I recently read that “house flipping” has reached a ten-year high, which caused me to reflect back on the financial devastation left in the wake of the Housing Bubble and Great Recession from a decade ago. Apparently, some would be investors have already forgotten one of the most important lessons from that difficult economic experience: the use of excessive debt matters when evaluating the risks associated with attempting to generate returns. While real estate investing does have its place in a sound investment strategy, house flipping using other people’s money is nothing more than speculation and should be avoided by investors who are serious about building long-term wealth.
What’s the Difference Between Investing and Speculation?
Generally, speculation involves taking on extreme risk for the possibility of earning significant rewards in a short time frame. On the other hand, investing assumes an amount of risk commensurate with earning solid returns over a long time frame. Real estate and stock investors rely on patience, discipline, and perseverance to identify reasonably valued assets with the expectation of holding them for several years or more while capitalizing on current cash flow and appreciation.
What Makes House Flipping Speculative?
There are several factors that drive speculation in flipping houses. But then, you can just substitute stock speculation, and the same factors apply. While both can lead to significant profits, they can also result in devastating losses – just ask the victims of the housing bubble in 2008 and the 2000 dot com bubble. These factors were present in both.
Rising Prices: Speculation almost always relies on significant changes in price regardless of changes in the value of the underlying assets. Between 2005 and 2008, a substantial portion of the housing bubble was a result of speculators (primarily house flippers) driving up the prices of houses beyond their real market value. As with any bubble, prices can only climb so far before investors determine the risks far outweigh any potential return at which time prices come crashing down. The problem for speculators is there is no way to predict when that will happen.
Quick Profits: Speculators are attracted to the potential for profits to occur within a short time frame. For day traders, it’s just a few hours; for stock speculators, it’s just a few weeks; for house flippers, it’s a few months. Waiting any longer for anticipated price changes to occur increases the cost (reducing potential profits) and the risk of holding the asset.
Leverage: With most speculative endeavors, leverage is used to increase potential returns while limiting the out-of-pocket investment of the speculator. This can work fabulously when prices are rising. But, when prices are declining, it could be disastrous. Research reveals that two-thirds of the home flips during the housing crisis were financed with loans by people with good credit who were forced to walk away from their investments.
House Flipping Today: Risks are Up and Returns are Down
Although house flipping has reached a new peak, investors are reaping smaller rewards while taking on greater risk. Higher home prices, increasing competition, and low inventory are driving up both the stakes and the risks. Also, while fewer house flippers are financing their ventures, the cost of financing house flips for those who still do is nearly triple the cost of funding a conventional home loan. That’s because flippers now have to turn to private lenders, who charge as much as 10 to 12%. That’s very different from a decade ago when flippers could use cheap and easy money to finance their trades.
These factors can reduce both the return on equity (ROE) for investors using their own capital and the return on capital (ROC) for investors using a combination of cash and debt. Except for a few regions of the country, margins are tightening for house flipping, forcing investors to rely more on market fundamentals and less on price changes, which are not nearly as pronounced as they were over the last 10 years. In fact, an increasing portion of the house flipping market is being consolidated under institutional investors who have the capital and resources to benefit from smaller margins on a large number of properties.
Warren Buffett once said famously, “You never know who has been swimming without their trunks on until the tide goes out!” Well, today there appears to be an increasing number of would-be investors who are wading in at House Flipping Beach without proper swimming attire. Only time will tell whether the economic tide will reveal their investing indiscretions.
Very few people have built their wealth on stock speculation or trading. Building true wealth is a process that occurs through adherence to proven investment principles and practices, patience and discipline. The bottom line for investors is that, unless you are working with capital far more than what you need to secure your financial future, there is no room for any type of speculation in your retirement investment plan.
