I often serve as an expert witness in real estate litigation matters and recently had a case that illustrated the challenges of the buy-and-flip strategy for a home featured on one of those cable programs on your favorite real estate home improvement channel. The stars of this show are a young couple; she is the designer, and he is the contractor. One day, while scouting a popular high-demand area of Henderson, Nevada, they located a vacant home with weeds 3 feet high, a leaking pool, dated appliances and countertops, drafty windows, a bootleg garage-to-bedroom conversion, and so on. They purchased the property for $199,000.
The show highlighted the demolition of pretty much everything in the interior of the home, down to the studs. Then a time-motion video showed the process of renovating the kitchen with new counters and appliances, decorative painting and tiling, and pool replastering, making the property the best home on the block. The beautifully completed home was sold to an older couple from out of state for $295,000. Thus, with renovation costs of $24,000, and closing costs of $11,800, the couple claimed that they made a net profit of $60,200 in four months.
That was great until the buyers sued them, alleging that the workmanship of the renovation was deficient and that the property had construction defects that would cost $150,000 to correct. The case ultimately settled, but no follow-up episode of the program acknowledged that the $60,200 “profit” was really a loss of more than $100,000! So, don’t think that those impressive home improvements, “Buy low/sell high” “reality shows” are always the true “reality”!
Although they can be very entertaining and give you some great upgrade ideas for your existing rental properties, these shows are not realistic; they always seem to understate the true costs of acquiring, holding, upgrading, and reselling property. The flippers seem to have significant available cash, which they tie up for four to nine months at zero cost, never placing a value on their sweat equity or time, and ignoring the real costs of commissions and operating costs such as property taxes, association dues, or utilities during the hold period. Finally, when was the last time one of these shows featured a flip that was actually a flop? That outcome is likely at least a third of the time for even the savviest flippers.
In today’s world, more and more demands are placed on your time, so many aspects of rental property ownership are appealing. People want to supplement their current retirement plans (which are predominantly invested in cyclical stocks, bonds, and mutual funds) with additional sources of cash flow, and real estate has a proven track record as one of the greatest wealth-builders of all time. Most folks find that generating a stable income without having to punch a time clock and not being limited to earning an income only for time spent working for someone else is an attractive option. Even most professionals, such as lawyers and accountants, find their income to be constrained by their billable hours. Usually, the more hours they work, the more money they make. But they are limited in the actual number of hours they can work, which limits their income potential, so having ways to generate income outside their main job is beneficial.
Recognizing the Advantages of Owning Rental Property
A great advantage to building wealth through real estate is the ability to use other people’s money (referred to as OPM in Urban Dictionary and on online real estate investing websites). You’ll likely purchase a rental property with the help of financing from a lender; then your tenants provide the monthly funds for the debt service payments and for ongoing operating expenses and capital improvements.
The wide availability and low cost of real estate financing over the past few years make real estate investing a viable, realistic option for virtually everyone. Even when commercial lender real estate loans were difficult to obtain during the financial crisis of 2008–2012, many deals still went through, thanks to seller financing.
Most people purchase real estate by using leverage gained by borrowing from the seller or a lender. Leverage is the purchase of real estate with financing; it usually consists of a cash down payment from the buyer and a loan or other people’s money. Here are the two types of leverage:
Positive: With this type of leverage, you can earn a return on both your cash investment and the entire value of the real estate. The ability to control significant real estate assets with a small cash investment is one of the best reasons to invest in real estate. You might purchase a $100,000 rental home with $20,000 in cash and a bank loan for $80,000, for example. If the home value doubles in the next decade, and you sell this home for $200,000, you’ve turned your $20,000 cash investment into a $100,000 profit.
Negative: Real estate enjoyed a long run of steady appreciation from the mid-1990s through 2007, but if you were unable to make your loan payments and other financial obligations as a rental property owner, the economic downturn of 2008–2012 illustrated the negative potential of negative leverage. Negative leverage can wipe out your entire investment with a 20 percent decline in the market value of your rental property. So if you buy a rental home for $200,000, with $40,000 in cash and $160,000 from your bank, only to see the economy falter or the local real estate market sour, you may have to sell your rental home for less than your acquisition price. If you sell the home for $160,000 after the costs of sale, you may have just enough to pay off the bank, and your cash down payment of $40,000 evaporates. Unfortunately, negative leverage is the experience of many investors and homeowners who aggressively purchased real estate in the early to mid-2000s with little or no cash down and learned during the Great Recession (2008–2012) that their mortgage balance exceeded the current value of their property.
Despite the occasional downturn in real estate nationally, people with an incredible amount of capital have sought to acquire rental real estate in many markets, even during the pandemic that started in 2020. Though opportunities always exist for patient and persistent investors, finding really good, well-located rental properties is competitive and challenging in many urban markets.