Author: Luke Babich is a real estate investor in St. Louis, MO with over 24 units who specializes in multifamily units. His first investment was a house hack with Clever Real Estate’s cofounder, Ben Mizes.
House flipping is definitely having a cultural moment. There are many television shows about the craft airing right now and, according to the latest data, 5.4% of all home sales in the third quarter of 2019 were house flips.
But popularity alone doesn’t make a superior investment strategy. House flipping may get all the glitz and glamour from the entertainment industry and media due to its usually immediate turnaround and quick pace; however, the buy-and-hold strategy can be very stable, profitable, and fitting for many investors’ business plans.
Which strategy is better for you depends on your investment goals, how much bandwidth you can devote to your investments, and your appetite for risk. Let’s look at the advantages and potential downsides of each investment approach.
House flipping: An overview
We all know how house flipping works; you find a house that needs a refresh, then you buy, renovate, and quickly sell for a profit. It’s a great way to contribute to a community, and make a significant return—experience and expertise can tip those odds steeply in your favor.
The pros of house flipping
There are many benefits of trying your hand at house flipping—discover them below:
Potential for fast profit
House flipping is popular for a very simple reason: it can be incredibly profitable. According to the latest data from the analysts at Attom Data Solutions, homes flipped in the third quarter of 2019 were purchased for a median price of $160,000, and sold for a median price of $224,900, for an average gross profit of $64,900. The median household income for the U.S. is $56,516, so if you flip one house a year, you’re doing pretty well pre tax. If you flip two or three, or half a dozen, you have the potential to really expand your wealth.
Of course, this comes with some caveats. That gross profit doesn’t take into account costs like carrying and renovation. Carrying costs like utilities, property taxes, and insurance can run up to a thousand dollars a month, and renovation costs can easily balloon if they’re not closely monitored. If it takes a year to rehab and resell, you could be looking at a net profit that’s half, or less, of your gross.
And as with all real estate, the market you’re in has a huge influence on your profitability. On the low end, house flippers in Raleigh, NC averaged a lukewarm profit of only $25,000, while flippers in Pittsburgh more than doubled their money, on average, with a stellar ROI of 132.6%.
The more houses you flip, the easier, and more profitable, it will be for you. Each time you flip a house, you’ll gain valuable knowledge about the local market. What kind of home design is most popular in your local market? What kinds of features and aesthetics are local buyers looking for? What areas are desirable, and why? You’ll also gain an on-the-ground perspective on home renovation. You’ll learn how to spot problems, how much labor and materials cost, on average, how long different aspects of a renovation take, and a lot more. Your first house flip is going to be a series of guesses; by the time you get to your tenth one, you’ll be able to tell at a glance how much it’ll cost, how long it’ll take, and how fast it’ll sell.
Expanding your network
If you’re in the house flipping game for the long run, you’ll need a reliable network of industry professionals. The right agents, inspectors, insurance brokers, attorneys, and contractors can make your house flips go much smoother; the wrong ones will waste your time and money. The longer you’re in the game, the more you’ll be able to expand your network of trustworthy professionals.
The cons of house flipping
House flipping is a legitimate business, but it can also be a gamble. Here are some of the potential downsides of fix-and-flip investing.
You might lose money
That average gross profit of $64,900 might sound like a lot of leeway, but if your recently acquired property needs a new roof, that could cost you $20,000 right off the bat. There are, of course like any investment, certain risks. To avoid them, educating yourself about the real estate investing industry, understanding the costs, the process, and what to best renovate to get the best ROI is important so you can always stay a step ahead.
The tax situation
When it comes to taxes, house flippers can feel like they’re being pulled in two opposite directions at once. That is due to the difference in how normal income and capital gains are taxed.
If you purchase a home and resell it within a year, your profits will be taxed as normal income, which is usually going to be at a rate of between 22% and 37%. If you hold the home for longer than a year before reselling it, those profits will be taxed as capital gains, which is going to be 15% or 20%.
Clearly, it’s much more advantageous, from a tax perspective, to hold your homes for more than a year. However, a house flipper wants to resell as fast as possible, not only because more turnover equals more profit, or because carrying a home is expensive, but also because carrying a home is risky.
If the market crashes before you can resell, you could suddenly find yourself under not ideal financial obligations. Under certain local market scenarios, you might need to consider a buy-and-hold strategy out of necessity.
Forget buying and renovating; just selling a home is expensive. There are closing costs in addition to the typical 6% real estate agent commission that sellers pay (although there are more affordable solutions), and in a business of shrinking margins, those costs can make the difference between a successful investment and a loss.
The upside? If you use the same real estate agent for all your transactions, they’ll likely be willing to negotiate down the commission, since they’ll make it up in volume.
Buy-and-hold: An overview
The buy-and-hold is the opposite of a house flip; instead of reselling as fast as possible for a one-time profit, the buy-and-hold investor purchases a property and then rents it out long-term. The short-term profits are lower, but it’s a much safer, and less stressful form of investment. Let’s go over the pros and cons.
As you might imagine, most of the pros of the buy-and-hold strategy are related to stability.
Predictable passive income
When you rent a property, you have rent checks coming in every month like clockwork. That predictability works on the front end, too; once you learn how to calculate rental cash flow, you can accurately project potential rents on any investment property. That takes most of the guesswork out of the equation, so you’ll know what your cash flow is going to be as you go into the investment.
A rental investment property comes with an impressive amount of tax deductions. Not only can you deduct all your associated expenses, you can also deduct mortgage interest, insurance premiums, property taxes, legal fees, depreciation, and property management fees. As long as you keep meticulous records, you and your accountant will be very happy at tax time.
And let’s not forget that, since you’re holding onto your property for longer than a year, your eventual sale will be taxed at the lower capital gains rate, and not as normal income.
House flippers force appreciation by putting money into it in the form of renovations and improvements. But when you buy-and-hold, appreciation happens naturally over the long term. So all the time that you’re collecting rent, the market will be rising inexorably higher, increasing the value of your property. That means that, aside from your passive income, you’ll also be getting passive appreciation. Who says you can’t get something for nothing?
Of course, the buy-and-hold strategy is dependent on finding and retaining the right tenants, and any property manager will tell you that that’s not easy to do. So most of the strategy’s downsides are related to this issue.
Sometimes tenants don’t pay their rent, whether it’s through negligence or circumstance. And if you have to evict, that takes time and money. A good percentage of this can be avoided by carefully screening tenants, and only renting to prime candidates. For those unforeseeable instances, you should always carry rent default insurance.
Like rent defaults, vacancies are a normal part of the buy-and-hold rental strategy. But also like rent defaults, they can be vastly reduced by careful planning upfront. For your buy-and-hold investments, only purchase properties in high-demand areas, so you won’t have to chase tenants. And for that unavoidable turnover, a good leasing agent can make filling vacancies much easier.
Tenants sometimes mistreat the properties they’re renting. The best way to guard against this is to carefully screen tenants, and collect adequate security deposits. You can also make your rental property more resilient by using durable finishes; for example, tile flooring can take much more abuse than softwood flooring.
Is it truly passive income?
There’s some debate over whether rental investing can truly be called “passive” income. You’ll need to find tenants, keep them happy, fix broken toilets, work with contractors, and manage the property.
There’s definitely the opportunity to automate and delegate a lot of this work, but buy and hold is more than a purely passive investment strategy.
So which is the superior investment strategy— buy-and-hold, or house flipping? That depends on your present needs, but the reality is that they’re two sides of the same coin.
If you decide to go with house flipping, and the market takes a downturn before you can resell, you can easily transition to a buy-and-hold. And if you start out as a buy-and-hold investor, only to realize that you don’t have the time and temperament to be a landlord, you can flip the property and still realize a profit. Many investors even split their portfolio among the two strategies, with fix-and-flips bringing in short-term profits, while buy-and-holds provide long-term value.
No matter what strategy you decide works best for your business plan, LendingHome can support you, providing competitive rates, a helpful team, and an online, simple process. And with our bridge loan and rental loan products, we have everything you need in a financing partner to help you seamlessly move through the journey, alongside whichever strategy you think works best for you.
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