Page 25 - From Ghetto to Gucci: The Basic Principles of Flipping Houses

And you will have just invested $22,125 for the privilege of flipping one house. Your profit on
each house is now going to be reduced slightly from the original $30,000 to $27,000. Multiply
these numbers by six, and if you brought $150,000 ready to invest and took out these loans,
you just invested $132,750 for a profit of $162,000. In three months. That’s a 122% return on
your investment in three months. That is the power of leverage—you just multiplied your return
on investment six times by using the loans and monies available to you.

The Downside of Leverage

While leverage can do amazing things to multiply your profit, it can also have the opposite
effect. Have you heard the saying, power isn’t inherently good or evil, it depends on how it’s
used? The same principle applies to leverage. Leverage isn’t inherently a profit maximizer or a
loss maximizer. All that leverage does is magnify the results of your profit or loss.

That’s where the downsides of leverage come in. Let’s say that you go through the scenario
listed above. You’ve got $132,750 invested into those houses, but let’s say that you had
decided to go ahead and pull a little bit from your rainy day fund to invest in housing. Because
hey, the opportunity looks fantastic. Now, three months into things, you’ve got all your houses
repaired and on the market. You thought that they would have sold by now, but the market’s a
little softer than you thought. You’ve invested $154,875, which you were expecting, but now
more interest payments are coming up. Next month, you’ll have to cough up $5,000 to cover the
costs of your construction loans and mortgage.

What can you do in this scenario? You’ve already dipped into your rainy day fund, and none of
your houses look like they will close anytime soon. This is the classic scenario for overleverage.
This is what led us to the financial crisis of 2008. If you don’t strike the proper-balance between
risk-taking and precaution, you can find yourself facing obligations that you’re unable to pay. As
you look at your loan options in flipping, watch out for overleveraging yourself.
Overleverage is almost always accidental, and comes when you least expect it. In flipping
overleveraging can occur in a variety of ways. For example, say that you flip the houses in the
example above. You’ve got six houses, and instead of $50,000 in rehab expenses for each
house, you end up spending $60,000. That extra $10,000 is coming from your pocket, not from
the construction loan. You’ve underestimated the costs on the house, and it’s coming back to
bite you.

Underestimating the time it takes for a construction project is another common pitfall. I’ve flipped
houses within a week and sold within a month, but there are other times that a three-month
project ended up taking an entire year to complete work on. The timelines for construction can
vary drastically.

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