Why Flipping Properties in a Dropping Market is a Dangerous Idea

Recently I have been contacted by a number of graduates of real estate investment "schools" to assist them with their properties. There are some common themes that I've seen and as a long time (25 years) real estate investor in 3 different countries, these themes break my heart. All too often these new investors are people who have lost their careers to the deep recession and they are being encouraged to tap into their 401Ks and IRAs to invest in real estate as a way to make a new start and maybe to make up for losses suffered in the stock market meltdown. Many would have been better off staying in the stock market given the recent recovery and the fact that they are now suffering the double whammy of having gotten out at the bottom and investing in something they do not understand. In addition to my real estate practice, I am a financial advisor and I am simply not permitted to accept real estate investments totalling more than 10 - 20% of a person's investable assets. Yet I am seeing people who are taking their whole retirement account and investing it speculatively in real estate flipping. This is a dangerous game in a rising market and can turn deadly in a falling market.

Many of these flipper school are teaching people to go out and find deals that they can buy for under market value and then with some fixing up sell for a tidy profit. There are a number of flaws in this approach. First, when foreclosures and short sales were uncommon it might have been possible to find some dislocations or inefficiencies in the marketplace. Now, at least in my Chicago market, these properties are widespread in the MLS and in the end the market is pretty darned efficient. The schools teach their "investors" to try to locate distressed properties off-market and negotiate a better than market price. Apart from the obvious ethical issue, this is way harder to do in today's market. Then the investor has to get the product back out into the market and ideally fool somebody into paying too much or more realistically selling into a falling market. As I said the market is terribly efficient so the whole premise is questionable.

Now let's say the investor finds a property that is below market value and then puts money into it to fix it up since it must be in pretty sad shape to be bought below market. (Is it really below market or just discounted for condition?) In the meantime, the market is falling so what was a discount to the market now is less of a discount and investments have been made, but the property has to be priced to compete in the marketplace with other similar properties which have fallen in value. Our hypothetical investor buys a house for $100,000 and invests $50,000 to get it into shape to sell for $200,000. (use your own numbers, I'm using my market). Meanwhile the price in the marketplace has dropped 10% since the original property was purchased and rehabbed. In order for the original economics to work, I now need a 10% lower original price that I don't have, but more importantly the higher-valued finished product price is lower in the marketplace. If prices have dropped 10%, my new market price is $180,000 and my gross margin has dropped from $50,000 to $30,000. That's 40% drop. My transaction costs of 8 - 10% haven't changed so instead of having a net margin of $30,000, I now have a net margin of $12,000 or 8% not 20% even though the market has "only" dropped 10%. Throw in the fact that my investor has neither experience in buying/selling real estate nor in rehabbing and chances are very good that the 8% is gone too.

These investor schools can issue all the disclaimers they want about the risks, but the pitch is always the same. "Look how easy this is....Anybody can do this.....Look how much money I've made doing this...". Fact is, real estate investing is not a game for amatuers and the fact is also that many of these schools teach people how to rob their retirement funds to do something where few will succeed. Personally I find this reprehensible and it will just give real estate another black eye that it certainly doesn't need.

Real estate investing is a road to long term wealth and has made many people wealthy. Usually this wealth builds over time through the gradual rise in property prices, judicious use of debt leverage, repayment of the loan principal by renters and tax-deferral of capital gains and depreciation recapture through 1031 exchange. This stuff is all too boring to teach and won't appeal to those people who are trying desperately to recover their portfolios with looming retirement and little chance of finding a new job which will replace their old income. Real estate investing has been really good to me, but is has been an accumulation of over 25 years.