are probably wondering how I came up with some of the numbers outlined in the scenarios listed above.  Buckle up, because here we go:

Traditional Fix-n-Flip Option
The costs of the sale tend to be approximately 10% of the sell price.  In this case that would be $13,500 – these costs consist of commissions, seller’s costs, and concessions.  After subtracting out the costs of the sale ($13,500), the cost of acquisition ($77,000), and the costs of the rehab ($18,000), there’s a profit of $26,500 of which 35% ($9,275) will go to short-term capital gains taxes for an overall net profit of $17,225.  Dividing $17,225 by $95,000 (the costs of acquisition and rehab) yields an ROI of 18.1%. 

PROS 
  • all costs were recouped
  • a net profit of $17,225 was made
  • there’s no further obligation  
CON
  • no property has been retained that may appreciate in value

*Immediate-Cash-Out Option
Once the work on the house has been completed, an appraisal is ordered, and it comes back at $135,000.  The property can be refinanced at that point up to 100% of the acquisition cost, which is $77,000 in this case.  The monthly mortgage payment of $465 is based on a conventional fixed 30-year mortgage at 3.875% (4.893% APR).  The difference between $900 (the projected rental rate) and $465 is $435.  Multiplying $435 by 12 yields $5,220 in annual profit.  Dividing $5,220 by $18,000 (which was the investment in this case – the rehab costs) yields an ROI of 29% for the first year.  

PROS
  • a property has been retained that may appreciate in value
  • the cost of acquisition was recouped
  • avoid short-term capital gains taxes
  • no sales costs
  • an income-generating property has been established

CON
  • a mortgage requires obligation

**Delayed-Cash-Out Option
Six months after work on the house has been completed, an appraisal is ordered, and it comes back at $135,000.  The property can be refinanced at that point up to 75% of the new appraised value, which is $101,250 in this case.  The monthly mortgage payment of $605 is based on a conventional fixed 30-year mortgage at 3.875% (4.893% APR).  The all-in costs for this property were $77,000 for acquisition and $18,000 for rehab, for a total of $95,000.  The difference between what can be pulled out in the refinance ($101,250) and the all-in costs ($95,000) is $6,250 in PROFIT.  Because the money available to pull out through refinance is greater than the all-in costs, the ROI is infinite. 

PROS
  • a property has been retained that may appreciate in value
  • the costs of acquisition and rehab have been fully recouped with a profit
  • avoid short-term capital gains taxes
  • no sales costs
  • an income-generating property has been established

CON
  • a mortgage requires obligation
Everyone has a different set of circumstances and needs, and they change as life events and other things take place, which means that no one option above is better than the other.  They each have their advantages and drawbacks - it's up to you to decide which strategy you want to pursue, and you may implement a different strategy for different properties and for different goals.  And that's the reason I wanted to line out the three options - it's kind of hard to exercise an option if you don't know it exists.  

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