3 Types of Fix and Flip Investors
I had a thought I wanted to share with you, particularly about fix and flips. A lot of the people that I coach, the people that I teach how to do what I do, a lot of times they come to me with ideas that are very employee mindset based. If you know anything about me, if you've read in my most recent book Mindset To Millionaire, you know that I teach people to be more wealthy mindset individuals rather than employee mindset. Even investors, people who I have taught for quite some time, still occasionally have a hard time breaking out of the that employee mindset.
So, I want to talk about the three different types of investors, particularly when it comes to fix and flips.
Type number one is the type of individual who wants to move into a fix and flip. Now that may be for a number of reasons. Maybe they can't come up with a more creative way to buy a property than just to get a mortgage on it. A mortgage company looks a lot more favorably on an individual when they’re owner occupying a house rather than when they are purchasing a house as an investment. So it's easier to get a mortgage when you live in the house.
The other reason an investor might choose to move into a house while fixing it up is that they think that they can save money by doing the work themselves. Now, from one perspective I see why they think that, but if you really look at the situation as a as a wealthy mindset real estate investor would, you're actually not saving any money. I currently have five fix and flips that I'm doing at one time. This first type of investor that we're talking about wouldn't be able to do that. If my plan was to move in and fix it up myself, I could only do one at a time. I do a really high-end repair on the properties that I fix and flip. My average repair bill is about fifty thousand dollars. So let's say that I can save ten thousand dollars by moving in and doing the work myself, well if I moved into it, I could only do one at a time.
So, from that perspective, if I were to move into a property and fix it up myself to save ten thousand dollars, I'd be stepping over a hundred thousand dollars in potential profit in less time.
The second type of real estate investor is the type of investor who likes the structure all of their money in debt. They understand the principle of leverage, they understand that you can make more money when you leverage other people's time and leverage other people's money, but this second type of investor doesn't understand fully how to structure money, so he may borrow it as debt; the entire cost of fixing up the property as well as the entire cost of purchasing the property. Now, this creates a problem because a lot of times fix and flips will have between 10 to 20, 30, 50-thousand dollars, sometimes I've seen 70 thousand, and if you're lucky you get up over a 100 thousand dollars in profit.
What if 2008 were to happen tomorrow? We can't control the market, your guess is as good as mine as to win the next collapse is going to happen. There's indicators in the market, but nobody knows the exact day or the exact hour that that's going to turn. So I treat every property as if we're going to have a downturn in the market tomorrow.
This second type of investor that structures everything is dead if they've only got thirty thousand dollars potential profit. That's all the room they have to lose before their break even or their negative, right? Well, most of the properties that I do, they cost me over two hundred and fifty thousand dollars to purchase, and I sell them for over three hundred and fifty thousand dollars. Between that and the other fees and the repair costs, usually I profit on average somewhere around thirty thousand dollars.
Well, if 2008 were to happen tomorrow, everything over 250-thousand dollars would get a hundred-thousand-dollar haircut. Now, most downturns aren't that severe, but there's nothing preventing that from happening again. As educated investors we like to protect ourselves against that kind of thing.
The type two investor that we've been talking about only has one exit strategy, and that is sell it for more than what he put into it. That's risky and now, I can see looking at that perspective, I can understand why people say real estate is risky because that is a very risky approach. One exit strategy one plan is not enough.
The third type of investor I want to talk about is the type of investor that I teach my students to be. We'll call it an educated investor. The educated investor understands that they have no control over the market, but it can turn at any time, and if they're caught holding a property when in that turn happens, then they could potentially lose money for themselves and for their investors. An educated investor wouldn't let one simple property make or break them. The sad thing is that because the other two types of investors are either over-leveraged on the property or leveraging the property themselves on their own credit, it's a very risky proposition.
You could take the same property, the same amount of repair costs, the same contractor, the same materials, same amount of potential profit, and by simply structuring the money differently, you mitigate most of the risk. Now let's say that our property costs 250-thousand dollars to purchase and we're going to put fifty thousand dollars in repair costs into it, so we're three hundred thousand dollars into this property and we're planning on selling the property for 375,000. After agent fees and holding costs and different things that you may factor in, let's say that our profits going to be forty thousand dollars. For the second type of investor, the economy turns and the property takes a one-hundred-thousand-dollar haircut, we learn your property's only worth 270,000. You've already put 200,000 into it and that's not including holding costs so you're upside down.
I don't know of any bank that would let you refinance out three hundred thousand dollars’ worth of short-term debt for collateral that's only worth two hundred and seventy thousand in a down market. The way we structure it has educated investors is we use something called a blended structure. A blended structure is a blend of debt and equity partners. So we may go get a hard money loan on that same property for two hundred thousand dollars, and then we'll raise in private money the other hundred thousand dollars is needed to complete the project.
We structure that money in a partnership, so that means that our private money partners are just that, they're partners. That means they get voting rights, but it also means that if the economy turns while we're holding the property, they're in it with us and they understand that going into it. Now, because they're partners, they're going to get a share of the profit rather than a percentage rate so their potential upside is a lot better. The potential downside is they'll hang onto the property with you and one of the exit strategies is, that if you do go upside down on it, you just rent it out.
If all you have is thousand dollars in debt on a property and the same scenario happens that we talked about before, it drops from having an after repair value of 370,000 down to an after repair value of 270,000. We only have two hundred thousand dollars in debt, so even in a down economy, we’re in an equity position. We could take that collateral to a bank and get a mortgage for two hundred thousand dollars.
The other hundred that we spent is structured in a partnership. Our money partner is now a partner in a rental rather than a fix and flip, which means that he gets to share in the rents for as long as it takes for the economy to turn back around and for us to get the original value out of the property that we were planning on.
Worst-case scenario, our money partner makes more money. Yes, he has to wait a little bit longer, but you didn't lose any money for in that scenario. You satisfy the debt with your short-term debt lenders for your fix and flip, and most importantly, you had multiple exit strategies rather than just one.
What do I mean by multiple exit strategies? The third type of investor that we just talked about in that scenario could, in the case of not being able to sell it as a flip, rent it out, lease option it as seller financing, and many other things.
By simply being educated and having the knowledge on how to structure the money, we've mitigated most of the risk of real estate investing. On one hand, I can understand why an employee mindset person would say that real estate investing is a risky venture. But, on the other hand, if you approach it from the wealthy mindset, from a space of being educated and having knowledge of how to do it, you've mitigated almost all of the risk.