I often get calls from folks who want to buy distressed homes, rehab them and sell them for huge profits. Looks easy on TV doesn’t it? The reality is that flipping homes is a very, very hard business and extremely difficult to keep profitable over the the long haul. (key – long haul) I have seen way too many flippers get excited about early wins only to get hooked on the “flipping drug” which like many addictions leads to reckless behavior, destroyed relationships and financial ruin. This is really a business best left to professionals or those with extremely deep pockets.
Let me present some of the hazards and contrast how the professional views these vs the small investor who we will call DIY (do it yourself guy).
HAZARD #1 – THIN MARGINS
The profit is made with the buy. It is pretty easy to determine a ballpark number for the sale price of a renovated home. That price is relatively fixed. You can’t push it too much. If you do, the friendly appraiser hired by the buyer’s lender will help give you a dose of reality.
So, the lower the purchase price the bigger the profit. Sounds easy. Buy low, sell high. In a vacuum that would work well but the Northern Virginia market is anything but a vacuum. There are dozens if not hundreds of investors scouring the market for great buys. It is extremely rare to find a great deal no one else knows about. Others will bid up homes to a point where the profit potential is nowhere near what was calculated when first viewing the property.
Expense control during the remodel phase is critical. The other guy may have lower expenses and/or be able to survive on a lower margin. Let’s say DIY wants to do 2 homes a year and unless the profit is $x, it is not a home worth buying given all of the time and energy required. Well, a professional doing 50 homes a year, doesn’t need to make $x per home to make it worthwhile. For a professional, 1/2 or 1/3 of $x may be just fine as they make up on volume what they lose on margin. Thus they can bid higher as their margin requirements are lower.
HAZARD #2 – “I’LL DO IT MYSELF” – FORGETTING THE IMPORTANCE OF TURN
Over my years, I have seen many flippers get into trouble and end up in bankruptcy court. Among many of these, a common denominator was that they were very competent tradesmen who decided to fix the home themselves.
I have also seen investors succeed at this business. The common denominator among them? They very rarely picked up a hammer but had crews who could renovate the home in lightening speed. They understood money management and the importance of turn.
While DIY is slowly getting the home perfect, the professional, albeit at a higher labor cost, has whipped out 4 or 5 homes. Assume $x of profit was the goal on a home for DIY. To achieve that number, outside contractors could not be hired. It then took months to do what a professional crew could have knocked out in a few weeks. Meanwhile in the time it took DIY to work one deal for $x profit, the professional has done for 4 or 5 for 1/3 $x profit.
In the end while the actual profit earned by DIY may be something to boast about to friends, what did it really cost in terms of hourly rate? Would a part time job at a local retailer have generated roughly the same level of extra income for the hours put into the renovation? Was the hourly rate worth all of the time and stress? While working on the home, time was diverted from other activities or spending time with family. How is that valued?
And the carrying costs….
HAZARD #3 – The Cost of Money
Sure, one can get a traditional loan on a purchase of a fixer upper. But that is not the way the pros do it. First, there are some situations where a traditional loan can not be utilized – mainly purchases at the courthouse which will be the topic of another blog. Second, many of the professionals buy these properties with cash or put forth cash contracts and use “hard money” or credit lines to finalize the deal. Buyers with regular financing almost always lose out in these situations even if offering slightly more.
So to really compete, one really needs cash, a business line of credit with a local community bank or a hard money lender. Both lenders are extremely expensive. A business credit line with a community bank is several points higher then traditional loans. And hard money lenders – those who offer no questions asked money for 50% to 70% of the value of the property – lend at rates in the double digits with up front points and very short payback periods.
The cost of money factors greatly into the overall profit. Again, the longer it takes to remodel, the greater the carrying cost and the lower the return. Plus if hard money is involved and the house is not finished and the loan comes due ….well it could get pretty messy. Everything could be lost.
HAZARD #4 – “THIS HOME IS BEAUTIFUL, I WON”T TAKE A DOLLAR LESS”
I have seen the DIY fall in love with their work and let those feelings lead to overpricing a home. Then when an offer comes in they are insulted or not willing to go where needed to move the home.
The pros? They adhere to the mantra of turn, turn turn. Sure there is a price that makes sense. But trading a little profit for a sure and certain quick settlement is something they will almost always do. It is the wrong move to hold on to a home for a $2500 more when selling it quickly means freeing up capital to buy another one. Say, the profit goal was $20,000 and an offer came in that will settle quickly but generate only $17,500 in profit. Is it better to refuse that offer and wait for another that generates $20,000 or is it better to take the $17,500 and find another home that generates $17,5000 more? The pro will often do the latter. And thus when the DIY is bragging that he held out for his price and got his $20,000, in the same time, the pro has sold 2 homes and pocketed $35,000.
Of course, it is not always that clear but the point is that the pro really understands the importance of turn and, not having done the work themselves is not “insulted” when the market doesn’t react the way they planned.
HAZARD #5 – Surprise, Surprise
A distressed home by definition is one that has not been well cared for. Upon inspection prior to purchase certain things are obvious. But once walls are removed, toilets lifted, wiring exposed, there will always be that surprise that adds cost to the project. For DIY, this can wipe out all of the profit on a project and bleed into personal funds not planned for the remodel business. I have seen it happen more then once.
Also, the market can change on a dime. A few years back, I saw a small investor buy a home with great hopes of turning it for huge profits. The guy worked hard for months when a pro would have been done in weeks. Well, what had been a strong market over those months turned into a very soft market. There was no way they were going to get their number and eventually had to take a significant loss. It wiped out their capital and that was the last home they did.
The pros turn a home quickly, usually selling in the same type of market they bought in. Plus if they need to take a loss on one home, they can. Not all homes end up profitable. For the pro, it is like a stock portfolio. Most investments make a little money, a few are huge home runs but others are losses. Like in the stock market, an investor with a diversified portfolio, over time, will make decent money. But if all the money is in one stock, bad things can happen.
Furthermore, I saw many investors in the mid 2000s, get addicted to flipping. They started off with one property. Not because of their work but because of the rapidly appreciating market, they made lots of money on that home. So next they bought two. They were blown away with those profits and then bought 5. And so on and so on. Well, the market came to a screeching halt and all these mortgages still needed to be paid. Turning the homes in inventory into rentals didn’t cover the mortgages. So many, and I mean many, were caught short when the bubble burst. They either had their credit ruined because they ended up short selling or they were forced into bankruptcy.
This is a very intoxicating business that too often leads to unwise and risky decision making. Bottom line, if one is looking for a hobby and buying one or two homes with deep pockets, flipping is fine and can be fun. As a business, though, I don’t really see how this can been done profitably unless it is a full time job with strict financial controls and back up plans to handle construction surprises and market shifts.