A Strategy that Works in Any Market
Not long ago, but in a different economic era, speculators made huge profits flipping condos in Florida, Phoenix and Vegas before they were even constructed. Students of slick and glitzy gurus attended seminars in Las Vegas and ended up buying rental units at jacked-up prices with negative cash flows secure in the belief that in a market with 30% annual price increases, they would be able to refinance at lower rates and increase the rent rates in a burgeoning economy.
The pundits, financial commentators and observers remained skeptically on the sidelines, fearing that the housing bubble would soon burst. The Chairman of the Federal Reserve, Alan Greenspan, predicted “large double digit declines” in home values in 2007, and anyone looking at the situation rationally could see that the housing market was ready to cool off, if not worse.
Meanwhile speculators continued their activities and raked in profits while the market continued upward. Then came the collapse, and home values, especially in the here-to-fore overheated markets in Florida, Phoenix, Las Vegas and California spiraled downward. Elsewhere housing values flattened, and those people still speculating felt the pain.
Starting with 2008, the world of real estate investing became unrecognizable next to the conditions of the seven years before that. But don’t let the fool you. The market always has been and definitely is now quite cyclical. As with any other commodity the law of supply and demand determines its value, coupled with social and economic forces. However, supply and demand plays the major role. When buyers has a hard time finding a desirable house, prices go up. When there are more houses than buyers the prices go down along with reduced demand.
These cycles typically last 8-12 years from the time the prices begin to rise until they start a new cycle with a new increasing of prices. Although the cycle from 2001 to around 2011 was more drastic and extreme than at any time in our lifetimes, the timing was normal. The initial upswing definitely began in 2001, but the beginning of the next upswing is difficult to pinpoint and depends on location.
However, wise real estate investors made money throughout the cycle.
There is something to buying cheap when the market is in decline: master mutual fund developer and billionaire, John Templeton (1912-2008), told us we should “Invest at the point of maximum pessimism.” On another occasion he explained, “If you want to have a better performance than the crowd, you must do things differently from the crowd.”
The latter statement advises us that we don’t want to do the same thing that everyone else does because most people don’t know what they are doing. John Templeton made his first money in the stock market by purchasing stocks in European Companies in 1939 – at the time that the Nazi war machine was
ravaging the continent. He bought $100 of every stock trading below $1 on the New York and American stock exchanges, resulting in a junk pile of 104 companies, 34 of which were bankrupt, for a total investment of $10,400. Four years later he sold these stocks for more than $40,000.
He took this action after Germany had already taken of Czechoslovakia and annexed Austria, the Spanish Civil War had plunged the Iberian Peninsula into chaos, and Germany invaded Poland on September 1st and the Soviet Union invaded Finland in November. That does not sound like the kind of environment that the crowd would want to invest in, but Templeton understood market cycles. He eventually became a billionaire as a pioneer of globally diversified mutual funds, including the Templeton World fund. His flagship Templeton Growth Fund posted a 13.8% annualized average return from 1954 to 2004, well ahead of the Standard & Poor’s 11.1%. This is exceptional for a mutual fund, but also indicates the kind of thinking that comes from thinking “differently from the crowd.” In 1939 the world was “at the point of maximum pessimism,” but John Templeton saw things differently.
An Application to Real Estate
An intelligent alternative to speculative real estate investing, besides understanding market forces (which one should always do) is the strategy of flipping.
It is, of course, true that some flippers are also speculators, the speculators are definitely the amateurs of the real estate investing world. Investors who enjoy long-term success work in a more conservative and fundamental fashion. Speculating is certainly sexy and exciting, conservative flipping can be equally as rewarding as wild speculation while bringing far less risk.
A more significant difference between the two is that flipping works in any kind of market, while speculating only works in the right circumstances and times.
Speculation depends on the ignorance, stupidity or foolishness of others. It only works when the investor is able to find someone willing to take the property in hope or expectation of finding another patsy to dump the property on. Like a “legal” Ponzi scheme, eventually someone gets stuck with a property the cost more than it is worth.
Flipping Properties: Based on Fundamental Principles
When you engage in flipping properties, you don’t have to hope your timing of the market is impeccable. You don’t have to look for shooting stars in a rapidly appreciating market. Instead, you need only find undervalued properties, polish them up so that you can present them in a way that appeals to buyers, and sell them for a reasonable profit. This is something you can do in a hot market, in a flat market or even in a market in slight decline.
Logic tells us that finding undervalued properties should be easier in a slow or normal market. You can find them in a hot market, but they are not as easy to find because of supply and demand. Highly motivated sellers can more easily get the property sold through normal channels. Even if prices are falling, flipping works because you get rid of the property before the value declines below your purchase
price if you get a good enough discount. If some cosmetics, or even minor repairs, increase the property value, your profit can increase.
Always Have an Alternate Exit Strategy
Speculators often have to rely on a “greater fool” to take the property of their hands. Legitimate investors doing flip transactions have one of two feasible exit plans available to them.
Wholesale the property to another investor, or
Retail the property to the end user.
The retail transaction most often brings greater profits, but a quick wholesale can free up cash for other deals if you simply assign the contract.
We find that a wise consideration when considering the risk of any decision is to think of what the worst possible outcome would be and then decide whether you can live with that outcome. With that in mind, let’s look at what you would do if neither strategy were to work – if the market collapses and no buyers can be found. Is that the end?
The rental property market does not always correspond to the house-buying market. Quite often, in fact, their cycles move in opposite directions. You might not be interested in becoming a landlord at the early point of your investing career, but holding a property for rental income can be a solid backup plan. You cover your costs, even creating an income stream, until the market turns and you are able to sell for a profit. There is your safety net on the deal.
In fact, assuming the house needs a little rehabbing, you can refinance it and get all your own money out of it. Now at that point your monthly will be higher, and you can sell the property at your leisure. At the same time, you are in the position to offer the tenants and option to buy the property to go along with the lease. Many young families would love to own their home but cannot qualify for financing right now, and you can facilitate their ownership over time.
How to Do It Right – Six Strategies
The traditionalists that write or comment about real estate investors often like to see flippers as gunslingers, but this is absolutely not so. In fact, the truth is that the least desired outcome turns into the very kind of deals that these people favor – income property for the long term.
With just a little channel surfing you are likely to find a couple of flipping shows on TV at any one time. Financial journals, even news magazines and newspapers carry articles about flipping real estate. It seems to be the latest thing in the world of investing.
You always find something easier to do well if you first know how to do it right. We would like to discuss various ways to make money in real estate by flipping.
In flipping a house, you buy a property and then resell it as soon as possible, rather than keeping it for long-term income. Instead of renting it to tenants you help a household own a home. There are a number of ways to flip a house, most of which are both legal and profitable, some of which are not legal. We will explain how to avoid the illegal side of it.
Flipping Strategy #1: Buy, Fix, and Flip
This is the strategy that the TV gurus focus on and across the country is the most common technique. You buy a property that needs work, you fix it up and then sell it retail to the party that will inhabit the house.
As you can imagine, people have been doing this for years, and it is popular because it works well. You can easily earn $10,000 to $15,000 on a transaction depending on the market you work in and your ability to find bargains.
However, you should be aware of the potential hazards and pitfalls. You must be careful not to pay too much when you buy the house and make sure to get an accurate repair cost. You should be extremely conservative in estimating fix-up costs and always figure it will take longer to sell the house than what you might first think. As separate module will give you the information you need to correctly estimate your cost in doing the deal, which will include materials, labor, utilities and interest expenses during the holding period and the cost of marketing it afterward, probably with the assistance of a real estate agent. You want an accurate figure so that you can get enough money from your lending source or partner to pay it all without having to dip into your own pockets.
Flipping Strategy #2: Buy, Refinance, and Lease Option
This is a hybrid strategy. Whereas buy fix and sell brings immediate cash profits, this method produces cash profit along with cash income over time. Instead of fixing the property up and selling for cash, you sell for terms.
Terms are an excellent alternative to cash; as a rule you offer or accept one or the other. When you give terms you expect a concession on price. If you demand a certain price, you may have to concede terms.
Rather than sell the fixed up property for all cash, you sell for terms. You get the property into an acceptable condition, and then refinance to long-term, less expensive terms based on its new appraised value. Your improvements increase the value and allows you to get your personal money out of it while leveraging bank money to own the property. Now you put tenants in the house: the rent payment covers your monthly mortgage obligation, you get cash option consideration at the beginning. You can also structure the option for extra monthly consideration to increase the monthly income.
If the margin is favorable – your cost low enough next to a higher sale value – the rent payment alone will cover your mortgage cost with expenses of taxes and insurance. You can increase the margin by using an interest-only loan or an adjustable rate loan that is fixed for the first three years. You will pay the loan in full when the tenant purchases the house from you.
An attractive point about this transaction: your total return will be greater because you have no commission to pay to a real estate – you are renting the house out with an option to buy. If the tenant exercises the option more than twelve months from the beginning, you incur a lower capital gains rate on your taxes, as well.
Flipping Strategy #3: Buy and flip “as is”
Some people do not enjoy fixing up a house. Others love doing it. It is work, any way you look at it. Whether then investor enjoys the work, it does also represent an expense for materials. Hiring a handyman increases the expense.
As an alternative, you could sell the property in “as is” condition. Let the new owners take on their own fixer upper. Why would they want to do that? Because it makes it easier to afford a new home. How well you can sell such a house, and its condition, will relate to market conditions. In a hot and active market, you could sell it just slightly below market value. In slower markets you will have to discount it, but since the slow market allowed you to purchase it at a greater discount, you still enjoy a profit.
You might be surprised at how often this happens. We have witnessed sales where all carpeting had been removed because of severe pet smells, such that only the tack strip remained around the perimeter of the rooms. In another case, a toddler’s crayon mural remained on the living room wall. Had we painted it we would have used “oops paint” (paint returned to the store – especially big box stores – that the buyer decided was the wrong color; this would be in the broad family of “white,” and has now been dumped together in a barrel or other container and is made available for about 20% of normal cost).
However, in this case, we showed it as is and the woman that bought informed us that she was an interior designer and had plans to paint that particular wall a burgundy color. Although our paint would have cost little, we still saved ourselves the effort of applying it to the wall.
One last point, in urban neighborhoods going into a “gentrification” transition, this is method becomes especially attractive. The young professionals moving into the situation love to put their own stamp on their new home.
Flipping Strategy #4: Wholesale
The conditions that make our first strategy, buy, fix and sell, an attractive method, foster a good atmosphere for this strategy. Where fix and flip is very popular, there will be many investors looking for good rehab projects. In that case, you could much less effort into the process by bypassing the fix up phase and selling the fixer upper to an investor at a price that will allow the rehabber to pay the cost of improvements and still make a profit. Your profit would be less than had you fixed the property up and sold it at a retail price, by you make your money a lot faster and with much less work.
Flipping Strategy #5: Pre-construction
As you know, between 2003 to 2007, property values increased rapidly, between 10% and 30% across the country, and especially so in states with increasing populations – those in the west and Florida. It is possible to secure a contract on a pre-construction house or condominium, then after construction is
complete, flip it to another party. You should bear in mind that it will take time for the construction to finish – especially with the condo, maybe 12 months. However, because developers like the increased cash flow they enjoy with pre-construction sales, they will generally give you enough of a price discount that you could realize a 20% profit at sale – without the need of any rehab because it is new construction.
However, if the economy tanks, you could end up with a house that you cannot sell for what you paid, and given the condominium values are even more volatile than single family houses, you could possibly lose money.
This approach is nearly as much speculation as it is investment, so be careful. Make sure you are well aware of market trends in that area. If prices have been going up steadily for four years, you will avoid this method because history tells us they will top out in less than a year. If the increases started in the last couple of years, you can feel more comfortable that they will continue long enough to do this.
Flipping Strategy #6: Scouting
The Scout is an information gatherer, so not technically a property flipper. He is the “bird dog” who finds potential deals and sells the information to other investors. Many people get started as a Scout for other investors because it does not take any cash or prior knowledge to look for distressed properties.
The Scout finds a property for sale, gathers the necessary information, and then provides this information to investors for a fee. The fee will vary depending on the price of the property and the profit potential. The Scout can expect to make $500 to $1,000 each time he provides information that leads to a purchase by another investor.
Flipping Strategy #7: Illegal Flipping
Before we start, please read the heading: this method is illegal. It is a felony. Doing it means eventually you will get caught and face huge penalties. The authorities will make sure it costs you much more than what you made doing it.
Illegal flipping consists of buying cheap, run-down properties in low-income neighborhoods (for the most part), doing shoddy renovations to the properties and selling them to unsophisticated patsies at inflated prices.
You will notice that this activity differs from what we presented as strategy #1 only in small details. You buy the house for a below-market price, you renovate it and sell them to first-time buyers for a higher amount than what you paid plus your costs. Nothing wrong with that. You provided a valuable service and deserve the benefits that come.
This activity becomes less honorable when you do shoddy work on the house and pass it off as a quality renovation and inflate the price to much higher than market value. However, even at this point, however unethical that is, it is not yet illegal.
Frequently, however, an investor, an appraiser and a mortgage broker work in cahoots and get a buyer who can’t afford the house, conspire to submit fraudulent loan documents and a bogus appraisal. The buyer pays more than the house than he or she can afford, and it all hits the fan when the deceptively obtained mortgage goes into default, the bank investigates to discover what went wrong and learns that they lent more than the house is worth to someone that could not have qualified for the loan. More often than not the buyer was just an ignorant dupe who did not understand what was happening and was just thrilled to get a home. However, even without jail time, the buyer has still lost the home and all the money put into the deal to buy it.
The investor, appraiser and mortgage broker receive accommodations at a gray bar hotel for a number of years. For one thing, these loans are federally insured. The prosecution of the cases is federal, meaning penalties are higher and the perpetrators have no “good ol’ boy” influence on the enforcement.
Unfortunately, the net result is that the public often believes that flipping is illegal.
As we stated at the beginning, buying a house, adding value to it by clean-up, cosmetics and repairs and then selling it again is not illegal. However, the illegality on the unethical flips stems from loan fraud. It is, of course, illegal to commit fraud in the selling of the house.
If you stick to fundamentals and do things correctly, you don’t worry about risk and you stand to make potentially high profits.