Flipping to Fail: Why You Need to HOLD on to Your Properties
Fix and flip is absolutely huge right now. The cable TV home stations are flooded with rehabs, renovations, designs, flips, flops, flaps (I made that one up), but you get the idea. Celebrity rappers and has-been actors from the 90s are even getting involved. Charismatic hosts and hostesses lure people in and sell the “dream” of real estate investing. It’s not all bad necessarily; we think it’s great that people are seeing the benefits of real estate investing. They see the rising real estate market and want a piece of the action.
Okay…now, let’s get real. There is a difference between celebrity endorsed pep talks and real investing tips that show you how to make money in property investment. Although some TV shows are very informative, there is a huge push to “fix and flip” that needs to be evaluated in the current market. We are in a seller’s market and the distressed property you need for a successful flip is just not as cheap anymore. Contractors are in high demand, so they certainly won’t be cheap either! That deep discount you need is typically 70% ARV. ARV means After Repair Value and that is the target value of the property after you make your repairs. In order to get your maximum purchase price, you’ll need to subtract your repairs from the ARV. Here’s a quick example:
$100,000 market value * 70% = $70,000 ARV – $25,000 repairs = $45,000 purchase price
Deep dive into the 70% rule in this post: Wholesaling Real Estate — Is it for You?
The truth is, it’s hard to get that “70% ARV” these days. It’s not impossible to fix and flip, but you are just going against the grain and the odds are against you. You also need to realize that people don’t get rich off of fixing and flipping alone. Sure, you know of some examples, but they have most likely either held on to their rehab properties or rolled their cash into another long term investment. So, in a nutshell, fix and flip is not a bad strategy and people who do so are not bad investors. It is important to realize, however, that in order to really prosper, you need long term cash flow or else your flip earnings slip right through your fingers.
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Fix it Up and Rehab it–Go Ahead, but Hold On to It!
“So what do I do if I want to rehab properties? What are my options?” – Razzled Renovator
Avoid the commissions and capital gains tax and hold on to your “fix and flip!” Of course, you are no longer flipping it in this case. You may sell it after a number of years, or you might not ever sell it. Either way, now you are “in it for the long haul” with this property.
(Really, you can avoid capital gains tax? Check out our 1031 Exchange video for more.)
Are you ready for the killer tip in this article? The value you provide to your property is going to earn you money without you even having to sell it. This is something known as “creating equity.” You create equity when you buy a bargain property with outstanding issues and fix it up. Based on the upgrades and improvements you made, your property will appraise higher, and snap, you have created equity!
I pick up a distressed property for $50,000 with a lot of great potential. I take out a loan with a 20% down payment and purchase the property. I also spend $10,000 doing my rehab projects such as carpet, paint, cabinets, etc. I’ve increased the appeal quite a bit and now it’s been appraised at $75,000.
After the $10,000 investment, I can sell, get my rehab money back, and make $15,000 in profit. Great, I can just flip it now! Wait, so not fast. Realtor fees, carrying costs, etc. are going eat most (or all) of that up.
Here’s where the fix and hold comes in. With a Home-Equity Loan, or simply known as a second mortgage, you can borrow up to 80% of the property’s value.
Let’s do a quick comparison between the property you originally purchased and your improved property, after repairs.
Original Price: $50,000
Down Payment: 20%
Rehabbed (New Appraisal) Price: $75,000
Down Payment: 20%
As you can see in the example above, the value of your home went up $25,000, but since you can only borrow 80% of your value from the bank, you can get $20,000 out of the deal.
Equity Increase ($25,000) – 20% Req’d by Bank ($5,000) = $20,000 Avail to Borrow
The best part about the down payment is that you don’t actually “pay it.” The price increase of the house, due to your repairs, has taken care of that for you! You have an extra $20,000 you can borrow against the house via a Home-Equity Loan. Get your $10,000 rehab investment back in your pocket, pull $10,000 free and clear, and channel that profit into another $50,000 distressed property! The cycle continues…
A property deal like this sounds sweet enough as it is, but remember that this is just touches upon the “I” and the “E” of “IDEAL” Investing, which is comprised of Income, Depreciation, Equity, Appreciation, and Leverage. Holding this property instead of flipping it will let you take advantage of all 5 of these real estate benefits!