New investors rarely stop to address the subject of risk tolerance. People who have never done a single real estate deal see others making a lot of money in real estate and want to jump right in. They never stop to understand the true risks of real estate.
Most investors and books will tell you that real estate is a pretty safe asset class to invest in. This is certainly the case if you are buying core buildings or if you are employing a reasonable buy and hold strategy. Sadly, many investors hear safe investment and assume that opportunistic investing is just as safe.
If an investor is solely a real estate flipper, he/she is taking more risk than investing in the stock market. That might be a surprise to some, but consider the returns. On average the stock market returns 9-13%, while flippers should expect 15-20% returns on their capital investment.
This higher return is certainly accompanied by more risk. First, consider the fact that in the stock market your downside risk is typically capped at 20-30%. Very rarely does the stock market lose more than 10% in a given year. Additionally, a single blue chip stock is not likely to even have that kind of a loss. In contrast, a flipper has a very real chance of losing all of the money invested in a deal. The odds of this are even higher for a novice flipper.
Another aspect of real estate investing is the sweat equity or opportunity cost of the investors time. I can go into my E*Trade account in about two minute, buy a Dow Jones ETF (exchange traded fund), and essentially guarantee myself a 9-13% return on that money for 20 years. However, if I decide to flip property I either have to hire a property manager or I have to act as general contractor, organizing the work to be done. Either way, investors will still spend a tremendous amount of time working on site or dong something with the investment.
Taking this logic one step further, if I have a job granting me a salary of $100,000, I probably have to give that up to flip houses. If I don’t give that up, I have to hire a manager that would cost $10,000 per job (on the low end). As these costs rise the return from flipping must also rise. Many investors never consider the cost of their time when calculating their return on investment. This is a huge mistake. Investors should add a salary cost line for themselves to compensate for the time they spend on the job.
I am not going through this exercise to discourage flippers, but rather to encourage investors to seek the right returns. If your upside after all costs are calculated is only 10% (or less!), you need to think hard about the deal you are about to do. Most entry level flippers get anxious for deals and take investments that do not offer a reasonable return. In a good market many flippers get away with this; however, as the market turns (like now) these same flippers find themselves losing a lot of money.
Finally, don’t let getting burned once keep you out of the business. If you are in a business where the returns are 20-30%, there will have to be deals that result in huge losses. Understand this, learn from this, and get back in game.
Sock Puppet says:
I think you outlay the opportunity costs of flipping better than anyone else I’ve seen in this post.
However the single most important thing in flipping I think is where you flip. Don’t even think twice about flipping in a market that is loosing value, do it in a marketplace that is gaining in value.
That single factor alone covers a multitude of potential errors. In a rapidly gaining market, even inept smucks can turn a profit, but if that market turns, the bag they get left holding can be pretty big.
Jeff Brown raves about Boise for instance. I’d be sniffing for flips in Boise rather than San Deigo…
-Athol
June 22, 2007 — 7:17 am
Rob Green says:
I agree with you whole heartedly. Too often I get a phone call from an “investor” who has just finished the latest late night TV round of real estate investing and is convinced they’ll be rich by tomorrow afternoon.
It has been my experience that most so called investors are no better than gamblers and often end up with the same returns they’d get from a casino in Vegas. However, true investors are those with a reasonable strategy, clearly identified risk tolerances and a patience that speculators cannot abide.
I think another under discussed issue is that of tax planning. Many speculators figure that they can just flip enough houses during the year that they can afford to pay the capital gains at the end of the year. I know one such person that never filed his paperwork with the IRS, only to received notice that they were counting everything between his acquisition price and his resale price as profit. I think he’s now drinking Maalox from the bottle.
As for nods to a specific market I’d also say that the Salt Lake area has some very good opportunities for flipping right now.
Utah has become a bit of an osmotic center for real estate values over the past few years. We have thoushands of people from California, Nevada and Arizona flowing into our market buying up homes for cash and consistently driving up values.
You can see a graph of it at http://www.smartchoicerealty.wordpress.com
June 22, 2007 — 11:44 am
Louisville Real Estate says:
Great article, I think you hit on all the major points. I totally agree with Sock Puppet that attempting a flip in a market losing value can be a big killer.
June 22, 2007 — 5:27 pm
Ryan Brown says:
Excellent coverage of the true rate of return and opportunity cost of flipping real estate. Most(all?) of the popular media exposure of ‘flipping’ dramatically oversimplifies the investment analysis and profit calculations that serious investors employ.
Sale Price – (Purchase Price + Remodel Cost) = Profit
Not quite as bad as the Underpants Gnomes, but grossly oversimplified nonetheless. Sometimes the commissions and mortage payments are included, but that is generally where it stops.
As you said, it is critical to consider the opportunity cost and value of the investor’s time. It is also critical (and rarely done) to consider the time value of the investor’s money. Perhaps not for a 4-week flip, but certainly for a 9-month remodel/addition (depending on your time length constraints for what constitutes a ‘flip’). Applying your 9%-13% discount rate to an Discounted Present Value analysis can reveal prospective flip to as less than the slam dunk it first appeared to be.
Along these lines, one trend I’ve noticed here in Austin is flippers living in their finished products for 2 years after completion to avoid capital gains taxes. Avoiding the taxman will help the balance sheet, but over 2+ years the DPV should be a required calculation.
June 23, 2007 — 1:06 am
Sean Karr says:
Great comments once again Mike.
June 23, 2007 — 12:11 pm
Dan Dunleavy says:
You did a great job in sharing the importance of understanding the risk and its relationship to reward.
In the past, flippers had the advantages of a strong market to enable them to receive a larger profit on their flip. The property was still going up as they were doing their work. However, we all know this has changed.
With a buyers market, the flippers have to be smarter and utilize better financial tools to evaluate their flip. With the margins of profits being much smaller than in the past, it is critical to do a thorough detailed inspection, expense evaluation, and neighboring resale comps to accurately estimate the return on the investment. Too many flippers try to justify the property, which again creates a huge risk for the flipper. Its simple, either the numbers work or they don’t. Is the profit margin high enough considering the number of hours worked and time lost until the property is sold.
In our market in PA, it is still relatively competitive for purchasing flips. But, we see time and time again offers being made for way more than the rehab property is worth. If these purchasers are home owners looking to fix the property up slowly, then good for them or is it being purchased by a flipper who could be in trouble with underestimating their costs or overestimating their comps.
July 1, 2007 — 5:14 pm
Kirsten says:
I have a question for you. My husband is a contractor that does alot of repairs for reatators when selling a home. We are thinking of expanding his business by going into house flipping. How would you say is the best way to determine what our market is doing where we live?
July 23, 2007 — 8:58 am
Michael Cook says:
The easiest way to determine what the market is doing is to simply ask your clients. Many good realtors have great perspective on the market. In addition, looking at time on the market and average selling price should help as well. Finally, I think you should get an agent and look at some houses. From that you should be able to determine if there is enough opportunity out there in the market. Happy flipping.
July 23, 2007 — 10:20 am
Dan Dunleavy says:
Hi Kirsten,
There is a pretty cool link that provides you with up to date reports on market conditions. Here is the link:
http://realtytimes.com/rtmcrtop/home.htm
I believe you will find this link to be helpful. Our website FixtoFlip.com has tools and processes that can help you understand whether the damaged property makes sense from the numbers perspective prior to making an offer.
Good Luck in your new business endeavors!
July 23, 2007 — 10:25 am