How To Evaluate A Reno-And-Flip Proposition

I’ve long been of the opinion that flipping is dead in Toronto, given the high price of real estate, the transaction costs, and the fact that most properties that are candidates to be renovated and flipped end up selling for more than they “should.”

Last week, I took a serious look at a property that could have made a fantastic project.

Let me guide you through the process, from start to finish, with all the evaluation criteria that we used.

RenoFlip

I’ve actually stopped getting “those calls.”

The calls that used to drive me nuts.

The calls that made me sour on the level of logic that today’s Average Joe seems to possess.

Those calls that essentially start with, “Hi David, my name is Joe, and I’m looking to buy a property in Toronto, fix it up a lil’ bit, and flip it in a few months for a good profit.”

Those calls that eventually reveal that “Joe” works a full-time, 9-to-5 job, has maybe $35,000 in savings, and wants to be a player.

Joe wants a shortcut.

Joe wants to put all his money down on the roulette wheel, but he doesn’t want his odds to be 1-in-40.  He wants them to be 40-in-40, and he wants the wheel to spin quickly so he can take his winnings and move on to the next guaranteed score.

And best of all, Joe has no experience investing in or renovating real estate.

Don’t get me wrong – real estate is a great investment, and I applaud entrepreneurs of any kind.

But the calls I used to get…

My God.

“Do you have any experience renovating houses?”  Not at all.

“Do you know any contractors, builders, tradespeople?”  Nope.

“Do you have access to capital?”  Not really.

“What are your expectations with your first project?”  At least six-figures.

The calls were insane, and part of that had to do with the incessant amount of radio and social media as for these “real estate seminars” that claim you can:

1) Make money flipping real estate
2) With none of your own equity involved
3) No risk
4) No management or involvement

Yes, really.  And thus why I felt the need to produce this video, last year, just in case you never saw it:

Wow, those were fun times…

In any event, I do work with investors, and I do work with the odd person who is looking to flip a house, and last week I found the perfect property.

I can’t give you address because of the archaic and ridiculous rules that exist in organized real estate, but I don’t think they’re central to the story.

“The house” was listed for $599,900.

It was a semi-detached, 2 1/2 storey, that had three self-contained units.

It was not a legal triplex, but few in Toronto are.

The house was in absolutely miserable condition, and while some people figure a coat of paint would give it a “fresh, new look,” I figured it was a “down-to-the-studs-gut.”

So where do you start?

To evaluate the merits of this entire project, I want to know the following:

1) Likely sale price
2) Net income from three rented units
3) Prevailing cap rate in this area
4) Expected value upon completion
5) Cost of renovation
6) Profit

And away we go….

1) Likely sale price

Wow, where do we begin to come up with a likely sale price, given the condition of the property?

There’s nothing else like this for sale, and nothing that’s sold in the immediate area in the last six months.

So as is often the case, I go with the most efficient real estate tool that I know of: my gut.

My gut feeling on this house was that it would go for about $750,000, probably more, given the market we’re currently in.

That will have to suffice for now, but ultimately the next four steps will help determine how reasonable that estimate really is.

2) Net income from three rented units

Keeping in mind that we’re gutting this house, and that the existing layout of the home doesn’t really matter, I wondered if there was any way to make the existing 1-bedroom unit on the main floor into a 2-bedroom.

It was possible, but I’m conservative in nature when I evaluate investment candidates, so I decided to crunch the numbers as though this was a 1-bedroom.

A 1-bed, 1-bath apartment in this location, with a parking space, would fetch about $1,550.

The basement, believe it or not, had 12-foot ceilings in some areas!  The floor was exceptionally slanted and sloped, so the previous owners built a raised floor overtop, and the ceilings were still 7 1/2 feet!

This house was so awful, it’s hard to believe they had tenants in there up until December.  The basement was like a dungeon, but it was the access to the basement unit that was most scary.  There was a small extension built off the back of the house, that any renovator would undoubtedly tear off, that meant you went through two doors to get to the basement unit, which was accessed through the mechanical room.

All that had to change.

But the space down there was great, there were large windows at-grade, and I figured you could get $1,100 for that unit.

On the second and third floor of this house, there was a ton of space.  The whole layout needed to be re-worked, but again, we’re doing a “full-gut,” and I figure a 2-bed, 1-bath unit, over 2-storeys, could fetch $2,200 with a parking space.

So there you have your rent roll:

$1,550
$1,100
$2,200
$4,850/month

That’s $58,200 per year in gross income.

The taxes on this house are currently $3,500 per year, but after a renovation, and a visit from MPAC, let’s assume these taxes increase to $5,500.

The insurance on this house is $800 per year.

The water is $1,000.

The hydro would be paid for by the tenants, but can you get them to pay Enbridge as well?  Probably not.

That’s $2,000 per year.

So that’s $9,300 per year in expenses, and this assumes the owner manages the property him or herself.

I know you want me to include a contingency for vacancy, but this is Toronto, and if you have a vacancy with a triplex like this, then you’re half-assing this investment.

Let’s add in $700 per year for “miscellaneous,” and call it an even $10,000 per year in expenses.

$59,400 gross rent
$10,000 expenses
$48,200 net income

3) Prevailing cap rate in this area

Again, going with my gut, I would suggest that the prevailing cap rate in today’s market is anywhere from 3.5% – 5%.

One investor might suggest it’s insane to buy a property at a 3.5% cap rate, but that’s what’s happening in many areas of the city.

Another investor might laugh at the notion of a 5% cap rate on a triplex, but I’ve seen it.  It’s rare, but they might exist out there.

A property sold in March of 2015, on the same street, two blocks east of the subject property, and alas – it was a triplex.

This was a purpose-built, turnkey triplex, but it has pros and cons when compared to the subject property.

It’s a 40-foot frontage, with a 1-car garage, but it’s on the north side of the street and on a reverse-ravine, so the land is useless, and the lot is only 80-feet to begin with.

But the three units were in great shape.  Not brand-new, in the same way as we’re aiming for with our subject property, but overall, solid B+ for rental apartments in multi-unit dwellings in Toronto.

Looking at the income and expenses for this property, which sold for $1,052,000 last March, I noted a 4.3% cap rate.

You could argue that 11 months of appreciation would put this property over $1.1M, or you could argue that cap rates have decreased to 4.0% in the past year.

But either way, I elected to use 4.3% as yet another conservative estimate in my numbers.

4) Expected value upon completion

Very simply, there’s $48,200 in net income in the subject property.

And we have an acceptable 4.3% cap rate.

Thus we arrive at a projected value of $1,120,930 for the subject property upon completion of the renovation, and acquisition of three tenants for the three units at $1,100, $1,550, and $2,200.

5) Cost of renovation

I had two contractors come in to see this property.

Both were very different people, from different backgrounds, with different strengths, and who work different areas of the city.

Both came up with the same numbers.

The first contractor said it would cost $300,000.

The second contractor said it would cost $250,000, but that a $50,000 buffer was needed for contingencies.

Both came up with the same number, but did so in different manners.

So we were looking at $300,000.

6) Profit.

Buying this house at $750,000 comes with $22,200 in land transfer tax.

Selling the house for $1,120,000 comes with $56,000 in real estate fees.

The legal fees on the purchase and sale will run $5,000 total.

$750,000 purchase price
$300,000 renovation
$22,200 LTT
$56,000 real estate fees
$5,000 legals
$1,133,200

I’m conservative in nature.

You might argue that this house would sell for more than the $1,120,000 that I’m quoting, given we’d be looking to sell it in October of 2016 once the renovation is finished, and the tenants are in.

You might argue that my rents are low – the $1,550 for the 1-bed unit, or the $2,200 for the 2-storey, 2-bed unit.

You might also argue that you could find a contractor to build this for less than $300,000.  Or a Realtor to work for less than 5%.

But either way, the numbers just do not add up.

If you’re looking to flip this property, then they don’t add up.

If you’re looking to keep this property, long-term, and collect the $48,500 net income, then considering you’re in for about $1,077,200, you’re looking at a 4.5% cap rate, which isn’t bad for this market.

But a flip?

It just doesn’t work.

You’d have to get this house for $700,000, and do the renovation for $250,000.

But alas, the house sold this week for $783,000.  That’s more than my initial $750,000 “gut feeling,” and substantially more than would you would “need” to get the house for in order to make this project worthwhile.

I’ll say it again – when it comes to evaluating investment properties, I’m conservative.  But you simply have to be.  To assume $55,000 in net income, a $220,000 renovation, $39,000 in Realtor fees, and a $1,200,000 sale price would be irresponsible.

And even if those numbers held true, that’s $130,800 in profit.  With $80,000 more than you expected to sell the house for, $80,000 less than you expected in renovations, and a discount on the real estate fees.

That’s a big gamble.

And we haven’t even got into the borrowing costs, opportunity cost of your money, and “what if” scenarios with the build.

I’m not saying that there aren’t investment projects out there, but I am saying that they’re harder to find than you’d think.

But this is how you should evaluate a potential property, at the most very basic level.

13 Comments

Post A Comment

Your email address will not be published. Required fields are marked *

  1. Navtaj Chandhoke says:

    There are fellow Canadians who do very well in fixing and flipping houses for instant profit.This is not for everyone.You need to buy these properties at deep discount which you will not find on MLS.They exist but only few handful experts are able to grab them.You can learn more at http://www.Flipping4Profit.ca

  2. Appraiser says:

    Latest TREB mid-month sales data highlights are as follows:

    February 19, 2016 – Greater Toronto Area REALTORS® reported 3,500 sales through TREB’s MLS® System during the first 14 days of February 2016. This result represented a 13.5 per cent increase compared to 3,083 sales reported during the same time frame in 2015.

    The average selling price for the first two weeks of February 2016 was $677,380, a year-over-year increase of 12.5 per cent.

    The average price of condominium apartments was up by more than 16 percent year-over-year.

  3. AndrewB says:

    Those radio ads are the worst. Have the people listening to these ads never thought to themselves “if it was such an easy way to make money, why would they share such a secret with all of us”? A fool and their money are soon parted ways.

  4. Chroscklh says:

    This present economic which no make the sense. Not to mention income tax on flip if not primary resident. Canada mkt too mature do this. Back home my country, I do this 2x yr, but I have trusted team, and mkt less develop – and also I no buy flip house, I take with force. Different economic. But then again, risk of hyper inflate, currency collapse 99.98% is very real – happen 2x in 2015

    1. condodweller says:

      A voice of sanity! I know people who flip houses by moving in to do the flip. They pay no income tax on the gains.

  5. condodweller says:

    The way you positioned it no it does not make sense, unless of course prices go up another 10% this year and as you have said in previous posts, flippers don’t mind leaving houses on the market for a long time until they get the price they want. Anyhow, if I was considering flipping, which I would not in this stage of the cycle, I would get my real estate license so that I can keep the 5% between the buy and sale transactions, and I would do much of the gutting work myself and explore how much of the reno I could do myself to save on contractor’s costs. I would try to find a contractor that would take me on as an “apprentice” to do work on the house. Of course this means I’d be doing this as a full time work. I would consider doing this at the bottom of the cycle to benefit from market appreciation where the chances of the market appreciating are 80% whereas currently near the top of the cycle is much lower.

    I agree with Kyle on this one that a family home with a basement apartment might make more sense. Mind you, you can always move into one of the three rental units and rent the rest which would make financing the project easier.

    If you are doing a gut and rearranging layout, would you not need to hire an architect to do the planning or did the contractor include that in the 300k?

  6. Mark S. says:

    The ideal example here was illustrated this week when the princess margaret lotto Markham house. Full upgrade and capital investment that someone (insurance?) will have to write off due to it being next to a legal! grow op.

    Despite best efforts of everyone you still have to factor in the ‘unknown unknown’ and assume that something (underground river/watershed/grow op) might wipe out your plans.

    1. Mike says:

      What I found most amazing about that story was that someone would have a legal grow-op in their house. That’s really going to come back to hurt when they go to sell and I’m surprised they were able to get insurance.

  7. Marina says:

    Part of the problem is that many people view real estate investing as a sure thing, and the only reason not to “go for it” is if you don’t have the downpayment.
    For most people, you have to grow into it. Start with maybe a basement apartment in your house, or a small condo, something with much lower financial risk, where maybe you’ll be on the hook for low to mid 5-figures, but not 6. Learn if you can be a landlord. Figure out all the unexpected expenses that might come up. Build some experience, some equity, and relationships with plumbers, electricians and a general contractor.
    Then move up.
    I know of four people who started that way and now rent out 4-6 units each and have flipped a couple of properties each. But they started with ONE bachelor or 1 bedroom condo.
    If we ever go this way, I’m starting with a 1-bedroom downtown.

  8. Boris says:

    a contractor saying $300k for a gut means $350k at least, in this city, in this market.

  9. Kyle says:

    I mostly agree with this post. The slam dunk opportunities to make money by buying low, improving and then re-selling are few and far between now, but there are definitely people out there who are doing it quite successfully. In your example however, i don’t think i agree with the approach. Buying a triplex in a residential neighbourhood, gutting and then rebuilding it as a nicer triplex, doesn’t seem to be the highest and best use for that property. In today’s market where there are 10 families bidding for every listing, wouldn’t it make more financial sense to convert the triplex into a single family house with a basement apartment?

    1. jeff316 says:

      Agreed, although keeping a triplex may appeal to young families looking to rent out two of the units.

  10. Appraiser says:

    Experienced contractors are the most likely candidates to realize a profit in such scenarios. Even then there is the opportunity cost of personal sweat equity vs. renovating someone else’s project for a fee. Sorry, no weekend warriors need apply.

TWEETS