What Can Go Wrong Flipping Houses
The pitfalls of flipping houses no one talks about and how to avoid them.
“Want to make a huge chunk of money? Here’s how I made a boatload flipping houses.”
This is the hogwash I hear peddled by many salespeople on the internet and on the streets who are more into hawking the idea of flipping houses than actually providing insight into the reality of what it takes to do successfully.
They are flippant about the pitfalls of flipping.
The word “flip” makes what is a major process involving sweat, money, and time appear quick and painless. Yet, people buy into the notion that you can easily make $30k, $50k, or even $100k. The very idea causes hearts to beat faster and blood pressures to elevate. And, the fact that house prices have risen dramatically over the past eight years makes marketing this idea even easier to the uninformed.
Here’s the truth: Flipping houses is a lot of effin’ work.
In fact, most people who jump into it don’t realize the diverse range of skills it takes and the mountain of work it requires. Even worse, they can lose money doing it. There’s a lot that can go wrong if you don’t do your homework.
Now I don’t mean to say don’t do it. You can make money flipping houses. Yet, one has to be woke to the truth of how flipping works. Knowing the truth will save you money and increase the chance of your success. Therefore, I’d like to go over some of the pitfalls of flipping houses so you don’t fall headfirst into a tiger pit.
Flipping has been on the rise in the metro Detroit area, creating a feeling that flipping houses is always profitable
The rise in home prices has been so steep that, according to CoreLogic, Detroit flips returned 96 percent to investors at the end of 2018, the highest of any metro area. Sounds pretty great right?
Not quite
We have to consider that there’s a lot of competition out there for the little guy trying to make money flipping houses. Almost half (48.8 percent) of housing flips in 2018 were sold to all-cash buyers. These all-cash buyers are often big, institutional investors with huge amounts of money, talent, and experience. This year, the Wall Street Journal reported in June that the share of homes in the United States purchased by institutional investors had reached an all-time high.
While this investment does have the positive effect of pushing up house prices, we need to realize that there’s a lot of competition right now in the flip market. If you’re out there looking for flips, so are a lot of other people. You won’t have the luxury of time once you’ve identified a good property. You have to be quick when you see a deal (and you’d better be right).
Furthermore, while house prices have risen over the past eight years, data now suggests that house prices in metro Detroit are cooling. Attom Data Solutions reported in its end of year housing report that return on investment on flips in the United States sunk to a four-year low last year. So despite some of the good news stories about flips in metro Detroit, you may not make as much money as in years past.
Now that we’ve looked at the larger forces at work. We need to look at why people are messing up their flip project
First off, if you’re getting into flipping houses, hopefully you’ve got some “mad skillz” to start with. Flipping houses takes a variety of unique skillsets. A flipper has to be at least somewhat familiar with a number of subjects including construction, finance, real estate, and managing teams of people. Many who get into flipping have at least some of these skills beforehand. And, few of them do it alone. To do flipping well, you’ll need a network of contractors, suppliers, inspectors, and a good real estate agent. Start doing your research early for building a great team.
With flipping, it’s possible to mess up right out of the gate. A common saying is that you make your money at the purchase of your home, not the sale. You have to get the first step right, buying the right home at the right price. A lot of people buy a house without doing their research and end up paying way too much.
So, before buying, you’ll need to do what’s called the comps or comparables on the property you’re looking to flip. In real estate, when someone says to, “look at the comps,” they mean to compare the property you’re looking at to other properties in the area. This analysis includes factors such as: how much the property is expected to appreciate; where it’s located; and how it compares to other properties next to it in terms of its condition, size, and age. Positive location factors include whether or not the property is in a good school district or has a public park nearby. Negative location factors include whether or not it’s situated in a flood plain or is on the wrong side of the railroad tracks.
If you don’t do the comps correctly, you increase the risk that you’ll lose money. You’re basically “flying blind,” which is not what you want to do with so much money on the table. However, sometimes it’s hard to do the comps even if you try. Occasionally, there’s limited data available on houses for your area, even when you try to do the comps. If this is the case, you need to at least get an appraisal to give you some idea what the flip you’re considering is worth. Without doing a comp or getting an appraisal, you might as well head over to Motor City Casino and put it all on red. If you don’t know what a property is currently worth, you’re not going to be able to complete the remaining steps needed to determine if it’s a good flip.
Once you have your comps, you need to figure out what your house will likely sell for. What your project will sell for is known it’s after repair value or ARV. This is the value of flip only after it is fixed up to the same condition that other houses are going for in the area.
Be realistic, even pessimistic, in determining both your ARV and how much repair costs will be to bring it to this value. People often fail with flips because they are too optimistic with what they think the house will be worth after it’s all fixed up. They are also as equally guilty in underestimating how much money it will take to rehabilitate the property to bring it to its ARV.
Knowing how much it will take to fix up a property is an art and a science.
Estimating repair costs is a skill that largely comes from watching construction costs in your area. There are many factors that one has to take into consideration when determining what it will actually take to fix up a property. How much it will cost depends on whether the work you are doing is merely cosmetic (paint, carpet, a torn window screen, etc.) or if the repairs are more complex. You may need to make floor plan changes by tearing down a wall, raising the ceilings, or redoing the kitchen.
Without doing a comp or getting an appraisal, you might as well head over to Motor City Casino and put it all on red.
With major repairs, costs can rise as you start to tear down those walls, exposing gory details you missed in the initial inspection such as poor electrical wiring or plumbing that isn’t up to code. Perhaps you missed in your inspection before the sale problems with the foundation or that the roof is leaking. Due diligence on your part when estimating repairs is essential to ensuring your flip is profitable.
Due to the uncertain nature of repairs, especially where major repairs are concerned, I recommend that people factor a large margin of safety, or the margin between your total expenses and how much profit you hope to get out of your flip. A large margin of safety helps unexpected repair costs when taking away from your profit upon sale.
Once you’ve decided on the property you’re going to purchase for you’ll flip, you’ll need to get a real estate agent, a pre-approval, an appraisal, and pay all closing costs and commissions.
You’ll also want to make sure you factor in your carrying costs (also known as holding costs) into your expenses. Your carrying costs are the costs you pay during the time between when you acquire the property and when you actually sell it. This includes, above all, your mortgage payment which is made more or less expensive depending on what interest the bank charges you for using their money in your flip. Keep this in mind: The longer you take to buy, fix-up, and sell your flip, the more interest payments you’ll be making. While your carrying costs are not likely to scuttle the deal, you should factor them in when you consider how long it take to flip the property.
Once you’ve acquired a flip property
After you close on the house, now the real labor begins. For any major repairs, you’ll need to get an architect to draw up some blueprints outlining what work needs to be done and the specifications to which it will be completed. The blueprint will act as the guide to the contractors making the repairs. A blueprint helps the contractors build right the first time, helps keep down your repair costs and prevents headaches down the road.
Once you have blueprints, you’ll need to get contractors to make the repairs if you’re not going to do them yourself. If you’re working with contractors, I always recommend that people look for recommendations from certified contractors that do good work and then get multiple estimates for your repair project.
Recently, I was interviewing several different contractors for the repair of a ceiling that had sustained water damage from a ruptured water pipe, I found their estimates to be high, low, and all over the place. Ultimately, who you pick will be up to you. While you don’t want to get fleeced by picking the highest bid, you sure don’t want to work with someone who is gives you the lowest price only to do a poor job either.
Once you have a contractor doing the work, you’ll still need to give the project your attention. While you don’t need to be breathing down the contractor’s neck, you will want to check on the daily progress. To do so, I recommend that you either inspect the work yourself after each work day or as often possible. You’ll want to provide your contractor with a phone number or email address when problems arise—and they will arise! One way you can ensure quality work is being done is by having the project periodically inspected by a third party inspector.
Repair what matters, spare the frills that buyers won’t pay for
Buyers can mess up a flip by making repairs that are unnecessarily expensive. It’s important that you don’t spend money on things that fail to increase the price you plan to receive for the house. For example, while we can all say that a kitchen needs some good-looking, functional cabinets for $5k it does not need excessively expensive $15k custom-built cabinets. While a future buyer might comment on the cabinets during a showing, this buyer will likely not be persuaded to pay more for house simply because you installed fancy cabinets.
Alternatively, you can do repairs that raise the value of your flip without raising your costs by knowing what your buyer wants. Raising the height of the showerhead and increasing the size of the shower in a bathroom re-do may delight the buyer without increasing your overall costs. If you have an older house with several bathtubs, replacing one with a large shower can increase the energy efficiency of the house while boosting the appeal.
When redoing a bedroom layout, choosing to make the closet bigger at the expense of making the bedroom smaller seems to payout as it gives the appearance of a decluttered bedroom while providing space to store all your crap. This is type of cost and benefit analysis is what you need to think of when determining how to repair your flip.
Lastly for repairs, make sure you don’t “over-renovate,” meaning make sure not to do anything major that the property doesn’t need. Similar to the cabinet situation in the preceding paragraph, make sure you don’t add that extra bedroom if it’s not going to increase the home’s value. For example, don’t do something crazy like build a pole barn (unless you’re farm-flipping?!). To emphasize how important it is to not over-renovate, I tell flippers:
Don’t clown around, match the town
Making sure your flip is in line with fully renovated houses in the neighborhood is a good gage. If your house has three bedrooms and two full bathrooms and all the other houses have that—you’re good to go! If you turn your house into a McMansion in a neighborhood of simple, single-family homes, you’re the odd man out and you’ll never get that money back.
Once you’ve got the contractors making the repairs you need in a way that adds value, you’re in a much better position to make your flip profitable.
