Accountants often find out about a client’s investment decisions after the plan is underway or once the damage has been done. Sometimes you get lucky and your client asks your opinion in advance. Your client wants to become a real estate flipper. What advice do you give him?
As an accounting professional, you don’t have a lot of time to watch programs on HGTV, such as Flip or Flop. UK residents have Homes Under the Hammer on the BBC.
In these TV series, the hosts attend an auction, buy a piece of residential real estate, fix it up, and sell it on to someone else, usually at a decent profit. The UK show also includes real estate agents who do a walk-through and estimate rental income potential. Few people walk away disappointed. Your client thinks: “How tough can this be?”
There are lots of people out there without the skill, time, or desire to renovate a house. They prefer to buy a turnkey property and move right in. They will often be prepared to pay a premium for a house they really like, although the real estate business is heavy on price negotiation and time on the market.
Pros and Cons of Flipping Real Estate
When UK viewers watch Homes Under the Hammer, they often learn high bidders are adding to a portfolio of rental properties, and flipping properties is a major business for them. They often have a work crew they move from property to property, or a large extended family with the necessary skills and time on their hands.
Here are some pros of flipping real estate:
1. Robust real estate market. You’ve heard “location, location, location.” “Buy the worst house on the best block” is another piece of real estate wisdom. FYI: Philadelphia Magazine reports, “According to Zillow, homes within a mile of a Whole Foods have a median value more than double that of those that aren’t as close.”
If they got a good deal on a property in a prime area, this greatly increases their chance of success.
2. Speed. Sometimes a property just needs cleaning, repainting, and minor repairs.
If they can get this done virtually overnight and put the property back on the market at an attractive price, their return can be very attractive versus the short amount of time their capital was tied up.
3. Supply. The real estate market needs inventory at all price points. If you have done a good job renovating the house and priced it attractively, it may sell quickly if there is little inventory in that sector of the market.
The rules of supply and demand work in your favor.
4. Rental income. You don’t need to sell to make money. If you list it with a real estate firm or management company that handles rentals, it can be a source of income during a low interest rate period for the bond market.
The following are some cons of flipping real estate:
1.Who does the work? If you are retired, incredibly handy, and need a project, this can work for you.
But more than likely, youwill need to bring in professionals who will expect to be paid market rates.
2. Who supervises the work? Will you be acting as the general contractor, coordinating the tradespeople and doing cosmetic work yourself? If not, will you hire someone to run the day-to-day aspects of the project, adding another level of expense?
Bringing in someone who will do all the work usually has these costs rolled in.
3. Uncovering problems. Although you might inspect the property beforehand, you are buying “as is” in most cases. This is a factor that keeps the purchase price down.
There may be problems lurking behind the walls. You don’t know until they are opened up.
4. Permits and professional services. In many communities, you are required to file plans for home renovation projects. The permit office may require plans. This means you need to hire an architect to produce the drawings.
You will have costs before the work actually starts.
5. Overdeveloping. If you want to get top dollar, your buyers want modern kitchens and bathrooms. These cost money, increasing the overall renovation cost. This is balanced against comps (comparable prices) in the neighborhood, a key factor banks use when determining how much they will lend.
It’s extremely unlikely your property will sell for more than similar homes nearby, regardless of upgrades.
6. Cost overruns. They often happen. Even though you might build a 10 percent contingency into your numbers, the risk is there.
Projects usually cost more that originally estimated, which is why these numbers are called estimates.
7. Time delays. Parts aren’t available. Your tradespeople are also working on other jobs.
Work gets stretched out. You are still paying the carrying costs.
8. Taxes. The accountant’s area of expertise. Because flipping means buying and selling in a short period of time, it’s likely short-term capital gains will be part of the expenses.
Flipping can work for your client if all the stars align. Assuming he buys in an area where real estate has traditionally appreciated over time, the strategy can work if he renovates the property, rents it for a few years, and then sells, assuming prices have appreciated. Your client likely has vastly underestimated the costs of getting the work done. He needs to go into this venture with his eyes open.
Bryce Sanders is president of Perceptive Business Solutions Inc. in New Hope, Pennsylvania. He provides high-net-worth client acquisition training for the financial services industry. His book, Captivating the Wealthy Investor, can be found on Amazon.com.