In Ray Dalio’s book “Principles: Life and Work,” the concept of expected value is highlighted as essential for making decisions under uncertainty. Expected value, a statistical concept, calculates the average outcome of decisions with multiple possible results, each with a certain probability. This approach is invaluable for mitigating risk and maximizing remodel profits when deciding to purchase and later flip a property.

Expected value is the sum of all possible values, each multiplied by the probability of its occurrence. It represents the average result if a decision were repeated many times.

To understand this better, let’s look at a simple example. Suppose you are playing a game where you can win $100 or lose $100. The probability of winning is 60%. Here’s how you calculate the expected value:

1. Determine the win amount and its probability:
   • Win amount: $100
   • Probability of winning: 60%
   • Calculation: $100 * 60% = $60
2. Determine the loss amount and its probability:
   • Loss amount: $100
   • Probability of losing: 40%
   • Calculation: $100 * 40% = $40
3. Calculate the expected value:
   • Expected value = $60 – $40 = $20

If you played this game 100 times, you would expect to make money. It seems simple and carries very little risk.

Now, consider a different scenario. What if you could win $1000 but only lose $100, with a 20% chance of winning? Would you take this risk?

When faced with a decision under uncertainty, list all possible outcomes, determine their probabilities, and assign a value to each outcome. By calculating the expected value, you can choose the option with the highest expected value, theoretically yielding the best average outcome over time.

Remodel To Sell – Maximizing Remodel Profits

The most often asked question about Remodel To Sell is “What should I do to get the most profits”. The purpose for the remodel it to make the highest return on investment. The expected value calculation is a great way to determine how much you should remodel. You do not want to over remodel and waste money. But, you also want to make sure your home presents the best compared to the other homes for sale in the same price range.

To determine how much we should spend on the remodel we need to set some constants. the total profit we make from a remodel is our “win amount”. If we run into a scenario where we lose money, we will count that as the “loss amount”. the selling price for our project will be constant, while the amount we spend on the remodel will vary.

Example

Recently, I made a CMA for a client and I saw a perfect example for maximizing remodel profits. I love this example because it represents two types of projects we do. Firstly, Wind Cave Ct is a fixer, great for an flip. Secondly, Klamath Ct was sold without being remodeled. It has an outdated style. We can use that home as an example of a homeowner wanting to learn if they should sell as-is or update the home and sell.

All other homes were is really good condition with recent remodels. They present very well online. All these homes sold in under 6 days on market, except for Klamath Ct, which took 13 days.

What prices are comparable homes selling for

For this calculation we want to get a list of the previous sales. We will determine the top tier, middle tier and bottom tier.

I’ve added 6% selling costs.

Top Selling Price: $1,830,000 * 6% = $1,720,000

Median Selling Price: $1,650,000 * 6% = $1,550,000

Low Selling Price: $1,500,000 * 6% = $1,410,000

Remodel levels and styles

The main purpose of the calculation is to determine which style and finish level will be the most profitable, based on the probability of selling price.

Remodel Costs for various projects

Wind Cave Ct. is a fixer and in the public remarks states there are foundation issues. We consider the scope of work to be a restructure.

Standard completion style is $78/sqft.

Designer completion style is $88/sqft.

To get the total project cost, we multiply the cost per sqft with the square footage of the home. Do not forget to include the rehab risk. This would be a large project and many surprises await.

Total rehab costs for standard style: $150,000

The total cost to purchase added to the remodel costs for this level is $1,350,000

Total rehab costs designer style: $170,000

The total cost to purchase added to the remodel costs for this level is $1,370,000

Profits Based on Selling Tiers

The following profits are assumed if the home sells in each tier.

Top: Standard $370,000 Designer $350,000

Median: Standard $200,000 Designer $180,000

Low: Standard $60,000 Designer $40,000

Introducing probabilities of selling

Decide what the probability will be to sell in each tier. This information can only be provided by a real estate agent.

Designer level: Has a greater chance of selling in top tier, and a very low chance of selling in the bottom tier

• 25% chance of selling in top tier ( .25 * $350,000 = $87,500 )
• 70% chance selling for average sales price ( .7 * $180,000 = $126,000)
• 5% chance sells in bottom tier ( .05* $40,000 = $2,000 )

Excepted value = $87,500 + $126,000 + $2000 = $215,500

Standard level: Lower chance to sell in top tier and higher chance of selling in lower tier

• 10% chance of selling in top tier ( .1 * $370,000 = $37,000 )
• 60% chance selling for average sales price ( .6 * $200,000 = $120,000 )
• 20% chance sells in bottom tier ( .2 * $60,000 = $12,000 )

Expected value = $37,000 + $120,000 + $12,000 = $169,000

these calculation show that for Wind Cave Ct. flip, going with designer level finishes will have better success. Also, this is a great property to flip, because there is very little chance of loosing money.

Factors Might affect The Selling Probabilities

• Market Conditions: If interest rates rise unexpectedly, the probability of high and moderate profits might decrease, and the probability of a loss might increase.
• Local Real Estate Dynamics: If a major employer in the area announces layoffs, the probability of a high profit could decrease.
• Renovation Project Specifics: If the chosen contractor has a track record of timely and high-quality work, the probability of a high profit might increase.
• Financing and Cash Flow: If the investor secures a loan with favorable terms, the probability of high and moderate profits increases.
• External Factors: An unusually harsh winter could delay the project, increasing holding costs and the probability of a loss.

In conclusion, understanding and applying the concept of expected value is essential for maximizing remodel profits in real estate investments. By carefully analyzing probabilities and potential outcomes, investors can make more informed decisions, mitigate risks, and enhance their chances of achieving the highest returns. Whether flipping properties or undertaking remodels, leveraging expected value helps ensure that every decision contributes to your financial success.