This blog is about owning and operating rental properties in the Dallas, Fort Worth, Denton metroplex. If you are new to this blog, read “Get a Mentor” and “Getting Started” and you can follow the posts from there. Often the people I teach want to know why they can’t just flip? The question stems from the concern that dealing with tenants is tough and so we can just flip. I wrote an article earlier about “Myths about Tenants” saying that if you buy, rehab, and operate your rental property like we teach in these blogs, those painful stories about tenants will just be myths. There’s a right way to doing anything and so it’s key to learn from an active investor who is willing to teach you. So get a mentor.
Let’s pick a property and create two scenarios. In one, a person flips it and in another a person rents it out for a year after fixing it up. She then sells it. Let’s do the math.
We are assuming above a property tax rate of 3.5% and a mortgage interest rate of 4% which is applicable to Dallas, Fort Worth, Denton area markets at the current time. The above parameters are the same regardless of the plan to flip or rent. Now, let’s look at the difference:
The final answer is simple. Net Gain on rent for a year and sell is far greater. Let’s look at the line items.
- The first one is holding cost. Now, we have applied the same repair cost to the rent and flip scenarios. You should expect one of two things, either spend more on fix cost to make it attractive for sale, or just fix to median market value but expect it to sit on the market for sufficient exposure. So that’s what we have done. We have assumed that we are only fixing up to median market (rent quality) and we will let it sit for 3 months. Holding time for rent on the other hand is only going to be 1 month. Property is in market condition for the rental market. You can do the math differently by reducing the hold time for sale, but increasing the repair costs by 50% (to 15000). You’ll get similar results.
- Asset cost at point of sale/service is cost of purchase plus cost of purchase closing plus repair costs plus holding costs to the date of sale or date it’s leased.
Cost at time of sale is almost the same in the two scenarios. The only difference there is the cost difference due to holding time. The key difference comes due to three significant gains in the renting model:
1. Gain from cash flow: We are assuming a rent of $1500 which is fairly reasonable given the after repair value of the property at $150,000. That’s a 10% cap rate. Read the post on income approach. With that rent there’s almost a $400 cash flow after paying PITI (principal, interest, taxes and insurance). This is key as it alleviates the burden of ownership. You don’t work for your asset. Your asset works for you. The total gain from cash flow at point of sale (which is one year after service) is $4,649.
2. Equity Gain: With every mortgage payment, there’s principal reduction. We have assumed a 15 year term at 4% rate. With that, almost 50% of your mortgage payment every month simply goes back to you in the form of principal reduction. At the point of sale, you have reduced your loan by $4,301, so that’s your extra gain at sale. This value just gets a lot better each year the property is held.
3. Federal Tax Treatment: Normally given that the asset is disposed off after a year, the rent story enjoys long term capital gain treatment; the flip story does not. Based on your tax bracket, the savings from delayed sale could be very significant. Note also that you may be in a situation where if you are flipping for a living you are paying social security and medicare taxes as well. In this example we have used 15% for long term capital gains (which is the current rate) and 40% for income and FICA taxes. Your rates could be higher or lower for the flip model.
So that makes the total gain from renting for a year before sale almost $27,000 where an immediate flip earned you only about $12,500. The difference is clear. Is your irrational fear of dealing with tenants worth losing about $15,000?
Is there never a time to flip then? Of course there is. If you are using your own money to invest in real estate and you don’t want your money to be “stuck in the deal”, then you may want to flip. However, note that flipping is a job. You may own the job but it is a job nevertheless. It is not truly an investment. Once you bought, fixed and sold, you’ll have to do it all over again to make a dime more. One of the most difficult steps in real estate investment is acquiring the right property at the right price. If you are setup for flipping you are setting yourself up to keep repeating the most difficult step over and over again. Once a good asset has been acquired, try to keep the asset and let it generate wealth for you. Do not sell the goose that lays the golden egg.