Flipping Houses vs. Long-Term Rental Properties
HGTV has some really interesting real estate shows such as "House Hunters" and "House Hunters International." Both of these shows provide the viewer with a good indication of both sales comparables and rental comparables in towns and cities located across the U.S. and abroad. What the shows do not tell you, is the myriad of legal and financial red tape the buyers must go through to buy a property; and to some extent tenants as well must jump through a few more hoops than they probably expected.
One of HGTV's most interesting newer shows is "Flip or Flop." Two real estate agents, husband and wife, went into flipping houses in the Orange County area. What is nice about this show is that the two agents started with not much money in the bank and not much of a clue how to renovate a home, but by their tenth or fifteenth house flip the husband finally realized that his wife is smarter than he is (usually the case after a few years of marriage) and started using her design ideas. Their timing was good and their market was the epitome of location, location, location. So, they had market timing and location covered, they just needed to work on price, terms, and condition. By paying all cash for the properties they were able to negotiate some fairly good deals on dilapidated homes located in good areas. Their terms were all cash and a quick close, minimizing contingencies--if there were any at all. This allowed them to pickup up the properties at below-market prices because the sellers (many of them banks) were willing to accept less net proceeds if the buyer could close quickly and not cost them any more time and money. The banks were motivated to reel in as much of the original real estate loan as possible. An all cash and quick close deal would accomplish this.
The last variable the flippers were dealing with is condition. This is where the house flippers can really make a difference in the value of a real estate property. Depending upon the real estate market price range, different types of flips work better than others. For example, an expensive home located in a higher socio-economic area is better suited for an expensive renovation and quick sale. Where as an inexpensive home located in a lower socio-economic area may be more suitable for a long-term hold rather than a flip. The amount of profit from the lower-end flip may not be enough to justify the amount of risk being taken on by the investor. The house located in the lower socio-economic area will probably rent for a fairly good cash flow in comparison to the price paid for the property, while the expensive home located in a high socio-economic area will probably rent for a poor cash flow. Rents do not generally increase above a certain level, and a really high-end home will have to rent at a price significantly above the market for the owner to realize an adequate return based on the risk of the investment. Tenants looking at the higher end property will not have the ability to pay a high enough rent to make the investment worthwhile. For this reason, higher-end properties tend to lend themselves well to a flip, and not to long-term rentals.
Homes located in lower socio-economic areas tend to do well as long-term rentals because the cash flows can be a 10% return or more. Real estate investors will many times purchase a home and do just enough cosmetic renovation to appeal to prospective tenants looking in that lower-end rental price range. The investor will collect rents during the holding period--which will most likely last until the top of the next upward-trending sellers' market where the owner will convert the property to owner-occupied use--and sell it to an owner-occupied buyer. This allows the investor to sell the property based upon prevailing owner-occupied prices, interest rates, and loan-to-value ratios rather than purely investment income and capitalization rates; thus (possibly) providing an excellent overall rate of return during the holding period (called internal rate of return for you finance wizards).
What is even more interesting is at the top of an upward-trending sellers' market where buyers are scrambling for properties, the buyers will many times pay top-of-the-market prices for properties that have not been renovated. As long as the appraisers are carried along with the "rocket to the moon" syndrome where real estate prices will never slow down, prices could really get out of hand like we saw in the 1990-1991 and 2005-2006's upward-trending real estate sellers' markets in California.
In fact, if the market is so hot that buyers are really scrambling for homes, many investors in these lower socio-economic markets will sell their 3 bedroom and 1 bath homes for a very close price to the 3 bedroom and 2 bath homes located in the same neighborhood. The functional obsolescence inherent in the 3 bedroom and 1 bathroom homes may be overlooked by the buyers and appraisers because of the velocity of the real estate market.
Savvy real estate investors look to buy 3 bedroom and 1 bathroom homes during the bottom of a downward-trending buyers' market for rock bottom prices, which is due to the functional obsolescence caused by having only one bathroom in the property. The property is rented out at close to 3 bedroom and 2 bathroom rental prices because tenants in that price range aren't as picky as tenants in higher price ranges, and may have a little bit more marginal credit. So the investor obtains a better cash flow than the two bedroom properties due to the lower purchase price paid, and then sells the property at the top of the next upward-trending sellers' market for close to the two bathroom property prices--thus obtaining a better overall return than the 3 bedroom and 2 bathrooms homes. Of course, the real estate investor took on more risk with the functionally obsolete 1 bathroom homes and should receive a greater return commensurate with that risk. The risk-return tradeoff theory holds true once again.
House flippers and long-term investors have completely different tax strategies. The house flippers receive active income from their flips and must pay taxes as a business would on their active income.
The long-term investor's income is passive. The rents collected each year are taxed; however, most investors take depreciation on the improved portion of the property and write it off against this passive income to reduce their overall tax liability.
Depreciation is a paperwork loss the IRS allows the investor to take and can be significant during a long-term hold. When the investor sells the property in the future, the IRS recaptures the depreciation when the capital gains taxes are paid. Some investors, however, decide to do a IRC 1031 tax-deferred exchange where they exchange the property to another one and defer the capital gains taxes (and accrued depreciation) into the future. Of course, someone must pay the capital gains taxes in the future--hopefully your heirs will have to deal with paying the taxes on all the millions of dollars worth of real estate you own in California. Nice problem to have.
House flippers and long-term investors may take on a significant amount of liability when taking title to multiple properties and then selling them. A limited liability company or corporation may be a good idea to protect them against overly litigious buyers who may be looking for someone with deep pockets to take their loss if property prices go down in the future.
When a flipper is actively flipping homes, a significant amount of time must be spent finding the good deals and buying them. The flippers timing must be impeccable: getting in and getting out as fast as possible. Conversely, even if the long-term investor is little bit off on market timing, time usually heals. Over time the investor will probably be able to recoup some if not all of the lost value.
Both flippers and long-term investors who have a real estate broker's license, may be able to participate in the sales commission being offered to the agent representing the buyer, since they are representing themselves. If the flipper of investor does not have a real estate license, this could be a good market for a real estate licensee to go after and collect commissions for finding suitable properties for both flippers and long-term investors.
Flippers and long-term investors have two different business models with their own strengths and weaknesses. Flippers can physically impact their profitability with good purchases and renovation decisions. Long-term investors must wait for the real estate market to cycle through, so property management is the key to success during the holding period. If the property manager can increase income and reduce rents, this will increase the investor's net operating income and lower his capitalization rate which will allow him to sell the property for a nice profit at the end of the holding period. Whether you are a flipper of long-term investor really depends on personal preference and tolerance for different types of financial risk.