The other day I grabbed $40,000 tax free from refinancing a duplex that originally started as an ugly duckling. As I was walking out of the closing on my way to the bank, I couldn't help but wonder how a flipper would have fared on this deal.
I'm not telling you this to brag, but to give you perspective from a buy and hold real estate investor who doesn't have a ten thousand dollar course and coaching program to sell you.
I must admit, the allure of flipping has crossed my mind from time to time. Brandon Turner, at Bigger Pockets, calls this the shiny object syndrome.
In other words, your are doing something that works and then you hear about an investor doing something else and start to wonder if you could be doing something better. Pretty soon, your all over the map with different real estate strategies and have nothing to show for it.
Beware of shiny objects people!
Don't get me wrong. I have flipped a few properties back in the early days of my investment career only to find out later that the taxes and time weren't worth the hassle.
In my humble opinion, you can't build true wealth by rapidly buying and selling assets unless you have lots of capital and a unique edge that the market hasn't discovered yet.
Once the market discovers your edge, people pile in and your margins eventually evaporate. This is the nature of the beast called capitalism.
In the stock market, it's called the Efficient Market Hypothesis.
Like Warren Buffett, I trade little if not at all. My holding period is forever. All my time is spent nurturing my little flock of golden geese while waiting for the right deal to come along.
When it shows up, I pounce and attempt to create long term value through strategic renovations, repositioning or savvy management.
Notice how I'm not fighting the market like the typical flipper. I don't have to find a deal to put food on the table and I can patiently wait for the proverbial fat pitch. I'm simply surfing the wave of capitalism while making minor course corrections.
Yea...this is some heavy stuff. Kinda like Yoda trying to teach an impatient Luke Skywalker how to raise a spaceship from a swamp by harnessing the power of the force.
Let's take a look at my ugly duckling deal and compare it to a flipper who creates the exact same golden goose but kills it for a fast buck.
Way back in 2011, the real estate market was licking it's wounds from the Countrywide Mortgage Subprime Hustle. The loan market was slowly beginning to thaw while bankers were hiding under their desks. The only people who could afford to buy were hedge funds and folks with lots of cash on hand and AAA credit.
As luck would have it, my flooring guy told me about a vacant duplex that was in need of major repair and the owner would seller finance for little down. The perfect pitch!
After a quick assessment, I was able to structure a "win-win" deal where the seller would accept $2,100 down and finance the balance of the purchase of $37,000 at 5% for 20 years with a 10 year balloon. The payment worked out to be $245 per month plus taxes and insurance.
I say "win-win" since the banks had shut me out of the market and I could only buy if it was owner financed. Being that I already had eleven conventional loans, I was forced to deal with commercial banks that were simply not lending due to the real estate crisis.
How bad was it? I had two Countrywide loans that were sold to Bank of America and a commercial loan that was sold three different times in two years since the prior originators had went under. One of the lenders was actually Lehman Brothers-go figure!
The seller was delighted since he was sitting on an empty property and would receive steady cash flow without having to lift a finger.
I closed in December 2011 with my favorite title company and started renovating the first unit in January of 2012. It was almost a complete gut job, but I lucked out since the owner had already started the remodel process and most of the materials were already in the unit.
The place needed new flooring, kitchen cabinets, gas boiler, new shower, bath, a serious clean out and lots of paint. The plumbing and electrical were sound and this is why I quickly made an offer after my walk through.
After spending five months on the upper unit, I managed to get my first renter at $700 per month and had my monthly nut covered. I paid the water and garbage and the tenant paid the heat and electric.
Note: The reason the renovation took so long is I have a full time job and I do this on the side. Moreover, I used tradesman that work on the side as well.
Next, I tackled the lower unit and pretty much did the same thing. After four more months, the lower unit was rented in November of 2012 for $750 per month.
Once again, I covered the garbage and water and the tenant paid the rest.
Finally, I was generating some serious cash flow. Combined, I was taking in $1,450 per month in rents less mortgage payments of $245 excluding taxes, insurance, utilities, maintenance and the new gas boiler loan payment.
Here's a breakdown of the calendar years income and expenses from purchase to refinance.
Purchase date December 2011
Upper Unit Annual income: First renter in June 2012 at $700/mo
2012-$4200
2013-$8400
2014-$4200 before rent increase.
Lower Unit Annual Income: Second renter in November 2012 $750/mo
2012 $1500
2013 $9000
2014 $4500
Total cash flow $31,800
Total Expenses from January 2012 to August 2014:
Water -2,040
Garbage -1,200
Property taxes -3,600
Maintenance and repairs -2,120
Total operating expenses $8,960
Net Operating Income (NOI) over 2 years $22,840
Total debt service $7,272 (including new gas boiler loan).
Cash flow after debt service $15,568
How did I pay for renovations you might ask?
I used the cash flow from my real estate portfolio to cover the construction. Total cost for all the renovations spread out over 12 months or so was $29,941. This brought my "all in cost" of the ugly duckling to $69,041.
Based on my market analysis at time of purchase, I figured the property could sell for $110,000. Fortunately, I was a bit too conservative and the market had improved over the next few years.
Still, I live in a market were duplex values have not recovered since the peak of the sub-prime mortgage meltdown.
On August 8, 2014 the appraisal came in at $139,000. I was stunned!
Assuming I could sell it at this price, my total gain (before selling costs) would be $69,959. This is before I factor in the net cash flow from operations (NOI).
Adding in the NOI it looked like this:
Net income from buying and holding since purchase: $15,568
Profit based upon appraisal: $69,959
Total return $85,527
Total investment out of pocket: $31,941 (down payment plus renovations)
Total cash on cash return: 268%
WHAT IF I SOLD AS A FLIP?
Assuming I could renovate and close this deal in 6 months, I would have to hire a contractor to manage the renovations with a time line of 2 months or less.
Let's assume it take six months from acquisition to sale since the average days on market at the time of sale for this type of property was three months in 2012.
Furthermore, let's assume the contractor needs a 20% profit margin to oversee the flip. Adding in this factor to my renovation cost and I'm up to $35,930 for improvements.
Here's the math if I were a professional flipper.
Renovation cost plus purchase price : $72,930
Estimated holding costs (taxes, insurance, utilities, payments ) $3,500
Realtor commission and closing at 8% $11,120
Total cost as a flipper $87,550
Total gain before tax $51,450
But wait......that's before our silent partner with the initials IRS takes his cut.
Short term capital gain tax at 25% $12,863
Self Employment tax at 15.3% $7,872
Total loss to silent partner $20,735
Net profit after tax $30,715
$30,000 in six months is still a sweet deal. The problem is I can't find deals like this day in and day out to create enough income to hit my retirement goal while raising two kids, two dogs AND making sure my lovely girlfriend sticks around.
Throw in a few vacations, college savings, some walking around money and my annual household "nut" is way north of this number.
What happens when I cash that $30,000 check? I have to reinvest most of the money into another deal and do the process all over again.
Worse, the more I succeed as a flipper, the higher my tax rate.
Imagine if I were super successful flipper like some of the BP folks on the podcast. My combined tax rate would jump to 45% to 55% and this would force me to hire more people and reinvest larger and larger sums to keep the operation running smoothly.
Dang...just thinking about this makes me tired. I'd rather be Warren Buffet who manages one of the biggest companies in the world from a drab office in Omaha with a staff of 24 employes.
Oh, he sits around and reads a lot while sipping Cherry Coke. Periodically, he hops on his private jet to appear on CNBC to warn investors not to trade a lot and simply buy the market and surf the wave of capitalism.
Come to think of it, I bet Warren has less staff than some of the largest flippers out there who don't even come close to generating 182 billion in revenue.
Did I mention he is in a lower tax bracket than his assistant who draws a six figure salary?
Let's circle back now and compare my check from the closing to what I would have earned as a short term flipper.
As you may recall, I pulled out $40,000 tax free as a result of my refinance compared to a hypothetical flip profit of $30,000 by refinancing the seller note and furnace loan at 5.5% over 20 years. The new payment is slightly less since I paid off the seller note and the furnace loan.
Yes.....I could have grabbed more, but I wanted to keep the loan to value at 60% or less for strong cash flow.
Over time, I will continue to net about $13,750 per year tax free by keeping it as a buy and hold while the tenants pay all my expenses on the property including the mortgage. If I do sell, I will avoid taxes by simply doing this thing called a tax deferred exchange.
How cool is that?
If I die, my kids get the property at the current market value. All taxes are stepped up and my kids can sell the golden goose or continue collecting passive income.
Take that Mr. IRS!
Best of all, I don't have to wake up everyday and punch the flipper clock to generate another $30,000. I can generate the same income by simply replicating this deal with a couple of more properties.
Yes, I have to manage tenants, field phone calls and lease the property every so often. Still, a completely renovated property is easy to rent and has fewer repair requests as long as you let the right type of tenant into your property.
Lastly, this is not my typical deal. Over the years, I've made my share of mistakes. However, the good deals tend to smooth out the bad. Fortunately, real estate is forgiving as long as you buy for cash flow.
This ugly duckling in now my golden goose. She's just sitting there laying monthly golden eggs worth $1,145. As long as I continue to take care of her, she will take care of me for years on end.
Don't kill the goose.
