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The decision to make a real estate investment should be supported by a strong business plan, because it involves a significant amount of capital and a fair amount of risk. As an investor your strategy should be informed by extensive market research, financial planning, and an awareness of the potential pitfalls along the way. One of the decisions you’ll have to make is whether to adopt a fix-and-flip holding strategy, or to hold onto your investment for years while it appreciates in value.
This article will discuss the advantages and disadvantages of each strategy, helping you determine which is right for your own investment portfolio.
Flipping – The Pros and Cons.
Fix & Flip, “Flipping,” or “Buy and Flip,” are investment holding strategies in which an individual or group of investors acquires a property under market value, with the intention of reselling at a profit within a short period of time.
Fix-and-flip investors generally follow the 70% rule; for a profitable flip, homes must be bought for 70% of their actual market value after renovations. For example, if a home would be worth $100,000 if it were in good condition, but needs $20,000 of renovation, an investor will purchase the home for $50,000 ($100,000 x 70% – $20,000) and seek to sell it for the full $100,000 when completed.
Successful home flipping relies on negotiation and speed. The faster an investor is able to flip the home, the fewer number of months they will need to pay carrying costs such as mortgage charges, interest, property taxes, condo fees, utilities, and maintenance costs.
Advantages of Flipping:
- Because of the fast pace of this holding strategy, the main advantage is the ability to quickly realize gains and to free up capital for your next investment.
- Real estate markets are fairly easy to predict, allowing you to develop realistic financial projections for your investment
- Flipping is intended to keep your capital at risk for a minimal amount of time
- With no rental contracts involved, flipping lacks management and leasing risks, and requires less time over the long run
Acquiring a property to flip:
Since the acquisition and sales costs involved in a real estate purchase are significant, it is rare that profits can be made on flipping a property acquired at market value. Instead, there are two major types of properties that are used in the fix-and-flip strategy:
- Repossessed properties that are sold under market value because they are in financial distress. Investors adopting this strategy rely on their extensive market knowledge and real estate network; the combination of which allows them to very quickly acquire and resell properties with minimal transaction costs.
- Properties that have fallen into disrepair, or that require large structural or design renovations. “Fixer” properties tend to be sold under market value because they require work, but if an investor possesses the required capital and team to quickly overcome these issues, a significant profit can be made. Other ways of increasing the value of a “fixer” include remodelling the home to better suit a particular target market, or enhancing the design and function of a home to better reflect current housing trends.
Of course, in some cases properties that are both in financial and structural distress can be acquired, allowing investors to combine the two strategies.
Disadvantages of Flipping: (When a flip becomes a flop!)
- Unanticipated expenses such as material delays, contractor delays, obstacles in renovations, and budgeting errors can cause an investor to lose money instead of making a profit
- Repossessed properties are sold without a seller’s declaration or legal warranty, making it easier for an investor to overlook structural issues and to miscalculate renovation costs.
- Flipping properties leads to swings in income that can create both tax issues for the investor as well as cash management issues. In a worst case scenario, your profits could be absorbed fully by taxes.
- Holding costs such as insurance costs, mortgage fees and maintenance costs could take a large chunk out of your budget if there are delays in the property’s renovation or sale.
- Repeat fix-and-flip investors will need to seek alternative (private) funding for their mortgages, involving higher interest rates on the loan.
- You will be losing money every day you are unable to find a buyer for your property. In slow markets, the risk of a long selling time will outweigh the potential profits of a flip.
- Flipping a property is usually more stressful than holding real estate, since it involves high amounts of pressure coordinating a construction team and respecting sales delays.
Buy and Hold Strategy- The Pros and Cons
The Buy and Hold strategy involves purchasing a primary residence or rental property as a long term investment. Buying and holding is the simplest and safest way of investing in real estate. Essentially, the investor creates wealth by earning equity through monthly passive income, while waiting for property prices to appreciate. In an ideal situation, the investor would acquire a cash-flow positive investment, meaning that the total expenses and holding costs are covered by the rent collected. For example, if the total carrying costs of a property (including the monthly mortgage payments, bills, taxes, and maintenance costs) is $1000 per month, then you would need to rent the property out at $1000 / month to break even. If you were to rent the property at $1100 per month, your investment would be cash-flow positive with a profit of $100 / month.
The qualities of a good buy-and hold investment include:
- Location, location, location – for rental properties, this means buying in a neighbourhood where it will be easy to find a tenant. High vacancy rates will decrease the long term profitability of your investment. Buy and hold investors also look for properties in neighbourhoods where property values are expected to rapidly appreciate in the next decade.
- Low interest rates on your mortgage loan
- Easy-to-manage properties such as condos, townhouses and newly constructed single family homes.
- Buildings with amenities and features that reflect the needs of the rental market; for example, condos near metros with gyms, pools and garages, or family homes with yards and ample sized bedrooms.
- Revenue properties such as duplexes, triplexes and multiplexes tend to make good long terms investments, because they can serve both as a primary residence and an opportunity to gain passive income.
Advantages of the Buy and Hold Strategy:
- A passive buy and hold strategy is the most reliable way of investing into real estate. The method has been proven to work time and again, and is the preferred route for many seasoned investors as well as first-time buyers.
- Buying and holding involves fewer headaches and less stress, since the investment expenses and returns are amortized over a period of many years, instead of a few short months.
- Long term growth is easier to predict than short term growth, making the investment a safer one.
- Buy and hold is better for capital gain taxes. A property held for more than a year is eligible for a long term tax rate rather than a higher short-term rate.
- Rental properties are management intensive and can come with a myriad of logistical or legal issues
- Vacancy rates will fluctuate based on external market conditions which are beyond the investor’s control.
- Finding long term, quality tenants can be a challenge.
Choosing a Strategy
There are the questions each investor must ask themselves:
- Will you need the capital within the next 12 months?
- Are property prices expected to drop in the near future?
- Do you have enough capital to buy, sell and renovate a property?
- Do you have strong contacts in your local real estate, financial lending and construction industries?
- Are you comfortable with high-risk investments?
- Are you comfortable with potentially slipping into a higher tax bracket?
The choice of whether to flip or to buy and hold depends on one’s investment goals and financial situation. For investors with diverse portfolios including a core real estate portion, the long term holding strategy is more appropriate. For individuals or teams wishing to approach real estate investing as a primary source of income, flipping may be the more profitable strategy. Flipping is best suited as a transient investment strategy, for short term projects capitalizing on favourable market conditions and low interest rates. In the long term,the buy-and-hold strategy is a better way to amass equity and leverage the profits to finance other investments.