Flipping homes is a common practice and term in the United States’ real estate market. It describes the technique of buying a revenue-generating asset and “flipping” (selling it quickly) for profit.
Methods Used For Flipping Homes
If you are interested in real estate investing, you must unquestionably have come across this term. The strategy works if you conduct some research on the market and play it smart. There are several strategies for flipping homes, and we will talk about them here. This information will give you a better understanding of them to determine which one’s best for you.
1. Fix and Flipping Homes
When people flip real estate, their profits come from buying at a low price and selling at a higher value in a rapidly-rising market. Sometimes, profit comes from purchasing a property that needs extensive fixes and repairs before they put it up for sale and make a profit; this is called “Fix and Flip.”
In this technique, the flipper or investor first buys the property at a price that’s significantly lower than its market value. The owner may offer deep discounts because they need to sell the house quickly due to reasons such as a pending foreclosure, divorce, or relocation. Sometimes, the house is sold for a lower cost because it needs significant repairs or renovations which the owner is either unable or unwilling to do.
It’s the investor who then performs the necessary repairs and renovations. Later they try to sell the house at a price closer to or higher than market value. This ability to make money is what drives first time flippers into the game. Average home buyers don’t generally have the funds and time to update or repair a house before they buy. Most seek a home that’s in move-in condition. They are willing to pay a little above the market price, and therefore, this is how the “fix and flip” technique proves to be profitable for investors.
2. Wholesaling and Assigning Contracts
Wholesalers sign contracts to buy properties from sellers. They then sign agreements with third parties to resell those same properties, but at a much higher price and make handsome profits from flipping a home. The new buyers are assigned rights to the original contract. The wholesaler receives an “assignment fee” from the buyers in exchange for all rights to buy the property at its original price.
The contract comes with an “inspection period.” In this period, the original buyer can bow out of the deal and not close on the contract, if they are unable to find a suitable buyer to assign the agreement. Most wholesalers are only interested in locating appropriate properties for others that want to invest in real estate. They rarely ever intend to buy the property themselves.
Wholesaling is Becoming More Mainstream
Wholesalers that have developed the skill to identify lucrative investment opportunities for those interested in real estate investing can make sizeable profits using this technique. The original contract has a “cancellation for inspection” clause that allows the wholesaler to cancel it if they want, and return their deposit. Sometimes, wholesalers rely on this clause if they are unable to find a purchaser by the end of the mentioned inspection timeframe, and cancel the original purchase contract. It means they don’t lose any money on the planned deal.
The other attraction to wholesaling is that very little or sometimes no money will be is held in escrow. More often than not, the wholesaler has no intention of purchasing the property at all. Many infomercials and real estate coaching companies advertise the wholesaling process as “No Money Down and No Risk.” It’s because the deposit in these types of transactions can be as low as $10. In effect, if the wholesaler cancels the original contract before the inspection period ends, they can recoup that amount too.
Some people believe that since the wholesaler rarely ever intends to close on the properties themselves, the process is a fraudulent misrepresentation. However, this is a legal activity in the United States. Every real estate contract includes an inspection period and a deposit amount that the seller and buyer agree.
The real estate wholesaling concept is similar to wholesaling in other industries. Someone signs a contract to purchase something with the intent of reselling at a profit. In all successful wholesale transactions, the seller is often not aware that the original purchaser isn’t buying the property. In some deals, the wholesalers put up cash to buy the property. Later, in a second closing, they resell the property to end buyers. However, this is a costly proposition because the wholesaler pays the closing costs while buying and selling the property.
Many people in the industry believe that double closing is more ethical because the original seller sold their property to the wholesaler, who then resold it to a new buyer through a new transaction. If there are substantial profits in a particular sale, the wholesaler doesn’t mind a double closing (paying for two closing costs). In this process, they don’t need to request their buyers for a hefty assignment fee.
The wholesaler can’t buy any short sale and bank-owned properties utilizing an “assignment of contract.” In these cases, the wholesaler has to use the closing method. If the wholesaler has to pay for a property before reselling it, they would need ready cash. Alternatively, they may borrow the money from a private lender (the process is known as transactional funding.)
3. Multiple Wholesaling of a Property
Sometimes, a property is assigned numerous times, and several wholesalers make money in transactions from flipping homes. The original wholesaler first buys the property at a value below the market rate. They will then either sell or assign their contractual rights to some other investor. The latter then assign their contractual rights to another investor, and the process continues.
In many instances, the wholesalers work in tandem so that every party gets paid on a transaction. Since this practice seems illegal and unethical, the real estate community often frowns upon it. However, in method, assigning rights to a particular purchase contract multiple times (wholesaling) is perfectly legal.
The aspect to keep in view here is that a wholesale transaction opportunity exists primarily because original sellers are selling their properties for significantly less than the current market value. These are generally seller or property-related distress sales. In these types of transactions, the homeowner may be facing foreclosure, or the property may have suffered severe damage due to a hurricane, flooding, or fire.
Since the structure is compromised, the original seller is willing to sell it for far less than the fair market value. When a real estate purchase happens at a rate significantly below market value, it is known as wholesale real estate investing or distressed real estate investing, which is where the term “wholesaler” originated.
The Real Estate Bubble Bursts
Historically, trends in flipping homes occur when real estate markets are hot, and they slow when the real estate market cools. Over the last decade, the federal government relaxed borrowing standards. These included the ability for subprime borrowers to receive access to government funds, and for borrowers to buy homes with little or no down payment.
Likely resulting in a spike in demand for houses, this, in turn, impacted the supply. Since no down payment was required while buying homes, it became more accessible and more comfortable to borrow. The result was that many investors started to buy investment homes. But the ripple effect spread even further than this and affected potential owner-occupants too.
These people had minimal property options available to them because a large number of investors were sapping up all the investment homes on the market. Flippers did ultimately place some homes back on the market, but these properties had a much higher price tag than before the flip. It meant that now buyers had even less money for down payments. A vicious circle ensued, resulting in the real estate bubble bursting in 2008.
As the borrowing standards slowly started to regain normalcy, the housing market in the United States bottomed out before it began to correct itself steadily. Flipping was extremely popular in the US at the time. Numerous programs on TV such as A&E’s Flip This House depicted this process in detail. There are other repercussions to flipping. In this type of market, the interest rates begin to rise, which causes a drop in sales and significant price depreciation (typically far below the previous increases). The lack of buyers causes an influx of properties on the market. In turn, this creates a meltdown of the local real estate market and affects the country’s economy as well.
The Positive Effects of Flipping as an Investment
Flipping homes can rejuvenate and restore a previously rundown neighborhood. However, rising property values aren’t always a good thing as this leads to gentrification.
The broken windows theory states that unkempt areas or houses become an attraction point for criminal elements. This aspect deters people that make honest livings out of the local area and encourages even more criminal elements, which results in a vicious downward spiral.
In this situation, restoration proves to be beneficial in many ways, such as:
• When investors get interested and start rejuvenating rundown neighborhoods, they drive many changes. For one, it can create local jobs, particularly in the construction space.
• Local vendors also gain from increased sales by selling construction materials and supporting the workers, which generates more sales taxes, as well.
• Remodeled and spruced-up homes attract new populations.
• Slowly, businesses start to open shop in these areas, which catalyzes economic development.
• Remodeled homes also attract higher assessed values, and the higher property tax revenues add to the local government’s coffers.
• The increased tax revenues enable local governments to spend more on improving the region, which helps drive out criminal elements.
The Downsides to Flipping Homes
Just as many plusses emerge from fix and flipping, as well as the associated restoration. However, there are certain downsides to it as well, such as:
• If there is a rise in the frequency of flipping in a particular neighborhood, it can lead to a substantial increase in the total cost of living there.
• Ultimately, many of the current residents (particularly older people and less affluent younger folk) have to relocate.
• Sometimes, the lengthy renovations that flippers perform can cause a lot of disturbance and distress to their immediate neighbors.
• Since those who are flipping homes are rarely interested in neighborhood integration, it can strain their relations with long-term residents.
Flipping Has Far-Reaching Effects
During the United States housing bubble, flipping as well as gentrification had far-reaching effects; here we take a look at what these were:
• It resulted in people migrating to California in large numbers as wealth seekers were attracted to the flush of jobs and high real estate prices.
• This mass migration caused an effect of its own, and a significant number of native Californians had to ultimately migrate to the surrounding states, including Oregon, Texas, Washington, Nevada, and Arizona, where they settled in less expensive localities.
• The en masse relocation led to further gentrification of areas that the Californians had moved.
• Las Vegas, Arizona, and Phoenix were all inexpensive areas to live in before the real estate bubble. But gentrification led them to be becoming very expensive, although there has been a significant downward trend in prices since 2006.
Increase in Property values
Renovation helps improve the house’s condition and increases its lifespan. It means the property will fetch a higher price at the point of sale. The increase in price will also, in turn, increase the property’s tax assessed value. There is also a rise in the sales of services and goods associated with property improvement, which increases the sales tax. When renovation takes place on many properties, the neighbors benefit as well. All the attractive homes around them increase the value of their properties too.
Why Does Flipping Sometimes Have a Bad Reputation?
In the phase after the post-housing boom, uninformed parties and pessimists unfairly linked illegal and malicious acts to the development of abandoned or distressed properties and neighborhoods. In some cases, people use the term flipping to describe unlawful conduct, such as market manipulation schemes. It’s a derogatory term that some people use while talking about illegal, real estate investing and market manipulation strategies they perceive to be socially destructive or unethical.
When Flipping Becomes a Criminal Scheme
Sometimes, flipping can take on an illegal form. In this criminal scheme, the seller inflates the property value artificially and resells it for a significant profit. The seller often makes only cosmetic changes to the property. Once it looks spruced-up and appealing, they make a substantial profit on a quick sale. In this type of illegal property flipping, the real estate appraiser is hand-in-glove with the mortgage originator as well as the closing agent. The appraiser would first have to cooperate and provide an artificially-inflated, false appraisal report. The ultimate borrower (buyer) may or may not be in the know. This type of fraud is a significant loss and becomes very expensive for a lender.
Example of Illegal Flipping
To get a better understanding of how this illegal flipping activity takes place, let’s look at an example:
• A buyer signs a contract to buy a property in their name for an amount of $35,000.
• Just before closing that deal, they draw up another agreement to sell that same property at $75,000 (this amount is significantly higher than the market value.)
• They approach a mortgage broker or mortgage lender for a loan for the second contract and apply.
• They liaise with a real estate appraiser who inflates the property’s value high enough to justify the loan amount. This person would generally receive a fee three times higher than the standard amount. (There are many instances where scammers either intimidate or pressure incompetent/novice appraisers who get caught in this fraudulent scheme, unwittingly.)
• A mortgage lender then approves the application and releases the $75,000.
• The next step involves closure of the contracts; this may take place simultaneously or in quick succession.
• The person who originated the scheme then takes the $75,000 and pays off the $35,000.
• They divide the $40,000 that remain, between themselves and the other fraudsters (generally the loan office or mortgage broker and on occasion, the second buyer too)
• The lender ends up with a loan to value mortgage that is 100% or greater. The buyer makes some payments on that property, after which they default and allow it to move into foreclosure.
• Ultimately the lender finds out that the property value doesn’t even cover the total loan amount, which proves to be a considerable loss for them.
Over the years, many such illegal flipping schemes came to light. Not only were they unlawful, but they also disrupted the market as well. It’s why the USPAP (Uniform Standards of Professional Appraisal Practice) that governs real estate appraisals, and Fannie Mae, which is responsible for overseeing the secondary residential mortgage market, enacted practices to detect these fraudulent schemes.