Articles

BY JAMES MCWHINNEY   Updated Oct 30, 2018

 

It looks so easy! Buy a house, make a few cosmetic fixes, put it back on the market and make a huge profit. At any given time there are half-a-dozen shows on television where good-looking, well-dressed investors make the process look fast, fun and profitable. And plenty of homes are getting flipped. ATTOM Data Solutions reports that more than 200,000 in the United States were bought and the resold with the same 12-month period in 2017. That’s just under 6% of all the single-family homes and condominiums sold all year. Yet, the road to real-estate riches isn’t all about curb appeal and “sold” signs. Far too many would-be real estate moguls overlook the basics and end up failing. In this article, we'll look at the five biggest mistakes would-be flippers make – and how to avoid them.

 

The first, best piece of advice is to limit your financial risk and also maximize your return potential. Put simply, don't pay too much for a home (by knowing what it's worth) and make sure you also know how much the necessary repairs or upgrades will cost before you buy. Having that information, you can then figure an ideal purchase price.

 

The 70% rule states that an investor should pay no more than 70% of the ARV (after-repair value) of a property minus the repairs needed. The ARV is what a home is worth after it is fully repaired.

 

Here's an example: If a home’s ARV is $150,000 and it needs $25,000 in repairs, then the 70% rule means that an investor should pay no more than $80,000 for the home. $150,000 x 0.70 = $105,000 – $25,000 = $80,000.

 

Top 5 Must-Haves For Flipping Houses

The Basics

Flipping (also called wholesale real estate investing) is a type of real estate investment strategy in which an investor purchases a property not to use, but with the intention of selling it for a profit.

 

That profit is typically derived from price appreciation resulting from a hot real estate market in which prices are rising rapidly or from capital improvements made to the property – or both. For example, an investor might purchase a fixer-upper in a "hot" neighborhood, substantially renovate it, then offer it at a price that reflects its new state-of-the-art appearance and amenities.

 

Investors who flip properties concentrate on the purchase and subsequent resale of one property, or a group of properties. Many investors attempt to generate a steady flow of income by engaging in frequent flips.

 

So how do you flip a building or house? In simple terms, you want to buy low and sell high (just like many other investments). But rather than adopt a buy-and-hold strategy, you complete the transaction as quickly as possible to limit the amount of time your capital is at risk. In general, your focus should be on speed as opposed to maximum profit. That's because each day that passes costs you more money (mortgage, utilities, property taxes, insurance, etc.).

 

So that's the general plan. Now, here are the pitfalls.

 

1. Not Enough Money

Dabbling in real estate is an expensive proposition. The first expense is the property acquisition cost. While low/no money down financing claims abound, finding these deals from a legitimate vendor is easier said than done. Also, if you're financing the acquisition, that means you're paying interest. Although the interest on borrowed money is still tax-deductible even after the passage of the Tax Cuts and Jobs Act, it is not a 100% deduction. Every dollar spent on interest adds to the amount you'll need to earn on the sale just to break even. And if you use a mortgage or home equity line of credit (HELOC) to finance your flip-house purchase, only the interest is deductible. The principal, taxes and insurance portions of your payment are not deductible.

 

Research your financing options extensively to determine which mortgage type best suits your needs and find a lender that offers low interest rates. An easy way to research financing costs is by using a mortgage calculator. This tool will also allow you to compare the interest rates offered by various lenders. Of course, paying cash for the property eliminates the cost of interest, but even then there are property holding costs and opportunity costs for tying up your cash.

 

With interest rates having risen well off of their post housing-crisis lows, making a profit is tougher than it used to be. In fact, the first half of 2018 saw flipping activity slow to near a four-year low and profit margins shrink to the lowest average gross return on investment (ROI) since late 2014, according to ATTOM Data. That doesn’t mean there isn’t money to made (ROI was just north of 44%), but it does mean that care is required. The average gross profit on a flip is $65,520, but that’s gross.

 

Renovation costs must also be factored in. If you plan to fix the house up and sell it for a profit, the sale price must exceed the combined cost of acquisition, the cost of holding the property and the cost of renovations. A $25,000 kitchen, a $10,000 bathroom, $5,000 in real estate taxes, utilities and other carrying costs cuts that number by around two-thirds. Toss in an unexpected structural problem with the property and a gross profit can become a net loss. Even if you manage to overcome these hurdles, don't forget about capital gains taxes, which will chip away at your profit.

 

2. Not Enough Time

Renovating and flipping houses is a time-consuming business venture. It can take months to find and buy the right property. Once you own the house, you'll need to invest time to fix it up. If you have a day job, time spent on demolition and construction can translate into lots of lost evening and weekends. If you pay somebody else to do the work, you’ll still spend more time that you expect supervising the activity and the costs of paying others will reduce your profit.

 

Once the work is done, you'll need to schedule inspections to make sure the property complies with applicable building codes before you can sell it. If it doesn't, you need to spend more time and money to bring it up to par. Next, you'll need to invest time to sell the property. If you show it to prospective buyers yourself, you'll spend plenty of time commuting to and from the property and in meetings.

 

Is that worth it? For many people, it might make more sense to stick with a day job, where they can earn the same kind of money in a few weeks or months via a steady paycheck – with no risk and a very consistent time commitment.

 

3. Not Enough Skills

Professional builders and skilled professionals, such as carpenters and plumbers, often flip houses as a sideline to their regular jobs. They have the knowledge, skills and experience to find and fix a house. Some of them also have union jobs that provide unemployment checks all winter long while they work on their side projects.

 

The real money in house flipping comes from sweat equity. If you're handy with a hammer, enjoy laying carpet, can hang drywall, roof a house and install a kitchen sink, you've got the skills to flip a house. On the other hand, if you don’t know a Phillips-head screwdriver from a flat screwdriver, you will need to pay a professional to do all of the renovations and repairs. Accordingly, the odds of making a profit on your investment will be dramatically reduced.

 

4. Not Enough Knowledge

To be successful, you need to be able to pick the right property, in the right location, at the right price. In a neighborhood of $100,000 homes, do you really expect to buy at $60,000 and sell at $200,000? The market is far too efficient for that to occur on a frequent basis.

 

Even if you get the deal of a lifetime, snapping up a house in foreclosure for a song, say – you need to know which renovations to make and which to skip. You also need to understand the applicable tax laws and zoning laws, and know when to cut your losses and get out before your project becomes a money pit.

 

Keep in mind that Zillow, the real estate listing firm, is now flipping homes in select markets. The company expects to buy and flip properties within 90 days, and they’ve got the data and knowledge to offer mom-and-pop operators some fierce competition. Big-league lenders have also started to seek profits in the flip-loan marketplace, with global investment firm KKR & Co. Inc. (formerly known as Kohlberg Kravis Roberts &Co. and KKR & Co. L.P.) joining other private investment firms seeking a piece of the action.

 

5. Not Enough Patience

Professionals take their time and wait for the right property. Novices rush out buy the first house that they see. Then they hire the first contractor that makes a bid to address work they can't do themselves. Professionals either do the work themselves or rely on a network of pre-arranged, reliable contractors.

 

Novices hire a realtor to help sell the house. Professionals rely on "for sale by owner" efforts to minimize their costs and maximize profits. Novices expect to rush through the process, slap on a coat of paint and earn a fortune. Professionals understand that buying and selling houses takes time and that the profit margins are sometimes slim.

 

The Bottom Line

Before you start shopping for house, do some research on the nation’s wealthiest individuals. You will quickly realize that none of them flip homes for a living. If you still want to flip a house, you should approach the venture just as you would any new business. And, like any other small business, the endeavor will require time and money, planning and patience, skill and effort. It will likely wind up being harder and more expensive than you ever imagined. And even if you get every detail right, changing market conditions could mean that every assumption you made at the beginning will be invalid by the end. Take it lightly at your peril: If you're just looking to get rich quick by flipping a home, you could end up in the poorhouse.