How does a flipper make a profit (It's not what you think)

Question

How does a flipper make a profit (It's not what you think)Rehabs lose money? Discount at the time of the purchase is what makes money.

Jorge Vazquez · Answer

Rehabs lose money. Discount at the time of the purchase is what makes money.

Here is a real-life story. Gary is a newbie investor from Orlando. He works as a business analyst and recently received a 6 figure inheritance. He was thinking of ways to grow his retirement portfolio and zoned in on flips. He had read some articles about flips and had seen several flipping shows on TV. He met me at my office and during our fact-finding meeting, he told me “All I want to do is flip houses. I don’t want any rentals. I don’t want any other options. I just want flips.” I appreciated his clarity of purpose. Most investors don’t really know what they want. Here was a guy who knew exactly what he wanted.

Gary had come prepared for the meeting. He had researched various properties in his neighborhood that were on the market and advertised as fixer-uppers. He had gone through every photo of every home. He had even made notes on the estimated costs of rehabbing each property. He showed me one of the listings and started to describe what he felt needed to be done.

I noticed a pattern in his statements and it revealed a fallacy that most people have: He felt that the profit in flips comes from the rehab. He felt that by adding better finishes, the house will command a higher value. There is a grain of truth in that sentence but it's a case of confusing correlation for causation.

Here’s the Truth: Profits in a flip come from a discount on the purchase price of the property. That’s what creates the opportunity to make money from the deal. Doing the rehab allows you to realize the opportunity. However, if you didn’t get a discount at the time of the purchase, doing the rehab will not create any value. Instead, you will lose money.

In order to explain this to Gary, I gave him 3 examples.

Example 1

If you put in a pool in a property at a cost of $40k, how much value do you think it will add to the home? He said,  “About $45k. I think a 10% premium seems reasonable for the time and effort to put it in.” I replied, “Yes. That argument makes sense but based on actuarial data the value of the house will go up only by $13k. You are going to lose $27k by adding the pool.” Gary’s jaw dropped to the floor. It hit him like a bolt of lightning and he understood what creates value.

Rehabs lose value. They don’t create value.

When it comes to rehabs, there are very few items that add more value than they cost to put in. The market discounts the price of the rehab. For almost all items whether it’s installing a new roof, granite countertops or flooring, the increase to the value of the home will be lesser than the money spent on the rehab. For example, if you buy new appliances for $3k, the added value might only be $2k. If you add new floors for $7k, the added value might only be $5k. These values change based on comps in each neighborhood and therefore it’s hard to put a nationwide number on the amount you lose by doing the rehab.

Example 2

Consider a neighborhood where most homes are around 1500 sq ft and selling for $200k. Let’s say you buy one of these houses for $175k because it needs some work. You go ahead and install high-end granite countertops, solid wood floors, automated window blinds, and a ton of other smart home features to the property. The cost of the rehab comes to $75k. Ignoring closing costs and the cost of capital, the money you have invested is $250k. Do you think you will be able to sell the property for $300k? No. The appraiser won’t be able to justify a $300k value in a neighborhood where all the comps are selling at $200k even though you have the receipts to show the rehab costs. Doing the rehab will cause you to lose more money than if you didn’t do anything.

Example 3

Let’s say that you have a vacant plot of land in the same neighborhood mentioned in the example above. The lot size is similar to all the other houses in the area. Given that the cost of new construction is in the range of $120 - $140 per sq ft, it would cost at least $180k to build a 1500 sq ft home. There should logically be some sweat equity that is built in the process of building the new home. If we take a conservative number at 15%, that would be $27k. That would put the value of the lot at negative $7k. How much do you think lots sell for in that neighborhood? It's most certainly not negative $7k. The reason this happens is that the market discounts sweat equity and costs.

Discounts create profits. Rehabs cost money.

In almost every case, the reason profits are made is because the property is purchased at a discount that is steeper than the cost needed to fix it up. If you didn’t get a discount at the time of the purchase, you can’t make money on the flip no matter what you do.

How builders make money

Even though Gary had understood the concept by now, he still had some doubts. He asked me how builders made any money if new construction is not profitable. The answer is they buy the lots at steep discounts and in some cases, they sit on the land for long periods of time and allow it to appreciate. The other way builders create value is through economies of scale: they buy land by the acre and sell it by the lot. It's the same way a bar makes money: they buy whisky by the barrel and sell it by the shot.

The Why: Psychological Vs Financial Payoffs

Gary’s next question was more incisive. He asked me why this happens? Why does the rehab lose money, i.e. it adds less value than it costs? The answer is based on the concept of financial vs psychological payoffs. In almost every transaction, one side gets a financial payoff whereas the other side gets a psychological payoff. For example, when you go to a fine dining restaurant, you get the psychological payoff of enjoying a good meal whereas the restaurant gets the financial payoff of charging you a small fortune. In housing, most homeowners update their own homes because they want to experience the joy of having better finishes in the home. They are not thinking about making money with the rehab. Since most people want the psychological payoff that comes from the rehab and it constitutes the bulk of renovations, the market prices it accordingly. It’s like the salary we give to teachers in school or caregivers to the elderly. They are underpaid and overworked. Why don’t all of them just quit their jobs to pursue more lucrative careers? The answer is that they get the joy (psychological payoff) of helping others. It's what keeps them going and allows the market to discount their salaries. Teachers and caregivers get more of a psychological payoff and hence they sacrifice a financial payoff.

Flipping shows are untrue!

At that moment, with a puzzled look on his face, Gary asked me why flipping shows on TV focus entirely on rehab. The answer is for its entertainment value. It is entertaining to watch a guy run through drywall and knock over cabinets with a sledgehammer. It isn’t entertaining to watch a guy running numbers on a spreadsheet and calculating profits. Rehabs in real life are not like flipping shows on TV. Even after several years of doing this, I am yet to see any contractors demolish cabinets with a sledgehammer: They just unscrew them from the wall.

Conclusion

After our conversation, Gary left my office with a smile on his face. He had just understood a secret. The secret of making money with flips. Armed with a better understanding of the economics behind them, he purchased a flip at a substantial discount and finished the rehab. He was careful and didn’t over-rehab the property. When he listed it, he had a multiple offer situation and sold it for a handsome profit. He is on his way to being a successful flipper with a bright future.

Is flipping a good fit for you?

Joe Funari · Answer

@Jorge Vazquez I have made a profit on all my flips. I always have at least one flip in progress almost all the time. I purchase well below 70% of ARV minus estimated repairs. This ensures I generate a profit on every flip.  But would prefer to buy a property and place tenants in it. Buy and hold is the real long term strategy I prefer.