A wonderful thing about real estate investing is that there are so many different ways to make money, whether it be with commercial or residential properties.
Of course, investors have their preferences. Some prefer to flip properties while others prefer to become landlords and rent them out (that is, buy and hold). Flipping versus renting can cause big debates, so here’s what to know about both options.
Flipping versus renting: What’s the difference?
Even though both have to do with real estate, they are very different. Renting means owning a property and having someone pay a monthly fee to live there. Flipping houses means buying a property at a discounted price, improving it and then selling it for a profit.
Renting is more of an investment while flipping is more of a business. The money you make on the latter is based on the number of flips you can do, and there are more expenses, especially if you choose not to do the work yourself. Renting isn’t typically as involved as flipping.
What are the pros and cons of flipping a property?
The process of flipping requires investing money to buy the property and putting in the effort to improve it to then sell it. That’s a simple enough definition, but it’s much more detailed than that. Here are the pros and cons to this process:
Instant cash gains: Compared to buy and hold, property investment using this tactic leads to much faster gains. This also makes you cash-strapped for less time and gets you a one-time profit as soon as you sell.
Less time: Because flipping is done as soon as possible, the cash is available much faster than with a buy and hold strategy. Since it’s a faster way to get money, it can also boost an investor’s confidence and give some experience for buy and hold properties.
Potentially lower risk: In terms of value, this is also a lower-risk strategy and can offer a better return on investment (ROI). The lower risk stems from the fact that long-term real estate fluctuations wouldn’t affect a property that is being flipped quickly.
Fewer hassles: Lower carrying costs reduces the number of issues. Because most flips deal with distressed properties, the initial investment is usually lower than the market rate. And as opposed to a buy and hold strategy, there’s no dealing with tenants, plus you don’t have to worry about vacancies cutting into your income.
More on flipping from BiggerPockets
Unrealistic expectations: While flipping can generate profits in the shortest amount of time, this doesn’t always happen. This is because good properties for fix and flip are difficult to find. Most investors enter into flipping with unrealistic expectations, which can make matters worse.
Tax issues: Since these are short-term investments, flipping comes with its own set of tax implications. Therefore, before you get excited about the profits you’ll make, it is important to consider these.
Newbie problems: Flipping isn’t for everyone, and it takes time and experience before you become good at it. Many people think that a few TV shows and crash courses can make them an expert-level flipping pro, but that is hardly the case.
High investment costs: Investors often think that they can make quick money on flipping; however, if they don’t have the funds they need, short-term investments can prove to be expensive. This is because these investments come with higher interest rates. Many people also forget that even this type of investment can trap your cash, although usually for a shorter amount of time. The investment costs can be high, and you have to take holding and transactional costs into account as well.
To help combat these negatives, keep the 70% rule in mind. This means that an investor doesn’t pay more than 70% of the after-repair value (ARV) of a property minus the repairs needed.
For example, if an ARV is $200,000 but $30,000 worth of repairs is needed, that means an investor shouldn’t pay more than $110,000.
Use the following formula:
ARV x 0.7 = $140,000 – $30,000 = $110,000
Hiring contractors: Although doing the work yourself in a flip does save you money, not everyone chooses to do this. You can hire out to get the work gets done, but this means you have to take the time and energy to find the right people and you have to pay them, which becomes more expenses.
Living in a flip can be difficult: To save money, some flippers choose to live in their flip while they continue to work on it. Doing this means it’s more difficult to separate work from relaxation time and you’re always looking at what needs to get done.
Paying a capital gains tax: This tax is applied to the growth of an investment after it’s sold. For example, if you buy a property for $150,000 and flip it so that it’s worth $300,000 when you sell it, you have to pay tax on that $150,000 difference.
What are the pros and cons of holding and renting a property?
Just as with flipping, there are pros and cons to renting a property. Consider these when deciding to move forward with an investment property.
Income: Most investments offer either a consistent return like annuities or the potential for equity appreciation like stocks. Real estate offers both. Good buy and hold investments offer positive cash flow that not only offsets the expenses and debt service but also provides a monthly income from rental properties.
Additionally, this is passive income. As long as tenants are paying their rent on time, you’ll have guaranteed money every month to cover the costs and expenses of the home and to add to your wallet.
Depreciation: The IRS allows you to write off the value of any property over 27.5 years. Yes, this depreciation counts as negative income—but it’s only negative on paper because the costs of keeping a property in good condition can be paid for out of the rental income.
Less pressure: This is a much slower process. The value doesn’t come from the resell, the market has little to no effect on your cash flow, and there’s far less involvement required to get your returns.
Thus, the depreciation “losses” wipe out the positive cash flow from the property and remove any tax obligation. Unfortunately, due to the Tax Reform Act of 1986, only active investors can take advantage of this.
Equity build-up: Unfortunately, with a mortgage comes the obligation to pay it back. Fortunately, the cash flow mentioned above allows an investor to pay back that mortgage without spending any of their own money because the tenant pays it.
Furthermore, each month—assuming you don’t have an interest-only loan—part of the principal is paid off, too. For a 30-year loan, about 15% to 25% of each loan payment goes directly toward the loan’s principal. That adds to the equity you have in the property.
Accelerating equity pay down—the simple concept that with each payment you pay more toward principal and less toward interest—helps build up equity faster the longer you own a home.
Appreciation: Real estate, like any other asset, can go up or down in value, although the trend has been up. In fact, over the past 40 years, real estate has gone up an average of 4.62% per year. Combined with accelerating equity pay down, your equity has exponential growth the longer you hold a property.
Some have pointed out that the stock market generally has a better return than real estate. True, but it’s also not that simple. Real estate is generally leveraged at a rate of 4:1 or 5:1. Stocks, on the other hand, are rarely leveraged, especially after the massive losses taken by those “buying on margin” before the Great Depression.
Ownership: You’re always building wealth. There’s also an undeniable pride that comes with owning one property or a hundred. Finally, because there is no pressure on the investor to sell immediately, they can hold onto the property for as long as they wish.
Fluctuating market conditions: A major drawback of this investment strategy comes from market fluctuations. When you’re looking at a long-term picture, a market that seems to have valuable properties right now can lose its value years down the line.
Management issues: This form of investment comes with management duties. That usually means that there are issues to resolve and your time is involved. Managing properties is often outside the skill set of many investors. This also usually means putting in time and energy, which can get frustrating for those who don’t have enough of either. If that is you, check out the turnkey providers nationwide. Most offer a hands-on experience for investors looking for buy and hold turnkey properties.
Another option is to hire a property manager to handle everything for you. It takes the burden off you, especially if you’re not a fan of being a landlord, but it also comes with the expense of paying someone to do the work.
Lack of good tenants: While it seems convenient that you can maintain a steady cash flow for your rentals when you’re holding a property, good tenants are often hard to find. It takes a lot of patience and can be a time-consuming activity. Newbie real estate investors should also be wary of legal issues that could come up with tenants.
Is it better to flip or rent properties?
This isn’t a competition. Flipping and holding aren’t mutually exclusive since flipping can be a fantastic way to raise the money necessary to buy and hold real estate.
Also, every investor is different. What works for one person isn’t going to work for the next person. That’s why it’s so important to be as knowledgeable as possible before jumping into real estate investing. You’re on your first step right now.
The answer to the flipping versus renting debate is ultimately answered by the choice you make, and as we’ve discussed there are advantages and disadvantages to both. Whatever you choose, keep in mind that every real estate investment becomes a part of your portfolio. Therefore, it’s important to make the choice that works best for you.
Renting works when you have a lot of money to invest, and the property can be lucrative as a long-term investment. If you don’t want to deal with the headaches that come with managing a property, you can hire someone else to do it. All you have to do is be able to pay them.
Flipping can be ideal if you’re looking to grow your business. It can be fast money and a lot of it after everything is finished and the property is sold.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.