Jorge Vazquez, broker & co-founder of Graystone Investment Group, has participated in more than 3,000 transactions for the past 20 years.
Many investors and entrepreneurs have misperceptions when it comes to flipping houses. Here is a story to illustrate: Gary was a new investor who worked as a business analyst and had recently received a six-figure inheritance. He was thinking of ways to grow his retirement portfolio and zoned in on flips. He had read some articles about flips and seen several flipping shows on TV. During our meeting, he told me, “All I want to do is flip houses. I don’t want any rentals. I don’t want any other options. I just want flips.” I appreciated his clarity of purpose. In my experience, most investors don’t really know what they want. Here was a guy who knew exactly what he wanted.
Gary had come prepared for the meeting. He had researched various properties in his neighborhood that were on the market and advertised as fixer-uppers. He had gone through every photo of every home. He had even made notes on the estimated costs of rehabbing each property. He showed me one of the listings and started to describe what he felt needed to be done.
I noticed a pattern in his statements, and it revealed a fallacy that many people have: He assumed that the profit in flips comes from the rehab. By adding better finishes, he thought the house would command a higher value. There is a grain of truth in that impression, but it’s a case of confusing correlation for causation.
Here’s the truth: Profits in a flip typically come from a discount on the purchase price of the property. That’s what creates the opportunity to make money from the deal. Doing the rehab allows you to realize the opportunity. However, if you didn’t get a discount at the time of the purchase, doing the rehab is not likely to create any value. Instead, you could lose money.
Rehabs alone don’t create value.
When it comes to rehabs, I’ve found there are very few items that add more value than they cost to put in. The market discounts the price of the rehab. In my experience, for almost all items, whether it’s a new roof, granite countertops or flooring, the increase to the value of the home will be less than the money spent on the rehab. For example, if you buy new appliances for $3,000, the added value might only be $2,000. If you add new floors for $7,000, the added value might only be $5,000. These values change based on comparable sales in each neighborhood, and therefore it’s hard to put a nationwide number on the amount you may lose by doing the rehab.
Discounts create profits. Rehabs cost money. In almost every case, the reason profits are made is because the property is purchased at a discount that is steeper than the cost needed to fix it up. If you didn’t get a discount at the time of the purchase, it will be much harder to make money on the flip.
How Builders Make Money
Even though Gary understood the concept once I explained it, he still had some doubts. He asked me how builders made any money if new construction was not profitable. The answer is that they buy the lots at steep discounts and in some cases, they sit on the land for long periods of time and allow it to appreciate. The other way builders create value is through economies of scale: They buy land by the acre and sell it by the lot. It’s the same way a bar makes money: They buy whiskey by the barrel and sell it by the shot.
The Why: Psychological Vs. Financial Payoffs
Why does this happen? Why does the rehab lose money, i.e., why does it add less value than it costs? I think the answer comes down to the concept of financial vs. psychological payoffs. In most transactions, one side gets a financial payoff whereas the other side gets a psychological payoff. For example, when you go to a fine dining restaurant, you get the psychological payoff of enjoying a good meal whereas the restaurant gets the financial payoff of charging you a small fortune.
In housing, most homeowners update their own homes because they want to experience the joy of having better finishes in the home. They are not always thinking about making money with rehab. Since many people want the psychological payoff that comes from the rehab, and it constitutes the bulk of renovations, the market prices it accordingly. It’s like the salary we give to schoolteachers or caregivers. They are often underpaid and overworked. Why don’t they just quit their jobs to pursue more lucrative careers? The answer is that, for many of them, they get the joy (psychological payoff) of helping others. It’s what keeps them going and allows the market to discount their salaries. Teachers and caregivers get a psychological payoff, and hence they sacrifice a financial payoff.
Flipping shows don’t display the entire situation.
At that moment, Gary asked me why flipping shows on TV focus entirely on the rehab. I replied that the answer is for its entertainment value. It is entertaining to watch a guy run through drywall and knock over cabinets with a sledgehammer.
Armed with a better understanding of the economics behind flipping houses, entrepreneurs and investors can better approach these opportunities. Gary purchased a flip at a substantial discount and finished the rehab. He was careful and didn’t over-rehab the property. When he listed it, he had a multiple offer situation and sold it for a handsome profit. He is on his way to being a successful flipper with a bright future.
The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.