Why you don’t want to flip homes

April 16

 


It’s getting harder and harder to flip houses. (Justin Pierce)

Justin Pierce is a real estate investor who regularly writes about his experiences buying, renovating and selling houses in the Washington area.

Nearly every day I see another article trumpeting the profits being made by home flippers. I hear one guru after another on the radio or TV repeating the same stats and offering to share his or her home flipping system, for a small fee.

It all looks good. It sure does look easy and with everyone making money it seems like a sure bet. Let me be the one dissenting voice. If you’re looking to flip homes in the D.C. area, then I have to tell you that you’ve probably already missed the window.

In 2009, nobody wanted to touch real rehabbing and resale. Back then, you could go to the multiple listing service (MLS), pick your area and pull up dozens of homes that could be purchased at a price that would fit the home-flipping model.

I remember in October 2008 the average home price in Woodbridge dropped nearly 15 percent in just one month. I saw that and thought: opportunity. The average home price was less than two times the average household income for the area. Affordability was never better and the population was growing.

I started trying to raise capital and found that nobody wanted anything to do with real estate and certainly not flipping. It’s a war zone, I was told. Everyone wanted to hunker down at the time when the numbers looked the absolute best.

Now the newspapers and real estate gurus are saying this is the time to flip homes. Well, let’s take a look at the numbers today.

I just pulled Fairfax Zip code 22030. In 2009, the average home price was around $375,000 and the median household income was around $100,000. So that means that the average home price was about 3.75 times the average household income for the area.

In February 2014, the average home price in the 22030 Zip code was $531,300, according to Real Estate Business Intelligence, a subsidiary of Rockville-based multiple listing service MRIS. The average income is not much more than it was in 2009. The Census Bureau has the median household income at about $102,000, granted the latest data released was from 2012. Even if we call the average income $110,000 that still puts the price to income ratio at multiple of 4.8.

Once again home affordability is going in the wrong direction fast. RealtyTrac found that the average cost of owning a home is up 21 percent from a year ago. And, as you can see from my Fairfax 22030 example, the home price is up more than 41 percent and the median household income has barely moved in that Zip code.

Interest rates are another factor. I think everyone agrees that interest rates are artificially low. They cannot stay this low forever. The Federal Reserve has announced that it will start tapering off its bond buying. The economy is improving slowly but surely. These and other factors will start to put pressure on interest rates, and when they start going up they can go up fast.

So let’s say the average gross household income for Fairfax 22030 is about $9,000 per month. Most lenders say you can spend about 28 percent of your gross income on your mortgage so that’s about $2,500 per month. At 4 percent interest on a 30-year mortgage, $2,500 per month will buy you about $523,600 worth of house with nothing down and not including taxes and insurance. Now if interest rates go up to 5 percent then you’d only be able to afford $465,700 worth of home. That just killed $57,900 of buying power. That would be an 11 percent drop in buying power.

I normally build in about a 15 percent profit margin for my deals. A move like this could wipe out all profitability. Even worse, as competition increases real estate investors are paying more and more for their projects. They’re cutting their margins to the bone and getting very optimistic on the renovation budgets. It feels a little like the perfect storm could be brewing.

The gurus and good news are bringing the home flippers and other home buyers out of the woodwork. There are bidding wars for tear down homes in bad neighborhoods now. This is squeezing margins and people are taking big risks again.

I am not saying that D.C.-area home prices are going to drop 11 percent. I’m not saying anything except that despite the headlines there are some very ominous signs out there for the real estate flipper. I’m just saying be careful.

What is more likely to happen is that interest rates will rise and the market will level off and possibly even stagnate for a while. Real estate is not all mathematics. If people can’t get what they want for their home they will just stay put. You, as a real estate flipper, cannot. That flip home is like a huge weight around your neck. You have to get rid of it as soon as possible. In a rising interest rates scenario like this you’d have to make your home the absolute cheapest in the neighborhood to get it moved. The market may not drop 11 percent but you may have to.

I’m not talking doom and gloom. I’m still flipping homes. As of right now, I’m still able to get homes that work with my business model but I am spending a lot of time and money to find those leads. You can’t go to the MLS and pick your project anymore.

I’m not a psychic. I don’t know the future and I am not trying to convince you of anything. I stopped buying homes in 2004 and I looked like a fool for two years. This little run could go on for a while but if you are not buying very smart and very cheap then I think you’re setting yourself up to get a pretty bad burn.

And, please, let me give you one little warning. Beware of the real estate guru. Some are good and they have some very good techniques to teach. However, it seems to me that there are a few out there who are active home flippers who’ve built a little following of students. They like to get homes under contract. If the home is a really good deal then the guru will take it himself. If the deal is too tight they’ll turn it over to one of their students (for a small finder’s fee). So the guru makes a quick buck and the student is stuck with a very tight deal to try to turn.

I’m still flipping homes and I’ll continue to do so but it is tougher than ever. Just know that while you’re looking to jump in I’m looking for the next thing to rotate into — the same way I did in 2004 and 2008.

Read Pierce’s previous posts:

Remodelers — not consumers — have the upper hand as their workload picks up

At long last, investor’s pop-top house sells

Setback may push Temple Hills renovation beyond Oct. 1 deadline

Crews make up for lost time in pop-top project

With plan approved, race is on to reconstruct house for fall sale

Pop-top renovation becomes pop-back plan

Gone are the low lying fruit of real estate investing

 

 

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