Switching From Landlord To Flipper -Action Economics

Why I am planning to continue divesting from Rentals and focus on flipping:

How Rentals have worked out for me:

Our plan since the beginning was to buy the houses that no one wants, invest a ton of sweat equity into them, then rent them out and collect rental income that on paper results in close to a 15% return. Get 10 houses and the cash flow is enough to live comfortably off of. Fantastic! In practice it has not worked out that well.

My biggest frustration as most people would guess is tenants. It’s devastating to come back to a property a year or two later and see that tenants destroyed your hard work.

From a cash flow standpoint the 15% figure is a lie and always has been. It makes assumptions that aren’t true.

It assumes that the tenant will always pay (they don’t).
It assumes nothing expensive will break (it will).
It assumes the cost to turnaround a property after moveout will be covered by the security deposit (it won’t).
It assumes that the sweat equity was free (it wasn’t).

Example:

I bought a house for $30,000 and invested $20,000 into it as well as Mrs. C. and myself working 40 hours a week on it for 3 months. We rent the house out at $1,100/mo

Assuming $150/mo for taxes, insurance, and maintenance, and at the time a $370 mortgage, leaving $580 per month in cash flow, roughly $7,000 per year or 14%.

But What if the tenant doesn’t pay for 2 months of the year? All the expenses stay, and I’m out $2,200. This drops the cash flow to $4,800 or 9.6%.

What happens when the water heater goes out? That’s another $1,100 gone. Now we are at $3,700 or 7.4%. It’s much worse when it’s a furnace or a roof. You can’t deduct the expense in 1 year and it takes multiple years of cash flow to cover.

The tenant moves out after 1 year and there are two broken windows, all the doors are broken, the stove is destroyed, and the walls need repainted. Goodbye $3,000. Now the property only made $700 or 1.4%. But there’s more.

I never counted the sweat equity. I said the house was worth $50,000. It wasn’t. At a value of $20/hr each we added $20,000 in labor hours. Most of that labor was more productive and if we had the house appraised it likely would have been for $90,000 not $70,000. Now compare those above numbers to a $90,000 base. At the water heater when we had $3,700 of income against $90,000 that is only a 4.1% return. I can get 3.6% in T Bills!

The numbers get even worse with the numbers available today. For a similar home I would likely be spending $30,000 to $50,000 more.

Trapped Equity:

The next problem with this equation is the trapped equity. The property becomes worth more, but in order to access it I have to spend $7,000 for a cash out refinance. Even then, it is likely the new loan will have a higher interest rate, so it doesn’t make sense to access the equity and give up the rate. Our money is trapped in the property and we can not redeploy it to other investments.

Value from the real estate transactions we do come from several factors:

Value from buying the property below market rate
Value from our rehab
Value from rental income
Value from appreciation over time

Very little of this equation has worked out to be value from the rental income. We have gotten significant equity from appreciation over time, however that appears to be slowing down in our market. Covid along with some other factors accelerated it here, but it appears to be leveling off. At any rate in order to get the value of appreciation over time we have to hold the property, which generally means we have to have it rented out.

If we focus on the other two sides of the equation we don’t have to worry about tenants. We add value by buying below market and we add value through the rehab, then we sell and get our equity back.

Supporting Home Buyers Vs. Renters:

In general I want people to be financially successful and it is proven that owning a home is a major building block of building wealth. Home owners have 39 times the wealth as renters. The median household net worth is $192,900, the median household net worth excluding home equity is $57,900. If I want people to build wealth then encouraging home ownership is a better activity for me to engage in than acquiring rental properties.

If I pay cash for houses no one wants and rehab them enough so that they can get a loan on them, but not to the extent that we overbuild the neighborhood, then we make a profit and someone is able to become a home owner.

One of the primary reasons these houses end up as rentals is because they can only be purchased with cash by an investor because the properties are in disrepair. Of all the houses I have purchased only 1 would have qualified for a loan at the time of purchase.

The Entry Level Flip:

I hate the flips that most people think about. People take a house, generally in a challenged neighborhood and put in all new flooring, granite countertops, cam lights, and add a 2nd bathroom. In my area these flips distort the market and are often large outliers.

My goal is to buy the house and fix all the things needed for it to qualify for a loan. Rather than make everything new and perfect I make everything serviceable. The systems need to work and the home needs to be clean, safe, and functional.

Moving Forward:

This year we have sold 2 single family rental homes to owner occupants. As we prune our portfolio it is likely we will retain a small handful of single family homes that family/friends live in and will keep our multifamily properties. Each single family house we sell unlocks equity and reduces our long term liabilities. I am open to selling our 7 unit commercial property after we repair the unit that got hit by a car.

Any new investments will likely be fix and flips. There is also a good chance it will be years before we buy more investment properties. I have a busy work schedule ahead of me with some interesting projects on the horizon. The mobile home park we purchased has plenty of real estate projects to work on as well. We need more life energy at this point in time and fewer projects.