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Jon Kutsmeda

The Fix and Flip Danger Zone

The Fix and Flip Danger Zone …

TWO TYPES OF REAL ESTATE INVESTORS

There are two primary types of real estate investors, the “Buy-and-Hold” investor and the “Fix-and-Flip” investor.

It’s important to understand that buying a primary residence, a property that you live in as your “home”, with expectations that the property will be worth more in the future, is NOT buy-and-hold investing.

This type of property acquisition is speculating on unforced capital appreciation, and shouldn’t be classified as a real estate investing at all, since in this case the property is a liability, not an asset.

A true buy-and-hold investment should pay you today in the form of cash-flow. Rental income from tenants not only pay your holding costs, including the mortgage, but it also pays you a net-profit.

In the case of cash-flow property any unforced appreciation can be realized as capital gains, unlike with a primary residence where the pace at which a home appreciates (mostly due to inflation) rarely out-paces the cost of interest and property maintenance.

I always say, “You are either renting the home (tenant) or renting the money (mortgagor), but owning a primary residence is not real estate investing, it’s consumption.”

I’ll discuss the Buy-and-Hold approach and why owning a home is NOT investing in a separate article, but the point of this post is to send a warning to the Fix-and-Flip investor.

RECENT FIX AND FLIP DATA

ATTOM Data Solutions, a leading provider of property data, recently released its 2018 year-end data.

The total dollar volume of financed home flip purchases was $19.9 billion for homes flipped in 2018, up 8 percent from $18.5 billion in 2017 to the highest level since 2007 — an 11-year high.

Of the homes flipped in 2018, 13.8 percent were sold to FHA borrowers which is a good representation of first-time homebuyers. This figure is down from 17 percent in 2017 to an 11-year low.

So … we have the most active flip market since the financial crisis, and at the same time the pool of buyers is drying up, especially the first-time homebuyer who is the typical buyer of a fix-and-flip.

Profits are also down.

The average gross flipping profit of home flips in Q4 2018 was $62,000, which represented an average 41.9 percent return on investment (percentage of original purchase price), down from 42.9 percent last quarter and down from 49.6 percent in Q4 2017, to a seven-year low.

One of the factors for the falling profits, in addition to flood of flippers entering the business, is the time it takes to buy, fix, and flip a property.

Homes flipped in 2018 took an average of 180 days to complete the flip, down from 181 days in 2017 but up from 159 average days to flip 10-years ago.

ADDITIONAL FACTORS TO WATCH

Some of the other factors that are contributing to a reduction in profits include longer hold times as there are less buyers, and with the higher mortgage rates of the last two years buyers have been either priced out of the market or hesitant to jump in.

This doesn’t even take into account that the U.S. has initiated various trade wars which has increased the cost of materials, while at the same time experienced labor is in much greater demand with all the newcomers to the business, and so the price you’ll pay a contractor has also increased.

In a recent CNBC interview, HGTV’s Tarek El Moussa discusses some of these recent developments.

SOUNDING THE ALARM

Regardless of where you look the writing is on the wall. These are all classic late-cycle developments.

The 10+ year economic recovery (credit expansion) will inevitably turn into a contraction (recession), which is something I’ve discussed in previous market updates, including a recent blog post and an extensive video series I released on the topic.

When that shift happens, both newbie flippers and experienced investors need to be prepared.

Profit margins will be squeezed and the holding time before selling a flip could easily double, putting additional downward pressure on net-profits.

The summer buying season is upon and things haven’t exactly been hot out of the gates, with existing home sales tumbling year-over-year for the 14th month; another trend we haven’t seen since the financial crisis.

Should these trends continue and spook would-be summer buyers, things could get ugly quick.

So I’m sounding the alarm – we have entered the “Fix and Flip Danger Zone”.

RISK-OFF

Now is the time to be taking some risk off the table.

If you are a first-time flipper, then check your numbers again and make sure you have enough liquidity (cash on the side) to weather a storm you probably have considered already.

For seasoned investors, consider downsizing the number of deals you are working on at the moment.

Focus on the ones with the highest potential profits (obviously), those you can bring to market the fastest, or properties in more desirable areas.

With all the new flippers entering the game, you should be able to offload a few of your deals to another investor and downsize your exposure to a market correction.

The bottom-line is … regardless of what level you are as a Fix-and-Flip investor, it’s a good time to reevaluate your situation before the market turns for the worse and your flip becomes a “flop”.

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