The Flipping Myth

You watch the shows don't you? It's ok, we are all friends here. I'll start by admitting it first. I do enjoy watching some of the "reality" shows on the popular home and DIY channels at times.  And why not? They are entertaining and at times can be educational. Plus, as an experienced real estate professional it is fun to criticize the celebrity experts! Don't tell me you don't do it. Especially if you have been in the business long enough to experience both failure and success. Because in the shows, the heroes always overcome all obstacles to save the day.  But, those of us who work in the real world without cameras know "reality" doesn't always work in our favor and/or the path to success can be long. These are some of the points I want to address. Primarily focusing on the new, inexperienced and novice investor.

There are some serious misconceptions regarding flipping real estate. Specifically when using the term in its most common form when referring to flipping retail real estate. The TV shows can certainly perpetuate these misconceptions, but they are also found lurking in ads for RE seminars, presentations at local REI clubs and conversations with other investors. This is not to imply retail flipping is bad or not to pursue them in your business as they can definitely be lucrative.  My purpose is when you embark upon flipping a property you do it with full knowledge of the risks and rewards they entail. 

Misconception #1 - Flipping is a fast source of cash

Honestly, this is probably the most dangerous and misunderstood aspect of the retail flipping myth. Why is it dangerous? Because if you are betting your life savings or whatever resources you have on flipping a deal and making a quick buck the probability is high you will fail........miserably.  And there are several misunderstandings which make it so.

First, it takes time to find a property which fits the criteria for being a profitable flip. If the market is hot, the competition is fierce and prices get pushed up. If the market is down, you have to buy at a discount even greater than the traditional formula (i.e. 70% of ARV or after repair value) in order to mitigate the risks of a slower retail market. Now, you will hear me talk a lot about probabilities and possibilities here and elsewhere. So, don't think I am not aware of the possibility of going out on day one or even day 15 and finding a deal. But, it is kind of like playing the roulette wheel in Vegas.  There is always the possibility of picking the exact spot the ball will land and obtaining instant success.  The question is are you in a position to bet all you have on it? Most new investors are not.

Second, if you are going to realize a decent return on a retail flip there normally needs to be a reasonable amount of rehab or remodeling required.  Why? Because, properties requiring only cosmetic or minor repairs usually sale at or close to retail value. Do we purchase those kinds of properties in our business? Yes, but not as flips in the sense we are talking about here. These are properties we get at a decent enough discount to quickly resale for an assignment fee or profit to either an owner/occupant or landlord without incurring significant risks in the process. The money is good, but not the kind of profit most investors are talking about when referring to retail flips. 

Which leads us back to the point. If you are going to buy a property requiring enough rehab to be considered a retail flip, it is going to take some time to complete those repairs. Traditional estimates are to factor in one week for every five (5) thousand dollars in repair (Texas market).  And depending on whether your property is subject to municipal or requirements, the project time frame can be even longer.  The minimum we look for in our business is north of $25-30k in repairs to consider it worthwhile to analyze.  Anything less in our opinion falls under the cosmetic or paint and carpet category.  Using our previous factor of $5k = one week of rehab time, this means at minimum most rehabs are going to take 2.5-3 weeks or more after contract and closing.  In reality, we look for rehabs in the $60k or more range when targeting the larger dollar returns.  You can do the math.

Third, once you are done with your retail flip where is the time to market and close on the deal.  This can take anywhere from 45 days in a really hot market to more depending on your price point, average days on market and closing after contract.  Plus, if you consider the age old adage that price sells real estate, if you make a mistake there are only two choices: 1) lower your price and profit or 2) wait it out and hope for the best.  Both options being counter to your objective and reinforcing the basis for the first misconception.

I have estimated in our current market (Houston metro 2016) the average time to flip a retail property is about 6-14 months depending on the market area.  This is based on a reasonable estimate of 90-120 days to acquire and close on a wholesale deal, 6-10 week rehab and 45-90 day closing on the back end.  The remaining spread in the estimate taking into account variables in each stage could be more or less.

Let's add it up and see where we stand.  First, it will normally take some time to find a good property to flip.  Second, it takes some time to rehab a property if you are seeking out those which will give you a good return on your investment.  Third, it takes some time to market, get under contract and close a deal with a retail buyer.  Therefore, if time is not on your side then most likely betting the house on a flip is not for you.

Misconception #2 - Rehabbing a retail flip is easy

I don't have to belabor the point that if something was easy, everybody would be doing it. And they would be extremely successful as well! Unfortunately it seems like for most inexperienced investors this is a common misconception.  Construction can be less challenging for the experienced versus the inexperienced.  But, even the most seasoned veteran can tell you a story or two of the one that really put them to the test.  

There is also the misconception that all you have to do is hire the right general contractor and everything will go smoothly.  Since I started as a GC over 25 years ago, it isn't something we do in our business and for good reason.  Although, we have been asked on more times than I can count to come in a salvage a bad rehab.  The end result? Either profit, time or both suffer. Now, before the GC's out there start bashing me I am not saying all GC's are bad.  In fact, finding a good one for those who don't want to manage their own projects will be one of the most important partners on an investors power team.  But, they must be someone who rehabs at investor pricing (wholesale), not retail re-modelers and trustworthy.  

My advice if you are not managing your own rehabs is to use a GC who has some skin in the game.  Many investors are adverse to profit sharing, but I can assure you the benefit of having someone aligned with your interests far outweighs the potential damage of the alternative.  The rehab is the one of most critical aspects in the business of retail flipping. This is an area that can make or break your deal.  Don't take it lightly and don't get fooled by the misconception that it is easy if you want to be successful.

Misconception #3 - Focusing only on retail flips

This misconception (or mistake) is really a culmination of believing in the other two.  Once you understand flipping is not necessarily a fast path to cash and rehabbing is not always easy, then you probably have realized by now you can't just focus on flips to build you RE business. It should be one aspect of a well-rounded real estate investment strategy.

Still not convinced, then let's do some simple math.  First, how much would you like to make in a 12-month period? I am not talking about the high end, as most of us would like to make as much as possible.  I am talking about the minimum to get started and make it worth your time.  I am sure the answers would be varied, so let's just work an example.

Say you want to flip a property and make $50-70k. That sounds like a good number for a average flip property.  If we can make more, even better, but let's focus on something reasonably attainable for a first flip.  Now, remembering the prior discussions about timing we will use calculation of 9 months to source, acquire, rehab and sale the property. That equates to a $5500-7700 per month salary. 

Not too bad. I am sure there are many of you who would be more than happy with that kind of income. But wait, we forgot something really important. How are you going to pay the rent or mortgage during the time it takes to collect this nice check?  What about groceries, utilities and car payments? If you have other sources of income or savings (outside of your investment in the deal), then that is great.  Unfortunately though, many new investors have lost their primary source of income or jump into the fray without considering those costs. 

Even if you are happy and can live off the profit of one deal, there is still the timing issue of what you do in between to pay the bills.  And if you could do more than one at a time, even better. This again gets back to the first two misconceptions. If finding one profitable deal is tough, then finding more than one is even harder. If rehabbing one deal at a time is challenging, then rehabbing more than one even more so. Doesn't mean don't do them, just don't bet the house...........literally!

Misconception #4 - Gross Profit

This one is pretty simple, although it does fool many investors. 

Some would say the marketing of deals calculating gross profit is misleading or deceptive. I would have to disagree.  Honestly no wholesaler can estimate or should be responsible for calculating an investors net profit. There are way too many variables and variations to consider. The issue though is most new investors see gross profit estimates on deals and get stars in their eyes only to be disappointed. Don't let it be you!

Example: purchase price $85k, repairs $45k, ARV $185k GROSS PROFIT $55k!!

Here's a very important newsflash. You don't put gross profit in the bank!

A quick rule of thumb is net profit on a cash deal (no financing or loans) is about 18-20% max on a good deal. Factor in carrying costs, finance costs and other factors the number drops to around 12-15%. If it takes you longer than you estimated to rehab or sale the property, the number goes down even more. Really mess up and you are looking at break-even or possibly losing money.  

Starting with a 30% margin (ARV * 70% - repairs = purchase price), this equates to a net profit of 40-60% of gross profit.  Using our example above, the expected cash you would ultimately put in the bank once you closed the sale to the end buyer would be $22-33k. Again, this is assuming the ARV holds steady or improves and repairs cost no more than your estimate at time of purchase.  Still, not a bad payday if you have accounted for and factored in all the other variables in pursuing a retail flip.

In Conclusion

There are those in the business who perpetuate the misconceptions about being in real estate for their own benefit. And there are those who unfortunately buy into the misconceptions to perpetuate their own fantasies of getting rich quick.

Flipping real estate is a great business. Depending on market circumstances, flipping can be your only focus at times. But, market conditions change and as an active investor you want to have a well rounded organization with multiple streams of revenue. As a new or inexperienced investor you don't want to enter into the business with tunnel vision. Develop a well rounded portfolio of deal types which will sustain you in the long-run. Monetize every opportunity along the way.

Real estate is a business and like all businesses it requires you invest time and resources while practicing patience to build a successful one. This is a marathon, not a sprint.  Whether it is a mentor, seminar, wholesaler, lender or anyone else you entrust with your time or money; the question to ask is this: are they invested in my success? If not, proceed cautiously. Invest in real estate, not misconceptions!