Are Flips a Good Way to Build Passive Income with Real Estate?
There’s a lot of hype around flipping these days. Reality TV shows make it look easy, and everyone seems to be doing it. But is flipping really a good way to invest in real estate? In this blog post, we’ll take a closer look at the realities of flipping and why there are probably better ways to meet your passive income goals.
The first thing to know about flipping is that it’s not as simple as it looks on TV. There’s a lot of work involved, and it’s not always possible to find good deals. You might end up spending a lot of money on repairs, and there’s always the risk that the house won’t sell for as much as you want.
The Financial Side of Flipping
The goal of flipping is to find a distressed property that would not fare well on the open market, fix it up, and sell it for a return. Simple enough, right? Successful flippers will know their numbers well when going into a deal. On reality TV they make it look like flippers can pay basically any price for a flip without knowing the anticipated cost of repairs up front. That is a surefire way to lose money.
Let’s dive into some numbers.
Flippers will typically look for at least a 25% margin, meaning their all-in cost must be 25% less than their expected sale price. This figure has compressed over time, and in the wake of the Great Recession many flippers aimed for much higher margins. This percentage is thinner in higher end markets and wider in lower end markets, so there is no one set rule.
Here's an example:
Flipping a property that will be worth $400,000 when it’s all said and done. Aiming for a 25% margin, the maximum all-in cost would be 75% of $400,000, or $300,000. This example property needs $100,000 in repairs and updates. Therefore, the most you could pay to the owner is $200,000.
Bear in mind that the repair bill may end up being higher than you think! That margin will also be reduced by costs of capital (interest and points) and sale/transaction costs. As with any investment, you make your money when you buy!
Figuring Out Repair Costs
To be a successful flipper, you need to be able to estimate repair costs accurately. This is not always as easy as it sounds, because there can be a lot of hidden damage in an old house. The best way to get an accurate estimate is to hire a professional inspector to look at the property before you get a property under contract.
The inspector will be able to tell you about any major problems that need to be fixed, and you can use this information to negotiate a lower price for the property. Once you have a realistic idea of the repair costs, you can start looking for properties that fit your budget.
Some contractors and inspectors specialize in working with flippers and investors. The best way to find those specialists is by attending local real estate networking events and talking with other investors. It will take time and work to find those professionals, and their services are not free. Investing in the knowledge of experienced professionals can help put you very far ahead.
Flipping can be cash intensive. You’ll need money to buy the property, pay for repairs, and carry the property until it sells. Many flippers finance their business with hard money loans, which carry much higher interest than long term debt. Hard money loans also have short timeframes, which pushes flippers to finish their projects as quickly as possible.
Hard money terms:
There is no one set rule for hard money loans. During the current market climate many lenders will look for 10-12% with a couple of points on the front end. Monthly interest only payments are common. Some lenders are willing to accept interest payments at the end of the project after they have established a strong relationship with the flipper/borrower. Either way, flipping is not a no-money-down business.
Taxes are much higher on flips than on other forms of real estate. The IRS considers flipped properties to be business inventory, rather than investment real estate held for productive use. . Flip profits are taxed as ordinary income, rather than as capital gains. Furthermore, flips do not qualify for 1031 Exchanges, which allow investors to defer capital gains taxes indefinitely.
The high taxation of flips makes this strategy much less appealing for high earning busy professionals. W-2 income is highly tax-disadvantaged, why focus on adding another high tax stream of income?
Ordinary Income vs Capital Gains Taxes
The biggest difference between ordinary income and capital gains taxes is the tax rate. Ordinary income is taxed at your marginal tax rate, which can be as high as 37%. Long Term Capital gains, on the other hand, are taxed at a much lower rate of 15% (20% for high earners). This makes a big difference when you’re talking about large sums of money.
Managing Contractors is Difficult
Managing contractors is a huge part of flipping houses. You need to be able to keep contractors on task and on budget to make sure the job is getting done right and on time. Most new flippers find that this takes a lot more work than they expected. Failure to adequately manage one’s contractors can mean big financial losses.
Contractors can harm your flipping business in many ways. The reality of managing them is much less glamorous than the TV shows make it look. Here are a few examples of ways they can harm your business:
- Taking too long: Time is money! Every day your flip is delayed results in bigger holding costs and delays your payday.
- Going over budget: You should always have a scope of work with clearly understood costs of each line item, and require your contractors to agree and stick to the scope of work. Scope creep can happen in any project, and cost overruns can quickly wipe out any flipping profits.
- Poor quality work: Not every contractor has the same definition of a job well done. You can mitigate a lot of that on the front end by looking at prior projects your contractors have completed. That will help you get an idea of what they look for. Unfortunately, sometimes when projects get tough, even the best contractors cut corners.
- Not Pulling Permits: Many investors will rely on their contractors to pull permits for work when necessary. But what do you do if your contractor says they pulled the permits, but really didn’t?
- Not Paying Subcontractors: If you’re using a General Contractor, they’ll hire subcontractors to perform most, if not all, of the work. Sometimes General Contractors will refuse to pay subcontractors for one reason or another, which can push the subcontractor to put a mechanic’s lien on your property.
Tough to find deals
The most successful flippers find their deals off-market, meaning they are not actively listed for sale. To find these deals, you need to network with real estate agents, wholesalers, and other investors. You can also look for properties that are in foreclosure or have been sitting on the market for a long time. Expired MLS listings are popular targets as well, but as the market has become extremely competitive in recent years the pickings are a bit slimmer.
Off-market deals are off market for a reason, typically due to some kind of distress of either the property or the seller. The seller may need to sell quickly due to personal financial reasons, so you need to be able to be able to close your purchase quickly. A property is considered distressed when it needs extensive repairs, typically due to negligence of the seller. In either case, traditional financing will not work to acquire a flip property.
Flipping real estate is time consuming because there are a lot of moving parts. You have to find the right property, get it under contract, line up financing, manage contractors, and then sell the property. All of these steps take time and if any one of them falls behind schedule it can throw off the entire process. Are you able to leave your job in the middle of the day to deal with a contractor’s issue?
Newer investors looking to build passive income will typically find that flipping real estate is essentially another job.
Scaling is Difficult
Most flippers ultimately fail to create passive income because they fail to scale their business operations. Scaling a real estate flip business is difficult because there are a lot of moving parts, each of which requires plenty of knowledge. You have to find the right property, get it under contract, line up financing, manage contractors, and then sell the property. All of these steps take time and if any one of them falls behind schedule it can throw off the entire process.
Scaling and creating passive income through flips means building teams and business systems around each and every one of the steps outlined above. New investors are typically not willing to take the ‘risk’ of hiring team members and investing in their businesses.
Doesn't Create Passive Income
This is one of the biggest problems with flipping – most flippers go from deal to deal rather than creating passive income. This means that they are always working, trading hours for dollars. Going from deal to deal, transaction to transaction, means flippers are ultimately not creating streams of passive income or building wealth while they sleep. After doing a few deals you may find yourself burned out and frustrated with how many hours a flip takes.
What does create passive income?
Passive income is all about systems that create cash flow without you being there. Rentals are the most proven way for real estate investors to create passive income. Each individual rental is just one piece in your portfolio’s passive income. Accumulating a large number of cash flowing rentals is the most proven strategy for building passive income.
These days, it seems like there’s a new real estate guru popping up every other week. They all promise to be able to help you make millions of dollars in profits by following their simple system.
But the truth is, most of these programs are overhyped and don’t deliver on their promises. The vast majority of people who sign up for these programs will never see the kind of results that the guru claims are possible.
The reason why most people fail to make any money with these programs is because they’re not willing to put in the hard work required to be successful. These programs require you to take massive action and hustle your way to success.
Flipping real estate is an established business model which has been proven time and time again, but can carry considerable risk. Flipping is not a passive way to invest in real estate because it is time-consuming, difficult to scale, and doesn’t create passive income.
Real estate flips do not receive preferable tax treatment, and proceeds are treated as active income by the IRS.
Busy professionals who are looking to build wealth and passive income through real estate investing are better served by focusing on other strategies that create passive income streams.
There are a number of ways to more passively invest in real estate. Unfortunately for the flippers out there, flipping isn’t one of them. I have found that the most successful strategies investors have used to build passive cash flow include turnkey properties, syndications, notes, triple net properties, and private lending.
Turnkey properties are investment properties that come with a “turnkey” solution. In other words, they are fully rehabbed and often professionally managed so that all an investor has to do is sit back and collect the rent checks. A syndication is when a group of investors pool their money together to buy a property.
Interested in learning more about how these strategies work? Tune into our podcast The Passive Wealth Strategy Show! New episodes every Monday, Tuesday and Thursday. We’ll help you escape the Wall Street Casino and build passive wealth on Main Street.