Are there lessons to be learned from the real estate downturn and house flipping? Absolutely. Even before the bull market in real estate there were fundamentals that made house flipping risky. Here are five reasons why house flipping shouldn’t make a mainstream comeback anytime soon:
1) Transaction costs
When homes are bought and sold, there is a large number of benefactors in the transaction in addition to the buyer and seller. Real estate agents, mortgage brokers, escrow officers, title representatives, mortgage investors and inspectors all take a piece of the action to help get the deal closed. The transaction costs are especially high for someone purchasing the property and then turning around to sell it within a short period of time. Transaction costs for selling are the highest and include:
- 3% to 8% sales commission: The statistics continue to support that homes marketing on the multiple listing services receive offers significantly better than FSBOs (for sale by owner) to justify the added cost. Discount brokers can get you on the MLS, but you will likely still need to pay a buyer’s agent to find a buyer for your property.
- Real estate transfer tax: Most states charge some type of transfer or excise tax on the sale of real estate, up to 4% of the total sale value of the home. On a $500,000 home, that could amount to as much as $20,000.
- Escrow costs: Escrow costs vary from region to region and are usually tied to the value of the home being sold. In typical transactions these costs are usually split between the buyer and the seller.
- Carrying costs: This is one of the big killers for house flippers. If you use bank money, your carrying costs include the mortgage interest, the mortgage origination fees and interest you have to carry while the property is being remodeled and waiting to sell. Hard money loans can cost even more. Even if you use your own funds, there is still an opportunity cost associated with your funds sitting idle in the property.
The government provides a generous tax exemption for individuals who sell a residence they own and have lived in for at least two out of the last five years. Investors, on the other hand, are not offered this same luxury. The best investors can hope for is to qualify for the capital gains tax which is at 15 percent. To qualify for capital gains treatment, investors are typically required to own the home for at least a year. Selling a home that you have owned less than a year will result in the gains from the property being taxed as ordinary income. This can push the effective tax rate on the property gains up to 35%. Even worse is if the gain from the property pushes you into a higher tax bracket. Short term owners also benefit little from other real estate tax advantages such as deprecation.
The bull was alive and well in the real estate market up through most of 2006. The market grew quickly and new real estate gurus were popping up every day with their tales of millions made with little work. Real estate hit mainstream in a big way and flowed over into entertainment. TLC’s “Flip that House” and A&E’s “Flip this House” continue to draw millions of viewers even in today’s real estate climate. House flipping has become a mainstream idea and the competition has followed.
Internet listing aggregators such as Trulia and Zillow have made it even more competitive. House flipping tends to rely on an investor’s ability to purchase an undervalued piece of property. Trulia and Zillow have taken comparable sales reports and put them in the hands of anyone with an Internet connection. Buyers can see exactly what was paid and when it was paid it through these services. A large increase in price from a recent sale price will be a red flag to most buyers.
The real estate market saw a large number of new and a small number of unscrupulous investors enter the real estate market. An increasingly competitive investor climate led to more and more creative ways to purchase undervalued homes and squeeze profits out of real estate sales. This has brought about a nationwide wave of state governments passing legislation aimed at regulating some of these investor strategies. Two primary targets have been protection for distressed sellers (especially those in pre-foreclosure) and warranty requirements for remodeled homes. These cut directly into the potential for house flippers by limiting their ability to find undervalued property and requiring additional expenditures and liability for their brief remodel work.
5) Reliance on market timing
The nature of house flipping requires an investor to be adept at timing the market. You must know not only when to start buying and flipping properties, but also when to get out of the market before prices slow or retreat. Warren Buffett has a famous saying: “The market can stay irrational longer than you can remain solvent.” This is precisely the concern for house flippers that believe in their powers of prognostication.
Will house flipping come back into style? Maybe. The general concept of buying and flipping continues to make its way through almost every type of investment, from the tulip bulb mania of the 1600s to the dot-com stocks of the late 1990s. Investors have a collective short term memory. People generally give too much weight to recent experience and extrapolate recent trends at odds with longer term statistical averages. That means that house flipping will likely come back into fashion at some point in the future, regardless of whether or not it should.