How to fill a house that you flip
You may want to rent out your property for a time instead of selling it right away. Let’s discuss why you would do this, how to find tenants, and when it’s time to sell.
“Filling” means renting out the property and filling it with tenants after you finish the rehabilitation, as opposed to selling it immediately. This is optional; you could simply just sell the property unoccupied and exit the investment. But there are several reasons, both property-specific and market driven, to fill a house with tenants and rent the property out before selling it.
Why to Fill vs. Sell: Increased Rental Demand
From a market perspective, there is more demand for renting now than there has been in several decades. In the wake of the two recessions in the 2000’s and the mortgage crisis in the late 2000’s, homeownership rates dropped more than 6% from their highs in 2004. Given that people still need a place to live, when families aren’t buying, they are renting.
That said, the rate of homeownership is starting to tick back up, as you can see from 2016 and onwards in Figure 1. That trend reversal can also be seen in Figure 2, which demonstrates the net growth in both ownership and rentership households from the peak of the mortgage crisis to now. As homeownership percentages dropped, families moved out of owned properties and into rented properties. In the last two years, that has changed, with more families choosing to buy than to rent.
While Figure 2 demonstrates a slowdown in the growth of rental demand, it’s important to note that homeownership is still at its lowest rate since 1995, thus rentership demand is still relatively high.
What’s causing the decrease in homeownership?
Let’s look at the reasons homeownership rates are down for context. Broadly, lower millennial homeownership rate is a key driver. Many millennials have entered an age typically associated with homebuying, but significantly fewer are doing it than previous generations. There are several factors to this. (following stats per Urban.gov)
Delayed marriage. Being married increases the probability of owning a home by a full 18 percentage points. If the marriage rate in 2015 had been the same as it was in 1990, the Millennial homeownership rate would be about five percentage points higher.
Greater racial diversity. The fastest growing segments of millennials are racial groups which tend to have lower homeownership rates. If the racial composition remained the same in 2015 as it was in 1990, the Millennial homeownership rate would be 2.6 percentage points higher.
Increased education debt. The Urban Institute’s data shows a 1% increase in student debt decreases the likelihood of owning a home by 0.15 percentage points.
Increased rents. Nationwide, rent just jumped to a new all-time high, surpassing an average $1,400 per month. And now, data shows that a 1% increase in a household’s rent-to-income ratio decreases the likelihood of homeownership by 0.07 percentage points.
Delayed childbearing. Not only are Millennials taking longer to get married, but they are also spending more time before having children. For those who are married, having a child increases the probability of owning a home by 6.2 percentage points.
Move to urban centers. Millennials want to live closer to the action, but it costs more to do so. Therefore, a preference to live in high-rent areas means they are saving less money, and therefore less likely to be able to afford to buy a home.
Why to Fill vs. Sell: Cash flow, appreciation, and tax treatment
Financially, there are several points to be made in favor of filling the property versus selling right after rehabilitation. Let’s go through them.
Taxes. When you hold a investment property for at least 366 days, the proceeds from its sale are treated as capital gains and not ordinary income. This represents savings of almost 50%, given the max tax rate for ordinary income is 39.6% while capital gains are taxed at 20%.
Upside. When you sell quickly, you lose out on the potential upside of the appreciation of your home. Real estate tends to appreciate when the market is healthy, so holding and selling later could make you more money. Obviously, the opposite is possible as well – in a market downturn your house could lose value, in which case you’d have to choose between selling for a loss or holding until it appreciates again. Do your research, only you can determine whether you’re bullish or bearish on the housing market in your area.
Income. When flipping a home, you’ll likely go many months with no income, followed by a big payout upon sale. This sort of irregular cash flow can be difficult for you and your family to plan around given the much more consistent nature of your own living expenses, bills, education costs, etc. If you rent the property out instead of selling, monthly rent from tenants provides an annuity which you can rely on for income.
Cash-out refinance. When you hold a property for long enough and refinance it, lenders will use the value of the home rather than the cost basis of the property. When this happens, you can get most of your money out and generate a very good return on equity, assuming your home appreciated after you rehabilitated it. Selling the property as a ‘turnkey rental’. There are lots of passive real estate investors who buy only to hold, and also would rather not have to manage the property on a day-to-day basis. If you sell the property as a ‘turnkey rental’, you will receive the proceeds from the sale of the property, and will pledge to manage the property and its tenants day-to-day. The investor will receive the monthly rent checks, and will pay you a monthly management fee. Generally speaking, you’ll likely be able to collect around a 3% fee for property acquisition, and then anywhere from 7 to 10% for ongoing management of turnkey rental properties.*
Show me the math
After rehabilitating a property, holding and renting it out can be substantially more profitable than selling it right away, provided you are willing to invest the time and the capital if market conditions tilt in your favor. To demonstrate, let’s walk through the numbers of a hypothetical flip. We showed our work, but the important numbers are the ones in bold:
Scenario 1: Flip immediately
Buy the home, rehabilitate it, and sell it. In this scenario, we will be buying a hypothetical $147,600 home in cash, rehabilitating it, and selling it at its new value. Here’s the math:
|Cost to flip||($9,000)|
|After Repair Value (Sale Price)||$180,000|
|Net at flip||$23,400|
|Ordinary income tax||($7,722)|
|Net after tax||$15,678|
|Profit % (15.7k / 148k)||11%|
In this case, you invested $147k of your money, increased the value of the home by about 23k, and after the cost of the project and taxes, you netted about $15k in profit, or 11%.
Scenario 2: Hold for 5 years
Buy the home, rehabilitate it. In this scenario, you still rehabilitate the home and increase its value by 23k. However, you do not sell it. Instead you first:
Cash-out Refinance. As mentioned above, a cash-out refinance will allow you to take advantage of the new cost of your property, and pull cash out of your home. Let’s say you finance 65% of the property. This results in having a $63k equity position in the home, despite having pulled out all but $31k:
|Loan to Value||65%|
Then, Rent it Out. Time to fill the property. In this case, we’ll assume you are able to rent it out for $1,800 a month, or 1% of the property value per month.
|Gross Monthly Rent||$1,800|
|Net monthly rent||$475|
Rent for 5 years. Here’s what the math looks like, assuming you have tenants for 5 years.
|5 year breakdown:|
|Net rent (monthly x 60 months)||$28,500|
|Ordinary income tax||($9,405)|
|Net rent after tax||$19,095|
Sell after 5 years. After 5 years of renting, it’s time to exit. We’ll assume 3% home appreciation per year.
|Proceeds from sale of property|
|Home price appreciation||3%|
|Price at sale||$202,592|
|Cost to sell||$10,130|
|Gain on sale||$44,862|
|Long term capital gains||($8,972)|
|Net at sale||$35,890|
Add it all up for total profits. Let’s sum the proceeds from renting with the proceeds from selling to determine net profit and profit margin:
|Net at sale||$35,890|
|Net rent after tax||$19,095|
|Total income, 5 years, after tax||$54,985|
|Initial investment (original home price)||$147,600|
|Profit margin (55k / 148k)||37%|
|Year-over-year margins (37% / 5 yrs)||7.4%|
In scenario 2, holding, renting for 5 years, then selling nets you $55k versus your initial investment of $147k, for margins of 37%. This is $40k more than what you make by flipping immediately.
That said, it did take 5 years. In scenario 1, you’re able to make 15k, or 11%, in one year. Scenario 2 nets you 37% over 5 years, or 7.4% per year.
You also have to tie up about $30k of capital for 5 years to make that extra margin, during which time you hypothetically could have flipped more houses with that money. These are all things to take into consideration.
Managing the property
If you decide to fill the property, the next thing to think about is whether you want to manage it yourself or hire a third party to oversee the day-to-day management of the property and its tenants. The biggest thing to consider is the fact that hiring a property manager is expensive. Thus, if you live close to the home, it’s probably best to manage yourself. We’ll go through an exercise showing how a manager affects your margins, but first let’s walk through some tips if you decide to manage yourself.
The first step is to find the tenant. Once the property is in move-in condition, you’ll want to list it on Craigslist, Oodle, Zillow, Hotpads, and Padmapper, just to name a few. You’ll get lots of inquiries this way. Another method is flyer the neighborhood. LendingHome flippers have found verbiage such as “Choose your neighbor” to be compelling – if a family from the neighborhood knows another family looking for a home, they can make a referral for you.
Once you list the home, be prepared to take calls and show the home. And once you find an interested and qualified renter, be prepared to write a leasing agreement. A lot of people worry about writing the contract, but it’s really not that stressful. Each jurisdiction has a boilerplate and a quick internet search will get you the language that is legally sound in your area. (Rocket Lawyer, for example, has a great tool for building your own agreement.) You’ll just have to plug and play property and borrower information and you should be good to go. (But this isn’t legal advice. You should seek legal counsel before committing to any major contract, especially if you lack confidence it is documented properly.)
There’s two important things you definitely won’t want to forget. First, collect a security deposit before the renter moves in. Don’t let a renter move in without one. (Tough to ask for it after they have…) And second, make sure to do an initial walk through and take lots of pictures. When a tenant moves out, the property will likely be in different shape than when they moved in. That’s natural – there’s wear and tear that comes with living in a home. However, you’ll need to have evidence that the wear and tear and other damages were caused by the renter, so make sure to extensively document the interior and exterior of the property before the tenant moves in. This will save you future headaches and provide you with leverage.
Using a property manager
If you don’t live close enough to the home to be able to quickly and regularly check-in, resolve issues, and meet with tenants, it’s much better to hire someone who can. Property management companies are businesses who handle tenant placement, maintenance, and day-to-day management and upkeep of your property in exchange for fees.
Property management companies come in all sizes, but for the highest level of service, we recommend a medium sized company (managing 15-400 properties) that are familiar with properties similar to yours. Do your due diligence – collect references, inquire about average days to placement, and average turnover cost. Responsiveness is critical, so try and get a sense of this as well. Do they pick up the phone? Are they responsive over email? Remember, these are people you are trusting to take care of your property. If a pipe or appliance springs a water leak, for example, a day or two is the difference between a minor repair and potentially thousands of dollars of damage.
Once you’ve found the management company that’s right for you, be prepared to pay. There are several fees that you’ll be asked to pay, the three most common being a tenant placement fee, a management fee, and a maintenance surcharge. Let’s take a look at how these affect the economics of your property investment.
Let’s take the same house from above, adding in the management fees:
Monthly breakdown (managed by 3rd party):
|Monthly breakdown (managed by 3rd party)|
|Gross Monthly Rent||$1,800*|
|Tenant placement fee||($50)|
|Property management fee||($144)|
|Net monthly rent, managed||$266|
|Net monthly rent, self-managed||$475|
This $209 difference represents about a 50% decrease in rent proceeds.
Here’s the 5 year breakdown (rent for 5 years, then sell):
|Self-managed||3rd party managed||% diff|
|Net rent, 5 years||$28,500||$15,690||-45%|
|Ordinary income tax||($9,405)||($5,267)||+33%|
|Net rent after tax||$19,095||$10,693||-44%|
|Home price appreciation||3%||3%||–|
|Price at sale||$202,592||$202,592||–|
|Cost to sell||($10,130)||($10,130)||–|
|Gain on sale||$44,862||$44,862||–|
|Long term capital gains||($8,972)||($8,972)||–|
|Net at sale||$35,890||$35,890||–|
|Total income, 5 years||$73,362||$60,822||-17%|
|Total income, 5 years, after tax||$54,985||$46,583||-15%|
Managing the property yourself would net around $55k, and hiring a manager would net about $47k. That represents a different of about $8.5k, or a 15% decrease in profit margin. Is this amount of money worth the peace of mind and the service you’ll get out of a good property manager? This is a key question to consider.
In our next blog post, we’ll take a closer look at the next F, “Flip” i.e. selling the home and exiting the investment. We hope you found the information helpful! We will be back soon with the next piece of our how to fix and flip a house series.
This article is offered for informational purposes only. The information and guidance offered is generic and may not apply to you or your specific project or property. Please seek out appropriate professional advice before making any investment decision.