Don’t Flip Over Real Estate Investing!
Spring is almost here. And with it comes thoughts of real estate.
A few days ago, I was flipping through the channels on the television. I noticed a curious trend that I hadn't seen in a number of years: A proliferation of house-flipping television shows.
The economy is poised for the popularity of these shows. Interest rates are low and property values are increasing. If you peruse your TV listings or check out your YouTube feed, you'll see dozens of these shows dealing with buying property, fixing it up and selling or perhaps renting it.
But what no one talks about is the massive risk within these ventures. These shows cherry-pick great deals. And when they don't show a deal to closing (which seems more often than not), they show the "expected" sales price.
I wanted to take a few minutes to walk through some of the risks in buying property as an investment. The profits certainly appear attractive, yet the risks can be far greater than we could ever imagine.
You Can Make Money in Real Estate, But. . .
Let me start by saying that most of us know someone who has successfully purchased and rehabilitated a property. I have several clients who have purchased properties, fixed them up and either sold them or (more often) rented them out. It is certainly possible.
From my observation, what most people discount is the countless hours spent on these ventures.
This isn't like buying a mutual fund and waiting for it to go up in value. It's years of working many hours for little or no pay. It's dealing with property issues instead of heading to a family event or even sometimes sleeping. It takes a special person that enjoys the work that they are doing and can sacrifice the time from their career or family to take care of the inevitable problems that crop up.
The biggest risk when buying property is leverage. Leverage is a wonderful thing. We all first learned about it in grade school. An object we can't lift can be easily moved when we use a long bar or stick to "lever" the object from one place to another.
Debt is a lever we can use in our investments. Let's say we want to buy a house for $300,000. We don't need to spend $300K. We can just put down a portion of value and borrow the rest.
This can be very powerful. Let's say we put $50,000 down on a $300,000 house, spend another $50,000 (which we also borrow) to fix it up and sell it for $450,000. Our total cost is $350,000 ($50,000 of our money, a $250,000 initial loan and the other $50,000 borrowed to rehab the property) and we sell the property for a $100,000 profit.
How much did we make?
We made $100,000 on a $50,000 investment. We tripled our money! What great leverage! We used $50,000 and a big mortgage (the lever) to make an extra $100,000!
But levers can work in reverse, too.
Let's say in the example above the house only sells for $275,000. Now we've lost all of our own money and we now owe another $25,000!
I saw this a lot when the S&L Crisis absolutely decimated condo values in the early 90’s. Five to ten years later, I was still seeing people who had bought at inflated prices, expecting values to continue rising astronomically.
Instead, the property wasn't worth what they owed on the property – even years later. On top of that, they were renting out the units to try and generate some cash flow to pay the mortgage. In almost every case, the rent wasn’t sufficient to pay the ongoing expenses. They had years, sometimes a decade or more, of negative cash flow as well as a 100% loss on their initial investment.
That’s how leverage can hurt you financially.
Currently we are in a robust economy and a rising real estate market. And as we've discussed before, the next downturn is closer to us than the last. What happens when the market does correct and we find ourselves owing more than the investment is worth? That needs to be part of our math when we calculate potential profits in our new venture.
Excitement Doesn’t Equal Experience
I find it amazing that people will dive into property investment with no prior knowledge or experience. To be fair, I've thought it too.
"Any idiot can do this. . . If that guy can do it, I must be able to as well. I'm smarter than him!" I've thought that thought 100 times myself. The allure of big money blinds us to our own weaknesses.
Without a lot of experience or a background in major house repair, it's easy to buy a home that might hide massive costs that we didn't anticipate.
Years ago, I bought a rental property. (I wasn’t looking for a quick buck but attempting to diversify my income stream. Alas, it involved far too many hours of my time and I couldn’t take time away from my business.)
The house was straight and level. It had a decent HVAC system. The roof was in good shape. The windows had been replaced several years before. It was an older home with a fieldstone foundation but it had a cement floor in the basement. Everything seemed perfect.
Weeks after the purchase, I discovered we had a termite infestation. Termites are amazing insects that can often invade a home without your knowledge. While I had a cement floor, the wooden columns supporting the house were on bare ground underneath that beautiful cement floor. Termites had tunneled under the home and were devouring the very item I was counting on to keep the house from falling in on itself.
That mistake cost me thousands of dollars in repair and correction.
There are a number of problems you might never see unless you are an expert in building, electrical, HVAC and plumbing. You might have hidden knob-and-tube wiring within the walls. There might be asbestos in the insulation or plaster. Lead paint could be hidden anywhere. A cracked furnace combustion chamber could be pumping carbon monoxide into the home. Uninsulated pipes are ready to freeze next Winter.
A good home inspector will spend 2-4 hours reviewing all of these issues. But even these experts aren't perfect. And to beat other investors to the next "good deal," you might forgo the inspection in order to be the winning bidder.
Suddenly, your budget has exploded and your profit has disappeared. A house you were planning on flipping might be worth less than you have invested. Now you need to rent it out in order to recoup some of your costs. And that comes with a whole new set of problems - tenants. This small error might continue to compound, taking time away from your family as you deal with issues with your new rental property or even doing something as mundane as cutting the lawn or shoveling the driveway.
Account for Everything!
Often the various costs associated with renovating a property are swept under the rug while doing your quick mental calculus to see if a property is a good buy or not. It’s not missing a big repair or being over-leveraged like we’ve talked about already. These are just costs that in our excitement, we might not factor into our buying decision. And they creep in and devour profits.
The biggest one of these is the real estate commission. Typically, you will pay 5% of the sales price to list and sell your investment. While many people attempt to bypass this by selling a home themselves, a good agent can also help avoid many problems that could crop up in a real estate deal, such as coordinating with lenders, ensuring city permits and regulations are met and connecting you with other local professionals.
Let's look at how this commission affects our example above. Instead of a $100,000 profit, we might only see a $77,000 profit. (Five percent of the $450,000 selling price is about $23,000.) If the value has dropped, our loss balloons $39,000! Not factoring costs like this can absolutely push you to the financial brink.
Other costs to factor in are permit fees for your rehab, utilities, insurance and taxes. If you are outlaying several hundred dollars per month, it’s going to affect your overall profit at the end of your journey. Account for it all!
Real Estate Isn’t Efficient!
The final issue that people fail to factor in is something I see often in buy/sell sort of TV shows. This isn't just house flipping shows. When I just want mindless TV shows on, I'll often catch a marathon of American Pickers on History Channel. Two guys travel the country looking for antiques and other oddities to sell in their shop.
What I find humorous is that almost always they compare the purchase price for an item to what they expect to make on the sale. Maybe they will. Maybe they won't. Maybe that item will sit on a shelf for 3 years and that money is tied up that entire time. But expected sales price is not profit in my hand.
The same goes with property. When we talk about financial markets, we refer to them as efficient. This means that if I want to sell 100 shares of IBM today, there are thousands of buyers. This ensures that the seller right before me and right after me are likely to get a price very close to what I paid. Because people are buying and selling the identical item over and over again, the buying and selling process becomes very efficient.
What about property? How often are you selling the exact same house and almost the exact same time? Not often.
You can gain some efficiency in the real estate market. If you are a developer and have 100 practically identical brand-new houses to sell in the same neighborhood, they will all sell for roughly the same price. It's somewhat efficient. (It's not totally efficient because you have differences in location, lot size, lot shape, tree cover, color and the like.)
But comparing 123 Main St and 345 Elm St - even if they are the same size and style house, is very very different. Not only are there vast differences in the houses themselves, we have massive differences in the market for those houses. Maybe some folks want to live on Main and others on Elm. And instead of thousands of buyers like we have for IBM, we might have a dozen.
Two years ago, three houses came up for sale at almost the exact same time on my street. A small cape and two raised ranches. The cape listed and sold first for $349,000. A week later, the first ranch went up for sale. It was on a better lot and the house was much bigger. It listed at $369,000. By the time it sold months later, the price had fallen to $339,000. The second ranch was a foreclosure. It had cosmetic issues but was in good shape. The bank could not find a bidder at $220,000.
How did that small cape beat both of the other houses? Because the market isn’t efficient. Counting on a sales price just isn't possible.
So Why Do We Do It?
That’s the question, isn’t it. I’m not the only guy sitting around on the weekend watching some renovation program thinking, “I could totally do that and make that money.”
It’s the same reason people are lured in by invest-in-gold infomercials. It just seems like it will be easy money. Worse, you believe you are definitely smarter than that guy on TV. If he’s making $25,000, you could make $50,000!
We get into trouble when this cerebral exercise gets legs under it and we find ourselves at our local bank borrowing $350,000 to buy a property we probably shouldn’t own in the first place.
Is investing in real estate bad? No. But it takes much more work than we realize and involves risks that we rarely consider in our excitement. As long as we go into a transaction with our eyes open, we are on our way to good financial decisions.
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This blog is the opinion of Successful Money Strategies, Inc. and is provided for informational purposes only and is not intended to provide any investment advice or service. Statistics and other figures are accurate at the time of original publishing. Any advice herein should not be acted upon without obtaining specific advice from a licensed professional regarding the readers own situation or concerns. Always count your change.