I recently had a unique conversation with a novice real estate investor who was beginning to question their strategy. It was the way he made the comment that caught me by surprise. It was delivered with the attitude of absolute certainty that I already knew what he was talking about; and that I must also agree with this socially accepted idea. I was curious, I had to know what brought on this recent wavering behavior. “What do you mean?” I asked.
“There aren’t any deals anymore because of the market.” he said. I must have had a deer in the headlights look because now he seemed more confused than before. I told him that the market is always changing, and the question to ask is “What does the market need?”
Many people looking into flipping real estate focus on the low hanging fruit; the projects that I call lipstick flips. These projects are the kind of deals that the majority of small-time real estate investors focus their attention on because they present a very lightweight improvement obligation.
The challenge with these projects is that their discount value (or equity potential) is not attractive. In most cases, these projects are already in livable (habitable) condition, and qualify for conventional financing. This means that the available market for the subject property includes both: (a) home buyers that wish to live in the home as their primary residence, and (b) real estate investors who are trying to tidy up and sell for a profit. In these scenarios, the competition demands a near retail price point — hardly a strategy to profit from.
Furthermore, many flippers rely on recent appreciation data to justify their future earnings. They are emotionally vested, and believe that the market will repeat its recent rate of increase.
“My mantra, is that appreciation is a bonus, not a strategy.”
An old adage of investing is that you make money on the buy and not the sell — meaning, what you pay for a stock, real estate, or any asset is of utmost importance to your bottom line. The reason is simple; the purchase price is the only static variable of your investment.
This is especially true with real estate.
Your improvement costs can change, your holding time can change, and your exit (sale price) can most definitely change.
“In value-add investments, all the variables come along the way.”
At a 30,000 foot view, there are four primary stages of valuation that correspond across all arenas of real estate investing, and with each stage, there area myriad of misconceptions that many real estate investors latch onto, and have difficulty moving past
- Finance/Holding Costs
In this issue, I am bringing clarity to the improvement costs and holding costs related to common short-term real estate investments. A recent analysis by RealtyTrac showed that 12 percent of flips sold at break-even or at a loss before all expenses. In 28 percent of flips, the gross profit was less than 20 percent of the purchase price. That’s a total of 40 percent failing or near failing.
Whether you think those numbers are high or low; it is incomplete data when taking into account the actual costs that are not delineated in a basic MLS search. Of the reported cases, 12 out of 100 projects sold for the same price they were purchased for — no account for finance costs, holding costs, or improvements costs. Ouch! And of the additional 28 out of 100 cases, the gross profit was 20 percent (or less) than the purchase price which also doesn’t account for improvement expenses, broker selling costs, escrow fees, or excise taxes. Yikes!
What does this look like in the real world? Disregarding the zero profit cases, and assuming that one of the mildly profitable projects was purchased for $350,000.00, with very minimal improvements (5 percent of purchase), and the lowest typical financing rates associated with non-conforming bridge financing (hard money), for a rare 6 month flip, we arrive at the following:
Financing Costs: $28,000.00
Selling Broker Fees (6%): $25,200.00
Escrow Fees (1%): $4,200.00
Sales Price: $420,000.00
Total Profit: -4,900.00
*according to sources: Redfin, Zillow, Opendoor, Trulia, Bankrate
I don’t know all of the details of these failures, but I can focus on the greatest challenges in the flipping world, and that is time.
“When it comes to flipping properties, time is at war with profit.”
The cost of time is a double edged sword; on one side it is worsened by permitting delays, or construction challenges, and on the other side, it is worsened by selling delays resulting in downward pressure on the sales price to meet the market demand.
Leveraged time is a cancer to profits. The proof of this is the exponential cost of financing.
Most real estate investors leverage their purchases using unconventional financing, i.e. hard money. This is because most projects having the biggest upside potential are lemons that need a lot of improvement, and are not financeable by conventional banks. The general idea of hard money financing, is that instead of spending 100 percent of your cash on the acquisition and improvements of a project, one can reduce their out-of-pocket costs to a fraction (20 percent down or less), and finance the remaining costs. The benefit of leverage is that it has the potential to increase profitability, or ROI (return on investment). However, it can be an inescapable trap.
Breaking Down the Delays
Where do they come from? Why can’t they be anticipated? I’ve heard these questions many times and truly wish that they could be planned for, or at least known in advance. The challenge is, they cannot be — and if anyone is telling you otherwise, ask them how many projects they’ve done, and then verify.
Television makes flipping houses look like a 60 minute process, but the reality is there is much research, time, and preparation involved in the process of renovating and building homes. Depending on the city, navigating the permit approval process can take months. Some projects will need architectural design, engineering (many different kinds), and may involve the schedules of multiple parties to coordinate appropriate decisions with city officials; these cooperative efforts can take over a year. Building permit delays (at the municipal level), contractor delays, material delays, permit delays, or renovations and materials that have not been budgeted for, can add up quickly and destroy any potential profit.
The construction timeline is one of the most frequently underestimated elements I’ve consistently contended with. Even with the great teams we have worked with for years, there are unforeseen issues that arise on every project; ranging from subcontractors and scheduling, surprising new codes that have been adopted, field inspection issues, weather related delays, back ordered items, tariffs on international materials that effect pricing and availability on lumber, windows, and other seemingly common products, theft or vandalism, and of course, all of the things hidden behind the walls, under the house, or in the attic where the original builder took a shortcut that costs more money. With that said, even our firm’s best schedule has delays.
Difficulty in selling a property may seem like a thing of the past, but I remember it like it was yesterday — it wasn’t that long ago! Excess and lack in the market ebb and flow like the tide. Home sellers who’ve experienced multiple offer scenarios were not in normal market conditions; in some areas, 120 days on the market is considered a fast sale, while 180-270 days on the market is average. That’s a 4-9 month range. That can be costly with leveraged financing, and even problematic; most hard money loan terms are only 6-12 months, or less.
In a softer market, you may be forced to offer seller concessions to the buyer, and concessions greatly reduce the bottom line. Each day that passes, unable to find a buyer, is another day of expenses that keep accumulating. The holding cost’s ever increasing nature work entirely against an “I’ll hold out for my price” methodology. The longer the property sits stagnant on the market, the greater the likelihood that the price will have to be reduced to generate a sale, which will eat into any anticipated profit. But the longer a price reduction is delayed to stave profit, the more the holding costs will remove from the profit.
I hope your take away from this article is a better understanding of the depth of the industry, and the risks associated when investing into real estate alone.
Our teams desire is to encourage investors to place their hard earned money into real estate with caution, and with firms that have embedded into their structures accountability, experience, diversification, and proven models. Our niche is our strength because of our experience. Our message surrounds education— education that there are other ways to experience the benefits of real estate investing without the need to quit your day job, or spend thousands of dollars learning the hard way, when you could be putting your money to work right now for the benefit of your portfolio.