By Kathy Fettke
Flipping homes has never been so popular. According to ATTOM Data Solutions, 207,088 single-family homes and condos were flipped last year alone. That's almost 3,000 more than in 2016, and the highest level of flipping activity since 2006.
Don't be misled by TV shows and real estate gurus who make it sound easy. Buying, fixing and reselling a home for profit is a bit more complicated than some slick marketers want you to think. Plus, new investors tend to arrive when the party is ending, and often end up getting stuck with the cleanup.
Here are some ways to protect yourself:
Take advice with caution. Don't get your advice solely from people who have only been flipping property since 2008. Real estate values have been on a tear upwards for nearly a decade since the Great Recession—it's a lot easier to make a profit when prices are on the rise; however, it's very difficult to make the numbers work when prices are declining. Get your advice from people who have been through several market cycles, and survived the ups and downs.
Look for signs of a slowing market. If you start to see price declines, increased inventory levels or longer days on market, be cautious. It could take longer to sell your property, which would increase your holding costs and eat up your profit. Plus, your final price could end up lower than you initially calculated. Always have plenty of reserves on hand to cover the possibility of extended holding costs.
Be wary of short-term loans. Flippers tend to get short-term loans to acquire and renovate properties. With interest rates rising, these loans may become more costly. Additionally, if a property takes longer to sell, you don't want to be stuck with a balloon note that is suddenly due before you've cashed out. All your hard work could be taken away by the lender.
Know your area's max affordability level. In many metros, home prices have shot up past their last peak. With interest rates on the rise, as well, buyers are getting stretched financially. To get a gauge on affordability, find out the average income of the area. The mortgage payment at a 5 percent rate should be about 30 percent of the average monthly income in the area.
Become friendly with your local city officials. Nothing can kill a deal faster than a slow permitting process. You've got to understand what the local municipality will demand of you. Some cities require that all repairs be inspected before the house can be rented or sold, and sometimes they may require additional repairs that were not in your original budget. Try to find out what may be required far in advance.
Don't take short cuts. If you try to do the work without permits, you could be held liable if you don't disclose it to the buyer. For example, if a fire broke out, your un-permitted electrical work (and you) could be to blame. Additionally, if the city finds out, you could be forced to tear out your work and redo it to current building code—at your cost.
Expect higher costs. Calculate higher costs of building supplies from recent tariffs, higher labor costs due to a shortage of skilled construction workers, higher permit fees due to increased regulations, higher interest rates, higher gas prices and higher acquisition costs. Margins are squeezed, and overall profits are down from last year. Don't think you can get the same profits today that others were getting these past years. Times are changing.
Budget your time. If you have a full-time job, make sure you have enough time left over to manage the purchase, renovation and sale of your flip. Otherwise, partner with someone who has both time and experience to get the job done right. Many people forget to calculate their time into the budget. You might find that after adding in the value of your time, you could make more money at your day job, or, you may just find you don't have time to get it done on time, with holding costs eating your profit.
Prepare for the worst. Make sure you include all potential costs into your budget assumptions, including a possible fluctuation in ARV (After Repair Value.) Also, add a minimum 10 percent margin for error. Here are just some of the costs that flippers need to calculate before purchasing:
- Holding costs (taxes and insurance)
- Debt service
- City fees (permits and deposits)
- Sales costs (title, escrow and sales commissions)
- Income taxes
- Price fluctuation (potential 5-10 percent change in either direction)
Know your tax liability. If you're in a high tax bracket, nearly half of your flip profits may go to Uncle Sam. You may want to consider holding the property for over a year as a rental in order to get capital gains treatment. Consider putting the property in an LLC for both asset protection purposes and increased tax deductions. If you use self-directed IRA funds, you could be forced to pay UBIT, which can be upwards of 40 percent in taxes to your IRA! Always talk to your CPA before making any investment.
Smart investors can certainly make a good amount of money flipping homes today. Those who succeed have systems in place. If you're just starting out, make sure you have an experienced expert/mentor to help you. Even if it costs you for their time, it will likely be cheaper than the School of Hard Knocks.
Kathy Fettke is co-CEO of Real Wealth Network and best-selling author of Retire Rich with Rentals. She is an active real estate investor, licensed real estate agent and former mortgage broker, specializing in helping people build multimillion-dollar real estate portfolios that generate passive monthly cash flow for life.