Buying a distressed property, or one that is in need of repairs and fixing it up to sell it for a profit is widely known as “house flipping.” The premises are simple: buy low, sell high. It is a simple enough rule, yet when applied to residential real estate, it falls short to convey the risks involved. Let’s unravel a few of the mistakes that make house flipping a flop:
1. Overpaying for the property. Fixer uppers are in high demand. Their lower asking price is attractive not only to owner occupants, but also to investors, thus creating a competitive situation were the final sale price may not reflect the actual value. This may eliminate, or reduce any possible profit margin.
2. The cost of renovations is higher than projected. Even with experienced remodeling contractors, it is not uncommon to under-estimate the final cost of renovations. The expense of renovations will not only include the cost of new materials and installation labor, but also the cost of demolition and repairs of hidden problems and upgrading the electrical and plumbing to new codes. Upgrading to new codes is a good thing, but it does not bring a higher asking price to pay for them. Providing a contingency for cost overruns should keep the project on track.
3. The transaction costs are not calculated carefully enough. Most will figure the cost of sale, such as Realtor fees, closing fees by title companies for title insurance and escrow, loan origination fees and mortgage interest. Not all calculate the cost of holding the property, such as real estate taxes, utility bills and insurance.
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4. Misunderstanding of the local market. In hopes of extracting a higher profit at resale, some investors and homeowners will over-improve the properties. They tend to install high-end finishes and luxury features that are not typical for the neighborhood. Predictably, at the time of sale, the extra value of these features most of the times goes away as the appraised value of a house is determined by comparable homes sold in the neighborhood that are similar by size, age and condition and prices are averaged out, therefore limiting the return on those extra pricey items.
5. Depreciation surprise. When buying a house to flip, conventional math does not work. In other words, by using a logical formula (purchase price + cost of renovations + transactions costs + profit = sale price) many DIY investors went broke. Just like a new car that is driven of the sales lot suddenly loses value, same with the cost of improvements. While some upgrades preserve their value better at resale, but most do not bring dollar for dollar in value.
6. Mis-interpreting the market trends. Disregarding, or getting the market trend wrong is fatal for a short-term investor. For example, If the prices are climbing up, getting a return on investment is built-in because of the upward trend. In a downturn, however, getting what you put into it may be a challenge.
7. Lack of exit strategy. However successful the investor had been in the past, there is always risk involved. A downturn in the market, a life event, or just plain bad luck can put a serious dent in the plans. An exit strategy for the worst-case scenario will prepare the investor and safeguard the financial situation. It may call for using the property as a rental property, or offering seller financing to broaden the circle of potential buyers.
House flipping programs are very popular on many TV channels. Professional crews make it look easy and profitable. The reality is more nuanced. Though the potential for doing well, while house flipping is true, a careful approach, educated planning and help from pros like contractors, Realtors and accountants will improve your odds for positive results.
Alex Ceaicovschi is a Realtor with Elkhorn Mountain Realty in Helena and can be reached at firstname.lastname@example.org.