On Wednesday, I pointed out that “if I don’t have direct experience in the specific area of a question, I will say so”.
This was the case with my response to Joshua (coincidentally, another 7 Millionaires … In Training! Final 30 applicant) who used a recent post to ask me a question about ‘flipping’, which I have never done …
… at least not for real-estate (there’s a strong case to be made that a year or two ago I ‘flipped’ a business for a rather large profit … but, that’s another story).
[AJC: Josh, I didn’t mention it then, but I would consider Dave Lindahl an expert in this area – I haven’t met the guy, but I have studied a lot of his material and consider it good-to-great, as is John T Reed’s stuff on real-estate in general … not sure what John has to say specifically about flipping: you should check]
But, Josh, I do have some advice for you:
Treat flipping as a business …
… it’s probably closer to real-estate development, than it is to real-estate (long-term buy-and-hold) investing.
The downfall of many a flipper (or developer) is when the market suddenly turns and you are holding inventory that you can’t afford to cover the holding costs on.
Since we are closer to the bottom of the current cycle than to the the top, this will become less and less of a fear as the market eventually (and, inevitably) starts to rise again … it’s the next ‘correction’ that will catch you out!
Here’s what happens:
You buy your first property – it might be a house that you intend to live in for a while – you fix it up … and, you sell it at a profit. Maybe you pick up $10k – $50k in the process … maybe more.
So, you do it again … then you buy two.
Pretty soon, you are earning a nice little side income buying/rehabbing/flipping houses all over the place … you don’t even bother to rent them out – you are purely looking at this equation:
Profit = Selling price – (Buying price + materials used + interest + closing costs + reselling commissions)
The problem with this formula is that you now have a second job!
Your time isn’t factored into this, since you are doing the work yourself … but, your ‘salary’ is actually included in what you call profit. In a great market, you are earning a great salary … in an ‘average’ market, you are probably not really earning all that much.
Here’s what to do:
Treat the rehab. business as exactly that … a business. Go and get a contractor’s estimate or two and add that cost into the formula (don’t forget to inflate the estimate by 20% to cover contingencies) to get:
Estimated Profit = Estimated Selling Price – (estimated Buying price + contractor estimate + interest + closing costs + reselling commissions)
Now, if the ‘profit’ that you estimate makes the project worth while, then you just may have a nice little ‘business deal’ going on here …
… and, it’s then up to you if you decide to hire yourself as the contractor!
But, there is a problem that I see with this ‘business’ … and, it’s a problem that arises out of too much success!
Yes, success makes you more aggressive … makes you do more and bigger deals in order to grow your little business into a bigger and bigger business (buying more/bigger properties to rehab).
That’s when you need to do a couple of things:
1. Move into multi-family properties,
2. Outsource the work,
3. Have a buy-and-hold contingency
The first two are obvious: these are the steps that will pave the way to unlimited growth in your (now, real) business … ALL businesses need to remove obstacles to growth, because a stagnating business is an (eventually) dying business.
The third one will (hopefully) protect you against the inevitable selling problems and market ‘corrections’ that will come up from time to time.
Which brings us to the subject of developers (those developing ‘on spec.’ to then sell ‘in pieces’ to investors and owner-occupiers):
Developers have all of the same issues as flippers, only on a larger scale … many flippers, in fact, end up growing to become developers themselves.
As developers become successful they tend to make two major mistakes:
1. They move into bigger and bigger developments … max’ing out their financial capabilites in one or two large ever growing deals. One market correction can sink them.
2. They start bringing teams of ‘helpers’ in house (architects, designers, builders, etc.) and they have to ‘feed the team’ with a constant stream of projects … it’s very hard to wind back if the market starts to tighten up a little.
So, while I can’t tell you much about the business of flipping or developing, I can tell you that like all businesses you have to be able to handle:
a) Growth, and
…. both very hard to do in a business that requires taking huge financial risk for each project.
Here’s what the smartest flippers and developers do: they start off buying to churn …
… this churn (i.e. quick reselling) generates chunks of cash; instead of investing all of this chunk of cash in their next (bigger) project, they divert some to buy-and-hold real-estate.
For example, they might rehab. and reposition an apartment building as condo’s …
… they might then sell most condo’s, but try and keep a couple for themselves as rentals. Do this a few times, and you just might have something left over when the next crash wipes your ‘business’ out (assuming that you have set up your business in the right legal entities so that your ‘hold’ portfolio can’t be touched).
All in all, what can I say?
Some people make huge fortunes (and others lose theirs) in exactly these types of businesses, so who am I to say that this is something that you should/shouldn’t do to start making your own fortune?
Nice easy-to-read description of the basic pitfalls to avoid. I know my ex-fil, an ENT & surgeon, made his money in real estate and even lost $1M one year and recovered. Not sure how they are faring now as I think most is out of real estate and ranching/orchards and more into stocks, but they didn’t confide in me before, so I could be wrong about that even. Worst advice I ever followed was his. WHen I asked about Microsoft (then selling about $42 and not yet discovered), he advised GM and Ford and DRIPs, nice conservative things. But I was 30 and he was 60-ish, so the opposite applied. Yet, when he and his brother bought MS and Intel (another I’d asked his opinion about), he didn’t bother to tell me. I am glad to read this no-nonsense and business-like analysis of what can happen when one tries to deal with growth and other contingencies many may be prone to treat as “when/if I get there.” Every plan should have an exit strategy.
@ Diane – Good advice in your last line! Thanks.
I guess thats why I like the idea of flipping. It’s a constant enter and exit, so if you can turn a house over in a matter of months, the risk of a downward market correction is diverted.
@ Josh – Provided that you have a backup/exit plan IF timing catches you short … one of my employees did a flip JUST as the market turned; cost him $40k++ His mistake: he didn’t check that the association rules in the subdivision precluded renting.
This market correcting is “forcing” real estate investors to think of buying and flipping more like a true business instead of a get rich quick opportunity.
@ Nedege – even builders who used to buy a block, tear down the old and put up a new ‘spec. home’ (then look for a buyer) are forced to simply bid on contracts … or, buy a block and wait for a buyer before they even start to build (this still carries holding cost, so is risky in the current market).