The first flip house project can be nerve-racking! There are so many things to learn. The entire network is new at this point. You may not even know who they are yet! We suggest that you begin with a low-risk property to bolster your probability of success. We want you to succeed in flipping houses! The property types listed here can still work for some, but they are niche investors. These properties have more variables to consider than other projects. Again, we suggest that you begin as simple and easy as possible.
If you have a house flipping calculator, then you should be able to avoid bad deals most of the time. However, we realized that some types of properties can trick either the lead generation or qualification systems. The math still works, but other factors make these properties more difficult to turn. With time and experience they become easy to spot, but we want to call your attention to them in the very beginning.
The article covers:
The Executive
The Behemoth
The Catastrophe
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The Executive
The executive house is a statistical outlier. Imagine an area with a mean home value of $300K and a standard deviation is $70K. However, there is one very small grouping of homes that sold above $1M (ARV) several years ago when they were built. One of these homes has hit your radar. You think it looks promising. You could only do this deal if you pull every dollar you can get together, and then maybe even finance the rest. This deal would put everything you have into one basket. You should skip this one! There is a good reason this deal is available.
Statistically, this project is a loser from the very beginning! Let’s consider the 68-95-99.7 rule (also known as the empirical rule) without getting too nerdy. The rule is based on a normal distribution (also known as the Gaussian distribution). The rule states that an estimated:
68% of the market is in a price range from $230K – $370K (mean ± 1 standard deviation)
95% (gain of 27%) of the market is in a price range from $160K – $440K (mean ± 2 standard deviations)
99.7% (gain of 4.7%) of the market is in a price range from $90K – $510K (mean ± 3 standard deviations)
That leaves only 0.15% of the market (the half of 0.3% from the high end) able to afford above $510K. After that, we still have to get from $510K all the way to $1M. These odds are worse than 1 of 1000 buyers!
The problem is there simply is no market for the property in this area! The majority of buyers with enough wealth to afford a house of that magnitude choose to live somewhere else. The few remaining buyers will be very selective. They can be because they are the 1% (in this area at least). They could also afford to build their own home and get exactly what they want. Your finished, polished, shiny diamond of a mansion will likely sit a very long time waiting for a credible buyer. Maybe several years! The carrying costs (mortgage, landscaping, heating + cooling, pool maintenance, taxes, insurance, HOA, …) will be relentless!
Try to target properties inside of the mean ± 1 standard deviation, at least for your first few flips. This will allow you to bring your finished property to a market where the majority can afford to buy. This will ensure that the property will sell in a reasonable time frame allowing you to hit the project estimate and pivot into the next one smoothly.
The Behemoth
The behemoth house is much larger than the other houses in the neighborhood. Much larger! Look at the neighboring house in the image above. This phenomenon is common in older neighborhoods that have mostly small homes. Several decades ago, it was normal for builders to make homes between 1,000 to 1,400 square feet. The behemoth house will typically be at least twice the size of the average home in these older neighborhoods. If the average square footage of the neighborhood is 1,200 square feet, the behemoth house may be around 3,000 square feet. You should skip this one too!
This house was likely owned by a contractor, or DIY enthusiast, that was outgrowing the house. However, they decided to stay in the house and increase the size, instead of moving to a neighborhood with larger homes. This is normally done in an effort to save money. This work could have been unpermitted and never inspected or approved by the building department. Beware of this situation. If the city and county records don’t match the physical structure, you may be in for a fight with the building department to obtain even the most simple permits.
The real problem with the behemoth is valuation. Everyone knows that a larger house is worth more than a smaller one. Unfortunately, that isn’t the whole story. The first 1,000 square feet or so of a property are the most valuable. While a 1,000 square foot house is valued less than a larger home, it has a higher value per square foot. As the property increases in size, it increases in value, but it decreases in value per square foot. Each extra square foot is worth less and less. Eventually, the value of the property reaches a limit. This limit is set by the other properties in the neighborhood. Above the limit, extra square feet do not add value. See the table below for an example. The limit in the example is $255K regardless of size above 1600 square feet.
SqFt Value Value/Sqft
1000 $200,000 $200
1100 $214,500 $195
1200 $228,000 $190
1300 $239,200 $184
1400 $247,800 $177
1500 $253,500 $169
1600 $254,400 $159
The problem comes when trying to value the behemoth. All comparable sales might have an average value per square foot of $190. Using that figure, the value for a 3,000 square foot behemoth house would be $570K. Unfortunately, that is more than double what this property is worth! There is a big gap in price and there are no comparable sales of homes above 1600 square feet. Now you are in a mess!
This makes sense from a buyer’s perspective too. If the work is done well, a buyer may consider buying the nonconforming 3,000 square foot home. However, how much would they be willing to pay? Would they pay the same amount for the home in the smaller and less expensive neighborhood as they would for the exact same home in a larger and more expensive neighborhood? No! They will expect to get more than half of this house for free!
The Catastrophe
The catastrophe house could have been in a flood. It doesn’t have to be an actual flood caused by a natural disaster. Usually, the house has had a water leak (plumbing or roof) for quite some time. Given enough time and neglect (think vacant house), the leak becomes worse, wood rots, and mold grows. Given a damp environment and time, airborne mold will spread everywhere.
The catastrophe house could have been on fire. Fire causes smoke, soot, and ash. These fill the house and turn everything black, leaving a bonfire smell throughout. This mess is almost impossible to clean. Even if you could clean it, you could never remove the bonfire smell.
The catastrophe house could have been on fire and then in a flood. It is very common for a fire property to experience roof loss. The cleanup and insurance claim and payout process for a serious house fire may take several months to complete. During those months without a roof, water problems arise. Yep! Wet, moldy, ashy, sooty bonfire smell!
This house needs a massive construction budget. The building department will require an architect to draw plans, structural engineer to stamp the plans, and a master permit (many permits together). Often, the demolition and cleanup must be completed before you can even assess the damage. Many architects and engineers will not begin to work before that cleanup for liability reasons. They have to make professional guarantees on whatever materials will be reused. The problem here is that you won’t invest a dollar to demo and clean up the project until after you negotiate and buy the property. You would have to guess the construction budget. That is a big problem at the first rodeo!
This project should not be where you meet your contractor for the very first time. You should skip this one! Projects like these may be very lucrative. They should be, because they come with much more risk than simpler projects. Investors should have a notch or three on their belts and know their contractor’s children’s birthdays cold before considering deals like this.
This saved me from a potential disaster.