Should You Invest in Rental Properties or House-Flipping?



Although the housing market looks like it’s already recovered from the pandemic-induced downturn of last spring, don’t make the mistake of thinking we’re back to normal. With millions of potential evictions looming, a potential mass migration from cities to the suburbs, and historically low inventory coupled with sky-high demand, it’s safe to say the market’s in the midst of a radical reshaping.

So how is all this going to affect investors? It’s hard to say just yet, but we know that some of the numbers are shifting on traditional investment models. Let’s revisit two of the most popular investments — house-flipping and rental properties— and see how they hold up in 2020.

The Pros of House-Flipping

Fast Profits

When done correctly, house-flipping can pay big dividends. According to data from industry analyst Attom Data Solutions, flipped houses in the third quarter of 2019 were bought at a median price of $160,000 and sold at a median price of $224,900. That comes to an average profit of $64,900.

And with many local markets setting record prices right now, despite the pandemic, that average profit could be significantly higher.

Of course, that’s the gross profit. Flippers will have to subtract all their renovation expenses, transaction costs, and carrying costs to figure out their true net profit, and therein lies the difficulty. Once you learn to minimize your costs through discount brokers like Redfin, honest contractors, and local lenders, your profits can skyrocket.

If it takes longer than planned to sell the house, the carrying costs — all the miscellaneous costs of owning a home — can add up fast. And if your renovation lands over budget, your profit margins will suffer. Still, the average profit from a single house flip is greater than the median U.S. household income.

Demand Is Higher Than Ever

One of the biggest risks of house-flipping is if your rehabbed home sits on the market too long. Carrying costs add up quickly, and if your house takes a month or two (or longer) to sell, you could be looking at a losing proposition. The risk of this has significantly gone down in the post-pandemic market, though. Studies have shown that, nationally, buyer demand is at an all-time high and that inventory is still very low, as sellers wait out the coronavirus.

The percentage of homes that sell within two weeks of listing is higher now than it was at the same time in 2019, which is a great indicator that homes are flying off the market.

Building a Network and Knowledge Base

House-flipping is very much a team effort. Successful flippers have a time-tested group of people who they know they can rely on — everyone from wholesalers and agents to lenders and contractors.

That means starting up can be tough. But as you become more experienced, you’ll build a team around you. And as you gain more experience, you’ll expand your knowledge base.

House-flipping is a game of margins, so the better you get at selecting and rehabbing properties, understanding how much renovations cost and how long they take, and what kind of materials and finishes are preferred by your target buyers, the more you’ll be able to increase your profits. As in most things in life, success breeds more success.

The Cons of House-Flipping

Don’t believe the weekend seminars and reality TV shows; house-flipping isn’t risk-free. Let’s look at some of the potential pitfalls of fixing-and-flipping.

Inventory Is Low

Many sellers yanked their listings off the market when the pandemic lockdowns began in March and April. Although the market has mostly recovered, the number of active listings right now is lower than it was at the same time in 2019.

Whether homeowners decided not to sell because of financial problems or if they’re betting on a big post-pandemic boom, a lot of potential sellers just aren’t selling right now.

That means it’s harder than ever to find cheap, undervalued rehab properties. Is it impossible? No. But there are a lot more people competing for a lot fewer properties.

You Could Lose Money

As we stated above, house-flipping requires a significant cash investment upfront, and even the fastest house flippers take a few months to buy, rehab, and resell. If the market fluctuates during that time, that deal could turn into an overpay.

There’s also a significant risk of expenses ballooning out of control. A $64,000 gross profit sounds like it gives you a big margin for error, but a new roof or foundation can easily take a $20,000 chunk out of that.

It Can Feel Like Walking a Tightrope

Let’s say you buy a home, rehab it, and flip it. If you achieve that within a year, your profits are taxed as regular income. That means you’re in a tax bracket of around 22-37%.

But if you hold onto the house for more than a year, the profits are taxed as capital gains, at the much lower tax rate of 15-20%.

That means that, from a tax perspective, it’s in your best interests to hold onto the property longer than a year. But from a risk perspective, knowing that the market is unpredictable, the longer you hold onto the property, the greater chance there is for an unfavorable downturn.

Now add that to the fact that your carrying costs mean that every day you own the property literally costs you money.

Triangulating these dynamics can be extremely difficult — and extremely stressful.

The Ups and Downs of Rentals

House-flipping is a short-term, high-risk game; owning rental properties is the opposite.

Owning rentals can be a fantastic source of a steady, predictable cash flow, but there isn’t a huge potential for short-term profit.

The Pros of Rentals

Steady Cash Flow

Once you get a tenant settled into your rental property, you’ll have money coming in at a steady pace — money that you can use to service the mortgage, invest in other properties, or simply pocket.

There are very few other investments that will generate cash flow right off the bat.

Great Tax Benefits

Landlords have access to a whole spectrum of tax deductions — including expenses, property improvements, mortgage interest, and depreciation. Depreciation is an especially powerful deduction, as it can help you produce a net loss for tax purposes, even if you have a positive cash flow.

The 2017 Tax Cuts and Jobs Act also added another powerful tax deduction for landlords; if you meet certain requirements related to how you structure your business, you could deduct 20% of your net rental income right off the top. There’s an income cap of $157,500, but if you qualify, this is a huge tax benefit.

The Cons of Rental Properties

A Lot of Things Can Change Over the Long Term

The pandemic has reminded a lot of people that unforeseen “black swan” events do happen. You could have an ideal tenant in one of your properties yet it can become unprofitable virtually overnight if the wrong thing happens. And it doesn’t even have to be something as dramatic as a pandemic; changes in the tax code, adjustments to local zoning, or skyrocketing expenses such as insurance or maintenance could take you from the black into the red.

In addition, a location that’s hugely desirable today could be out of fashion in five years. Rentals are relatively stable investments, but over the long term, nothing’s a sure thing.

They’re a Lot of Work

If you own a rental property, you’re either going to have to act as a full-time landlord or hire a property manager.

If you decide to do it yourself, that means getting phone calls at 4 a.m. to unclog a toilet. If you hire a property manager, they’re going to charge a percentage of your rents — often up to 10%. That’s a high price to pay, especially if you have easygoing tenants.

Instability Trickles Up

Even though the housing market has recovered after the initial shock of the pandemic, many Americans haven’t. Renters have been especially hard hit by the economic slowdown, with some experts predicting more than 10 million evictions over the next few months if the government doesn’t extend its eviction moratorium.

There’s no good news here for landlords. Analysts said up to a third of Americans didn’t pay their rent or mortgage payment in July, and that affects a lot of landlords. But the eviction moratorium also prevents them from removing tenants who don’t pay and getting paying tenants into the properties.

To make matters worse, widespread job loss and historically high unemployment means that qualified, financially solvent tenants are in short supply. In short, it’s a very bad time to be a landlord — and things might not improve for months.

House-Flipping Versus Rental Properties

Although renting usually offers an enviable combination of cash flow and predictability, today’s economic climate has hit tenants hard. Even if you found a qualified tenant, they could lose their job any day and be unable to pay their rent.

On the other hand, buyer demand is at an all-time high. Finding undervalued houses to rehab and flip has likely become more difficult, but the rewards have also increased.

There are pros and cons to both house-flipping and investing in a rental property. It’s up to you to decide which investment is best for you.

Thomas O'Shaughnessy About Thomas O'Shaughnessy

Comments

  1. Agree that the current situation has made rentals a little riskier but the vast majority are still making rent payments. You just have to screen a little more thoroughly these days to offset the extra risk.