I often hear agents and aspiring real estate investors talk about “carpet-and-paint flips” as if such unicorns exist in real life. Over 250 flips into my career, I have never seen a house I could feel good about selling after only fixing up the carpet and paint. In fact, our average construction budget on entry-level, 1,300-square-foot houses hovers around $40,000. That’s a lot of carpet and paint.
Here’s the rub with the carpet-and-paint myth: The internet is pretty good at valuing well-maintained houses, and sellers don’t give those houses away. If you want to flip houses in a Zillow-informed world, you have to add value through construction.
Once you accept that value is added to flips with construction, the next step is to accept that you have a finite construction capacity. That capacity may increase over time, but we all have a current construction capacity. It is a function of the available number and quality of subcontractors in our network, but that’s not the only variable. Even if we could hire more quality subcontractors, it’s not that easy. Construction capacity is also the product of our own systems and capacity to stage projects, deliver the right materials at the right time and effectively manage the people working on construction sites. Every experienced flipper has at some point out-punted the coverage, attempting to keep more crews producing than we were capable of managing. It’s an expensive lesson in self-awareness.
Be honest about your construction capacity. If you are starting out, your construction capacity is probably dependent on one intermittent crew you are managing in your free time. That is a construction capacity of between $40,000 and $100,000 per year. That’s the capacity you are currently equipped to manage in 12 months. With persistence and hard work, you will increase that capacity over time, but it will involve taking steps backward in order to go forward.
For now, let’s assume your capacity is $60,000. Once you identify your number, you can then begin taking it seriously in your property analysis. If flip profits require construction and you have a finite construction capacity, you have to consider this when analyzing prospective flips. At my firm we developed a metric called construction-profit ratio (CPR) to help us analyze deals. It is simply the construction budget divided by profit, with profit including quiet costs but no overhead costs. If you consider a project with a construction budget of $45,000 and a profit of $15,000, that is a CPR of 3.0. Given your construction capacity of $60,000, such projects place the annual profit capacity at $20,000 ($60,000/3) for the year. If you buy 3.0 CPR flips, your profit will be capped at $20,000 per year. If, however, you can find 2.0 CPR flips, your profit will increase to $30,000 without increasing your construction capacity.
Let’s consider two prospects. The house at 423 Rancher Drive requires a $30,000 rehab and projects a $15,000 profit, or a 2.0 CPR. The home at 678 Historic District Road requires an $80,000 rehab with a higher profit of $20,000. Which is the better deal? The higher-profit option, right? Not if you take your construction capacity seriously. Project this deal flow out over a year, and you will make $30,00 on the 423 Rancher Drive projects, while 678 Historic District projects will yield only $15,000 per year. If you are seduced into the deals that seem to have higher profit margins, you could cut your annual profit potential in half.
This is why it’s important to be honest about construction capacity and take it seriously when determining a maximum offer on any property. So, why not just buy 1.0 CPR projects?
In the real world where sellers don’t give away well-maintained houses and inspections are required to sell a flip house, such 1.0 CPR deals are rare finds. That’s why aspiring flippers must add value through construction. In the business of flipping houses, increased profits are tied to strong analysis and increased construction capacity.
Start by identifying your current construction capacity. Factor CPR into your analysis of prospect properties to maximize your current profit potential. Then, expand your construction capacity so you can increase your earning potential.