I recently commented on a conversation here on Fastlane which in so many ways posed the question – which is better, income-producing property or flips?
A few thoughts - hopefully some of you some a bit of value here:
First of all, to ask whether buy and hold is a better strategy than flipping is akin to asking:
They have no points of contact (almost, but that's too sophisticated for now). In their pure forms, the two strategies accomplish different investment objectives, produce different type of income which is taxed differently, require different skill-sets from an investor, and are guided and limited by separate economic realities.
To ask which is better is sort of senseless – they coexist happily, but accommodate different groups of investors, in different locations, and with differing objectives.
When answering questions like this, meaning, questions of such general nature whereby an answer could easily become a 20,000-word eBook, I find it best just to cut to the chase – what is most important…?!
In this particular case, since potentially big money is involved in either case, what I think is most important is safety – make sure you don’t lose, and then worry about winning. I don’t know if you agree, and I don’t much care, but not losing is my number one concern with everything I do in RE investing. This is one reason my investors like me
(the other reason is that I am so damn good-looking)
So – What’s safer, income property or flip?
The answer actually depends on lots of factors, a fair number of which are economic and outside of investor’s control. But, the basic underwriting is with respect to margins in both cases. In other words, what is the minimum potential underwritten profit margin whereby if everything went wrong you are sufficiently buffered against loss…?
Flips
How much profit on paper in your underwriting do you need to start with so that everything can go wrong and you still won’t lose money? Is it $10,000? Is it $20,000? Is it $50,000? Is it $75,000?
I am in Lima, OH – small town in the rust belt which has gone nowhere for 20 years. I do not flip – period. Why – because a typical house that I would flip retails for $80,000 - $120,000, and as you can imagine, the typical profit margin is $15,000.
Folks – I can’t even take a leak on a sidewalk for $15,000, let alone do a quality rehab. $15,000 margin is not nearly high enough to underwrite safety or justify the risk involved. This money could be gone in a blink of an eye…
If I could routinely underwrite $75,000 - $100,000 profit margins, I’d be doing flips. Such as it is – no thanks!
What About Income Property
Well, while things are rather cut and dry with flips as it relates to safety, when we talk income things get a bit more complex. The common wisdom would tell us that Cash Flow in and of itself is a safety mechanism in that it potentially allows us to hold property for an unspecified period of time while we wait for the right conditions to sell. Common wisdom would dictate that equity really doesn’t matter, since the reason we’ve bought the property was Cash Flow…
In principle, this common wisdom is not wrong - it's not right either. Indeed, income in excess of expenses does add tremendous safety to a purchase. And, sure, if we want to live off the cash flow, then the cash flow itself constitutes the underlying value of safety, and indeed ROI.
However, there are a lot of caveats and exceptions. Why – because not everything that cash flows will make money. Why – because not all cash flow is real…
But, with those last 2 statements we are venturing into the very sophisticated world of IRR underwriting and discounting of future cash flows to NPV - too much horse power for this thread. In the most general terms, if I were to name a purchase price-point relative to income that is “safe”, with the caveat that you’ve picked the right kind of property in the first place, I’d say – if you pay a factor of no more than 9.5 CAP on “real” NOI you should be safe…
Having said this, however, I must tell you that this is not full-proof. Capitalization Rate is a static metric, which makes it somewhat ineffective at valuing income property. Cap Rate is best used to measure the behavior in the marketplace, and not that of a specific asset. In order to get to the bottom of determining values of future potential cash flows represented by a specific asset denominated in today's dollars, the best place to go is indeed Internal Rate of Return (IRR), which I mentioned earlier. But, I won’t try to tackle that here…
So – What’s Safer?
Both are safe if you do them right. But, in order to do both right, you must receive permission of the marketplace. Not all markets will allow you to do a flip, and if you force it, you’ll get burned. The same is true for income-producing real estate, although to a lesser extent since I’ll take a 6/5% real cap with 20% back end appreciation over a strictly cash flow 10 cap any day of the week and twice on Sunday!
Much more can and should be said, but I am a busy guy. Hope this helps
A few thoughts - hopefully some of you some a bit of value here:
First of all, to ask whether buy and hold is a better strategy than flipping is akin to asking:
Which one is better – Saturn or Venus…
They have no points of contact (almost, but that's too sophisticated for now). In their pure forms, the two strategies accomplish different investment objectives, produce different type of income which is taxed differently, require different skill-sets from an investor, and are guided and limited by separate economic realities.
To ask which is better is sort of senseless – they coexist happily, but accommodate different groups of investors, in different locations, and with differing objectives.
When answering questions like this, meaning, questions of such general nature whereby an answer could easily become a 20,000-word eBook, I find it best just to cut to the chase – what is most important…?!
In this particular case, since potentially big money is involved in either case, what I think is most important is safety – make sure you don’t lose, and then worry about winning. I don’t know if you agree, and I don’t much care, but not losing is my number one concern with everything I do in RE investing. This is one reason my investors like me
(the other reason is that I am so damn good-looking)So – What’s safer, income property or flip?
The answer actually depends on lots of factors, a fair number of which are economic and outside of investor’s control. But, the basic underwriting is with respect to margins in both cases. In other words, what is the minimum potential underwritten profit margin whereby if everything went wrong you are sufficiently buffered against loss…?
Flips
How much profit on paper in your underwriting do you need to start with so that everything can go wrong and you still won’t lose money? Is it $10,000? Is it $20,000? Is it $50,000? Is it $75,000?
I am in Lima, OH – small town in the rust belt which has gone nowhere for 20 years. I do not flip – period. Why – because a typical house that I would flip retails for $80,000 - $120,000, and as you can imagine, the typical profit margin is $15,000.
Folks – I can’t even take a leak on a sidewalk for $15,000, let alone do a quality rehab. $15,000 margin is not nearly high enough to underwrite safety or justify the risk involved. This money could be gone in a blink of an eye…
If I could routinely underwrite $75,000 - $100,000 profit margins, I’d be doing flips. Such as it is – no thanks!
What About Income Property
Well, while things are rather cut and dry with flips as it relates to safety, when we talk income things get a bit more complex. The common wisdom would tell us that Cash Flow in and of itself is a safety mechanism in that it potentially allows us to hold property for an unspecified period of time while we wait for the right conditions to sell. Common wisdom would dictate that equity really doesn’t matter, since the reason we’ve bought the property was Cash Flow…
In principle, this common wisdom is not wrong - it's not right either. Indeed, income in excess of expenses does add tremendous safety to a purchase. And, sure, if we want to live off the cash flow, then the cash flow itself constitutes the underlying value of safety, and indeed ROI.
However, there are a lot of caveats and exceptions. Why – because not everything that cash flows will make money. Why – because not all cash flow is real…
But, with those last 2 statements we are venturing into the very sophisticated world of IRR underwriting and discounting of future cash flows to NPV - too much horse power for this thread. In the most general terms, if I were to name a purchase price-point relative to income that is “safe”, with the caveat that you’ve picked the right kind of property in the first place, I’d say – if you pay a factor of no more than 9.5 CAP on “real” NOI you should be safe…
Having said this, however, I must tell you that this is not full-proof. Capitalization Rate is a static metric, which makes it somewhat ineffective at valuing income property. Cap Rate is best used to measure the behavior in the marketplace, and not that of a specific asset. In order to get to the bottom of determining values of future potential cash flows represented by a specific asset denominated in today's dollars, the best place to go is indeed Internal Rate of Return (IRR), which I mentioned earlier. But, I won’t try to tackle that here…
So – What’s Safer?
Both are safe if you do them right. But, in order to do both right, you must receive permission of the marketplace. Not all markets will allow you to do a flip, and if you force it, you’ll get burned. The same is true for income-producing real estate, although to a lesser extent since I’ll take a 6/5% real cap with 20% back end appreciation over a strictly cash flow 10 cap any day of the week and twice on Sunday!
Much more can and should be said, but I am a busy guy. Hope this helps
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