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John T. Reed review of Flip That House

Posted by John T. Reed on

Copyright by John T Reed

The Discovery Home Channel (DHC) has a regular program called Flip That House. Each episode shows a person or group of people renovate a house, then sell it within a month or two for a substantial profit. Unbelievably, there is another show called Flip This House that is not related to Flip That House. I have never seen Flip This House.

I am inclined to start a third show to answer both of them. I think I’ll call it, “Flip This.”

I do not recommend the Flip That House show for a number of reasons:

  • it leaves out or glosses over a number of important facts
  • all participants have a powerful reasons to make flipping look good
  • the approach the show teaches is generally the opposite of what competent fixers should be doing

Transaction costs

The show tells viewers the purchase price of the home, the fix-up costs, and the sale price. That leaves out both the transaction costs going in and the transaction costs going out. In real estate, the transaction costs are scandalously high. Plus, there is a common way to reduce one of the main ones.

Binder title insurance policy

By getting a binder title insurance policy rather than a regular title policy, and requiring the subsequent buyer to use the same title company, the flipper can get 90% of their title insurance costs paid by their subsequent buyer. The TV show makes no mention of the wisdom of buying a binder title insurance policy. It should be mentioned in every episode.

Carrying costs

Flips are vacant. That means the entire carrying costs are borne by the flipper prior to closing of the resale. Single-family houses typically have negative cash flow when they are rented. Think how much negative cash flow they have when they are vacant.

There is also the issue of the actual closing date of the sale. I got the impression that they were not telling viewers the actual closing date of the sale. Rather, they seemed to be providing the date the second buyer’s offer was accepted. Normally, the closing is one or two months later because of the need for the second buyer to get financing, title insurance, survey, inspections, etc. Furthermore, it is also common for the various inspectors hired by the buyer to require additional work to be done. I suspect that such expenses are occurring, but not being mentioned in the show. Leaving out any expenses exaggerates the profit.

Value of the flipper’s time

Another large overlooked cost is the value of the flipper’s time. Although the TV show rarely explicitly mentions it, you can see that the flipper is spending a great deal of time meeting with contractors and agents, working on the property, and so forth. The shows I saw seemed to indicate that the flipper does this full time.

Furthermore, most of the time is likely spent finding the property before it is purchased. Finding a beat-up property you can buy for 60% of neighboring values is extremely difficult and time-consuming. I did not see any of the effort required to find the properties on the show. See my books How to Buy Real Estate for at Least 20% Below Market Value volumes 1 and 2.

It takes at least several man-months to find, renovate, and sell a property. At $30 a hour, three man-months would be worth $30 x 4.3weeks per month x 55 hours per week x 3 months = $21,285. See my book Fixers.

Obviously, the amount varies according to the value of the flipper’s time, the amount of time they spend per week, and the number of months it takes them to find, renovate, and buy the property. Roughly speaking, the flippers are expending tens of thousand of dollars worth of their time to pull these deals off. As far as I can tell, these amounts are left out of the figures shown on the Flip That House show.

Only look at profit margin

The show uses profit margin as the only measure of the success of the flipper. That’s fine as far as it goes. Profit margin is a meaningful statistic when you own the property being sold only for a short period of time. I will give them a little credit for not using return on investment, which is not very meaningful in a short-term “investment” like a flip. But they should be horsewhipped for completely omitting the value of the flipper’s time.

In a passive investment like certificates of deposit, how much the investor is making per hour of effort is a silly, misleading number because the effort is so brief and intermittent. Similarly, in an “investment” that only lasts a month or two, return on investment can also be misleading because such short periods jack up the annual rate of return. But when you are doing something full-time or part-time, you have to look at the amount of money you are making per hour. I have heard of many real estate investment schemes that wow seminar audiences, but which sound to me like the “investor” is working so hard that they would be better off shoveling french fries an McDonalds on a pay-per-hour basis.

Insurance

Owners of buildings must have hazard (often imprecisely called “fire insurance”) and liability insurance. But flips are vacant and insurance companies do not like to insure vacant buildings because they attract vandals, thieves, children, drug dealers, lovers, and squatters. Special arrangements have to be made to get such insurance and it probably costs more than normal homeowners insurance. Flip That House makes no mention of this problem or how to deal with it. I suspect most investors just fail to mention the planned vacancy to the insurance agent which could result in a denial of the claim if there was one.

Hassles

Buying, renovating, and selling real estate involves numerous hassles. Almost every purchase has seemingly insurmountable obstacles involving inspections, financing, disclosures, disputes about what is included in the sale, and so forth. The typical deal seems like it is sure to fall through at least once on the way to purchase. It is very difficult to get financing for a flip. Most real flippers do it with lines of credit which are hard for beginners to obtain.

Renovating also has many hassles. For one thing, it is very hard to get the standard three estimates from each and every trade required to do the renovations. In the real world, subcontractors do not return phone calls, they stand you up for appointments, they do shoddy work, they violate the agreement substituting lesser quality labor or materials than agreed to, they leave out things they agreed to do, they overcharge for minor changes, and more.

Building-permit authorities and government building inspectors often are obstreperous and cause unexpected problems. When you tear out an old wall, ceiling, or floor, you often find unexpected damage or structural features that must be corrected at unexpected additional cost.

Murphy’s Three Laws apply:

  1. Everything is harder than you think.
  2. Everything takes longer than you think.
  3. If anything can go wrong, it will, and at the worst possible time.

Flip That House often shows the renovations taking slightly longer than expected, but the other hassles of real world renovating are not shown.

Neighborhood price ceiling

One of the most basic truths about fixers is that you cannot raise the value of a property above that of the others in the neighborhood. Accordingly, if you buy in, say, a $200,000 neighborhood, the most you can sell for after fix-up is $200,000. Why? Because buyers who can afford $200,000 can get both a $200,000 house and a $200,000 neighborhood for that money. And that’s exactly what they want. They do not want a $200,000 house in a $130,000 neighborhood.

Work backward. Start with the resale price which is the neighborhood ceiling. Then subtract:

  • your profit
  • transaction costs
  • carrying costs
  • fix-up costs

What’s left is the ceiling on the price you can afford to pay to buy the fixer.

The case histories I saw on Flip That House seemed to have profit margins in the 25% to 30% range. That is, on, say, a $200,000 resale price, the profit would be, say, $55,000. The fix-up cost would be tens of thousands of dollars—say, $25,000. By their incomplete math, that would leave a purchase price of $200,000 - $55,000 - $25,000 = $120,000. In other words, the purchase price is about 60% of the resale price.

Now, go out in your local market and see how many houses you can buy for 60% of the prices in that neighborhood—even run-down houses. As stated above, I wrote two books on the subject of buying houses for at least 20% below market value or, in other words, 80% of market value. In the book, I have some actual case histories of people buying for even less, like 75% or even 60%, but I noted it was quite rare and took certain extraordinary circumstances to achieve it. Hint: “motivated” sellers is not the answer. All sellers are motivated.

If you are experienced, you already know the answer. And you are probably wondering, like I am, how the flippers in the Flip That House program manage to buy for such a huge discount off the neighborhood norm.

Bargain purchase price?

A recent study by Dr. Christopher L. Cagan found that flippers do not make a profit unless they make a bargain purchase and/or improve the property. If the profit margins the program claims are accurate, I suspect the properties were bargain purchases. That is, they were purchased for at least 20% below market value. How to Buy Real Estate for At Least 20% Below Market Value covers such situations as probates, foreclosures, OREOs, contaminated buildings, and so forth. None of the Flip That House programs I have seen acknowledged any bargain-purchase circumstances.

That leaves the impression that the buyers paid current market value for the properties. Given the huge profits they later claim to make, intelligent investors should wonder how the flippers got the properties so cheap to begin with. In my experience and conversations with and observations of other investors, the typical fixer only sells for about 5% or 10% less than comparable properties that do not need much work.

I also wrote a book on paying as much as current market value for a property, but then changing it to increase its value. That book is called How to Increase the Value of Real Estate and another called Fixers.

Dealer tax status

The deals depicted in Flip That House are dealer property for federal income tax purposes. That means the flippers cannot do tax-free exchanges, cannot deduct depreciation, cannot get long-term capital gains tax rates, and cannot avail themselves of installment sale treatment if they take back a mortgage when they sell. These are not deal killers, but they are significant and important and I would mention them if I did such a show. See the dealer property chapter in my book Aggressive Tax Avoidance for Real Estate Investors 18th edition for details of that.

Ratings and free publicity

Let’s consider the incentives and motives of the various participants in the show.

The producers want ratings. Would a program that showed flipping to be difficult and often unprofitable be rated as high as a program that seems to show flipping as an easy, quick way to riches? Obviously not. If ratings are the goal, the people who make shows like Flip That House ought to have the same mindset as the people who make get-rich-quick real estate investment infommercials. Indeed, it appears to me that they do have exactly that mindset. I sent this article to the producer of Flip That House before I published it asking if it contained any errors or omissions or if he wanted to make any statement about what I wrote. I never got any answer.

Would a show using grizzled old pro men or women flippers sell as well as a show that uses attractive young women? If you have not seen it, DHC’s Flip That House seems to be populated by far more attractive young women flippers and real estate agents than you would see in the real world. Obviously, grizzled old pros would be more expert and better teaching examples.

The flippers want to be seen as competent and successful to impress their friends, relatives, and to make their enemies envious. The producers want the same for ratings purposes. Human nature suggests they would behave differently if they were privately showing their best friend how they do this and what pitfalls to expect. In Flip That House, however, they are performing for an audience composed mostly of strangers whose failure to get an accurate picture of what flipping is really like they are not likely to be concerned about.

The subcontractors have an incentive to bid low. What is it? They get to be on TV showing off their work thereby getting them additional business. It’s free advertising and publicity that they could never otherwise get. Any chance they will bid low to make sure they get to be TV stars?
.
The real estate agents have similar incentives. If they come across favorably, they can expect to get listings, referrals, and purchasers. Suppose they come in and say that they think the flipper wasted a lot of money on stuff that does not pay or that the property will not sell for what the flipper and producers hope? Do you suppose maybe they will find another agent and the brutally honest one would end up on the cutting room floor?

I have not seen any government or other inspectors on the show the few times I saw it. But they would commonly be involved in such a project. In the real world, such inspectors are often very tough and obnoxious and act like bullies or even want bribes. Do you think any of that is going to happen with TV cameras pointing at the inspector?

Choice of improvements

The flippers in Flip That House generally make the typical beginner mistakes with regard to what improvements they make to the house.

The main mistake is the most common one among beginning flippers. They fix the house up as if the object of the exercise were to impress visitors to the house with their excellent taste and the completeness of their transformation of the property. In short, they make improvement decisions as if they were housewives whose only goal is to make their personal residences look really nice to visitors.

Get the fast buck, not the last buck

In fact, the object of the exercise is to maximize your profit on your investments of money and time. You must get the fast buck, not the last buck. The Flip That House flippers make the common mistake of chasing the unprofitable last buck.

Obviously, each improvement you make to a house has a different profit margin. Furthermore, I suspect most of the improvements made by the Flip That House flippers have a negative profit margin. That is, they cost more than they add in value to the home. They lose money. The flippers would have made more profit if they had not made the improvement in question.

Remodeling magazine’s annual survey

Remodeling Magazine does an annual survey of what various common home improvements cost and how much value they add to the house in question. You can see the most recent survey at http://remodeling.hw.net/content/CvsV/CostvsValue.asp?articleID=211765&sectionID=173.

They also once asked homeowners to estimate the cost of common home improvements. The homeowners were way off on costs. For example, they estimated remodeling a kitchen cost $18,658. The actual average cost of remodeling a kitchen was $38,769 that year.

The Remodeling Magazine survey also reveals that every single home improvement other than just painting costs more to do than it adds in value to the home.

Fixers book

For example, my book Fixers, urges readers to find houses that are literally uninhabitable or borderline inhabitable. Why? Because otherwise it’s hard to buy the house cheap enough to make a profit.

Now, do you suppose you greatly increase the value of an uninhabitable house by making it habitable? Absolutely. Would you also agree that just making it nicer after you have moved it from uninhabitable to habitable would likely make less profit per dollar spent on improvements than you made when you just made it habitable? Again, that’s obvious.

Sell fixers, buy disasters

My book about Fixers is not really about buying fixers. It is about selling fixers. It is about buying disasters. There is money to be made buying disasters and turning them into fixers. There is little or no money to be made buying fixers and turning them into immaculate homes like they do on Flip That House. Why? There are too many amateur fixers who will overpay for the slightly run-down properties.

And fixing a house is to building a house what repairing a car is to manufacturing a car in a factory. If you had your local auto mechanic beuild you a new car from scratch by ordering all the parts, a $25,000 car would cost about $100,000. So it is with fixing as opposed to building a house new as part of a development.

In order to buy such properties, you must outbid the idiot amateurs. If they are paying too much, and you are outbidding them, you have no hope of making a profit from fixing. Although you may make a profit from ambient, marketwide appreciation during the fixing and incorrectly attribute it to your fix-up.

Ambient marketwide appreciation

Flip that House never said what the ambient, marketwide appreciation was during the fix-ups in question in the markets where they were located. To find out what increase in price was attributable to the fix-up per se, you must subtract out any bargain purchase you got plus any ambient, marketwide appreciation. For example, if houses in the area all went up 10% during your fix-up, and you sold for 15% more than you paid, 10% of the increase was due to the ambient, marketwide appreciation. It would have happened if you had done nothing. Only 5% stemmed from your fix-up. And that would only be true if you paid full market value when you bought. If you got a bargain purchase price, you must be careful not to count all or part of the bargain as increased value added by your fix-up.

Other profitable improvements that I recommend in my Fixers book include changing a one-bedroom house to a two-bedroom by converting existing interior space into a bedroom, eliminating cat urine smell in a house where cats were allowed to roam wild and not required to use a litter box, correcting a bad foundation that scares away all buyers, and so forth. These are the techniques that really work. I saw none of them on Flip That House. The flippers were doing entirely the sorts of things that Remodeling Magazine says are money losers.

Ambient marketwide DEPRECIATION

Also, in 2006 and 2007, the market has gone down more than up. So flipping would be much harder to do. But when you are making your living doing a show called Flip That House, it’s hard to announce that flipping no longer makes enough sense because of the change in the market so the show is being cancelled purely out of regard for telling the whole truth.

I have not investigated any of the specific deals I saw on Flip That House. For one thing, they only give the first names of the flippers and they only give the metropolitan area location, not the street address of the properties. I hope some readers will tell me about specific houses or flippers that were on that show so I can publish the public records data about them.

But based on my almost 40 years of experience and thousands of conversations with and observations of professional real estate investors, I do not find Flip That House to be credible or complete. There is a lot more to profitable fix-up than they depict and the sorts of fix-ups that are profitable are quite different from the homemaker improvements they show. Finally, the profit margins of real, professional fixers are significantly less than those ostensibly achieved by the relative beginners on Flip That House. In short, it is nowhere near as easy as Flip That House makes it look and they way they say to do it is not the correct way.

Email about one program

Dear Mr. Reed,

Thanks for your honesty about the realities of house flipping.

You asked on your webpage if viewers of the program, 'Flip That House,' had noted any names of participants in that show.

I watched an episode yesterday about a house flipper named Justine Smith. Ms. Smith's name was openly revealed on the show. She is a young
woman who was portrayed doing her first house 'flip.' (That episode might be rebroadcast today, Saturday August 11 2007.)

Ms. Smith's house-to-be-flipped was located in Austin, Texas, and the house number was easily seen on screen: 1309.

With those facts and a little research I determined that the full address was:
1309 East 13th Street
Austin, Texas

I was curious to see how well Ms. Smith made out with her sale. The 'Flip That House' episode ended with a real estate agent telling Ms. Smith he believed he could list AND sell her house for about $240,000. But viewers are not told what the ultimate sale price was.

So I went online to try to find out, using Travis County's public records online. I was not able to determine the sale price, but county records showed a tax assessor's value of about $210,000.

Ms. Smith's expenses were listed on the program as:
$135,000 for house and lot
$ 70,000 remodeling costs

If the house did indeed sell for only about $210,000 (as contrasted with the $240,000 the real estate agent almost promises Ms. Smith on air), that would seem to be a rather poor profit, especially considering all the time and effort Smith put into the house.

If you do find out the actual sale price for 1309 East 13th Street, Austin TX, and post it on your site, I think it could be a valuable reality check for viewers of the show. Thanks.
--
j k
malkie04@fastmail.fm

[Note from John T. Reed about the email] Both the show and the email writer left off the transaction costs which are enormous in real estates—maybe10 to 15% of the price. So it appears that she lost money on the deal out of pocket. They also both left off the value of Smith’s time which she would have spent almost none of had she invested in stocks or bonds instead.

See my Web article on flipping for more information.


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