Flipping vs Buying and Holding — Basic Exit Strategies (Part 1 of 2) by Kevin Dunlap
A question that I am beginning to get asked a lot is what I should do with my homes after I have bought them. Let’s assume you did buy in bulk from a REO package or simply found them through a Realtor or other personal contact. For the purposes of this article, let’s assume you bought them at 70 cents on the dollar.
There are always two schools of thought on the debate of should a person flip or hold onto a property or group of properties. Also, if you are going to “hold” a property, then what will you do with that holding time. If you “flip” a property then you need to be aware of any additional charges that you will acquire with the flip.
There are benefits to both strategies and there are cons to each as well.
In this article we are going to explore both and other potential “exit strategies”.
What exactly is an “Exit Strategy”?
An exit strategy is a term used to determine what you will do with a property once you have acquired it. This is a critical part of doing any type of real estate investing. If you know what you will do with a property (long-term or short-term) depends greatly on how you buy. As an example, if your plans are to flip a property then you will want to buy using a Title Binder. This will save you money on title insurance on the sale.
Some of the most common exit strategies include buying a home or group of homes and then:
•Renting them out.
•Flip or sell quickly for profit
•Rehab and flip
•Rehab and rent
•Lease Option
•Seller / Owner Financing
•Seller / Owner Financing and then selling a Performing Note
Let’s discuss the basics by using a simple mathematical example. Repairs are included in purchase price. He will assume the following information is accurate and purchase was in cash.
Purchase Price: $100,000
Market Rent: $1200
Purchase Price to Value: 70%
Actual Value: $143,000
Equity Value: $43,000
Local Appreciation Rate: 3%
Estimated 1 Year Future Value: $147,300
Short-Term Strategies
Only a few of the exit strategies are short-term. These would be:
•Flip or sell quickly for profit
•Seller / Owner Financing
•Seller / Owner Financing and then selling a Performing Note
In the first scenario of “flip or sell quickly for profit” you are seeking an End User who will purchase your home from you at or near market value. With the new FHA guideline of holding onto a property for over 90 days before selling to someone using a FHA loan being temporarily lifted can make this a very desirable solution.
Here is a link to the FHA website showing this. http://portal.hud.gov/portal/page/portal/HUD/press/press_releases_media_advisories/2010/HUDNo.10-011
Pros & Cons for Short-Term Strategies
Flipping
The biggest advantage of flipping is that you are getting all of your money back and a profit, almost immediately. Thus, you can use your original monies and buy that same type of house again and do the same over and over again. Thus, within a short period of time you have flipped a few homes and made a decent profit.
Of course, in a down market you can sell at below market value and still come out ahead. The holding time should be less because you are offering a lower price than your competitors. For example you can list at 90 cents on the dollar and sell the home for $128,700. This is a profit of $28,700 minus closing costs. Not bad for a few months work.
The biggest con is that since you held onto the property for less than one year you are subject to short-term capital gains tax. The normal American is taxed for long-term capital gains tax at 15%. Short-term capital gains tax is at 33%. Of course this may vary and you should consult your CPA for more information. We will use these numbers for ease of use.
Your profit now becomes only 67% of your total profit (33% in taxes). Thus, the incredible $28,700 you just made is reduced to $19,200. Not too bad, though. You still made a 19.2% return on your investment or if you annualized this three month deal over a year it becomes four times this or 76.8% annualized return.
You may be asking what about the other two short-term strategies? Well, I am glad you asked. The remaining two actually may give you more profit AND more potential buyers.
Seller / Owner Financing (keeping the note)
As we all know in today’s worldwide recession many people have been stricken with poor credit, job losses, divorce and even foreclosures are commonplace. Who are these people suppose to turn to when banks are being very strict on lending practices and requiring substantial down payments. The answer can be you the investor.
Seller Financing (aka Owner Financing) is a common way investors can buy properties without having to use their credit or worry about having too many loans in their name and not qualifying for a new loan due solely to a high number of loans.
The average buyer can also participate in a program like this, but only wanting 1 home for them and their families. A family who was hurt by the recession will need help in getting back into a home either as a first-time buyer, or one who lost their home to short sale or foreclosure and wants to become an owner again.
Here is how it works. Since you are buying the property with cash you have a lot more options available to you (this still does work if you have a loan on the property but you need to really know your numbers first). You buy the home for $100K (repairs included). Then you shop around for home buyers who have bad or no credit. They put down at least 10% to 20% and they move into the home. The home is deeded to them. I would suggest you keep the deed in the name of a trust or LLC for your protection in case of missing payments. Sometimes you can do a Land Contract or AITD.
The purchase price will be set at today’s value, not a discounted value. Thus, in this scenario they are buying the home at $143,000. You will also charge the 20% down payment and now you are getting an interest rate on the unpaid balance. Try to keep the interest rate competitive to a low credit score conventional loan. Maybe 9% to 12%. This should make this deal very attractive to both you and the buyer.
Notice that 20% of $143,000 is $28,600. You have already surpassed your profits from the flip deal and you pay none of this on taxes because you are still owed the remainder of the $100,000 out of pocket expense from buying the home.
The remaining balance on the home is now $114,400. At 10% interest only rate comes to $1000 per month positive cash flow and they pay all interest, taxes and HOA payments since they are the owners. You are the bank. $1000 over 12 months comes to $12,000. In your first 12 months you have made $40,600! Thus, you have exceeded your profits from simply flipping the deal.
When creating the note you should put in a balloon payment so you are not carrying the note for 30 years. The most usual is 5 to 7 years. This means the family will have to sell the home or refinance the home in that allotted time. You can even put in an extension clause in case they do need more time.
Now let’s assume they have made all of their payments and they are ready to buy after 5 complete years in the home. Remember the bulk of your taxable income comes at the time they buy since they are paying off the loan.
This calculation is quite simple (we will ignore taxes on interest earned):
Down Payment + 5 years * $12,000 + remaining balance – 15% taxes on $43,000
$28,600 + 5 * 12,000 + $114,400 – 0.15 * 43,000 = $28,600 + $60,000 + $114,000 – $6,500 = $196,100 return Subtract off your original $100,000 investment and that gives a $96,100 PROFIT
Seller / Owner Financing (selling the note)
You may also want to sell the note. Maybe you keep the note for one year to show good performance history and then sell the note to a note buyer. This will be a Performing Note and you can get top dollar on it. You will sell at a discount maybe 90% of face value but the note buyer is gaining all of those future interest payments, too!
Let’s maintain the same example and sell the note after 12 months of ownership.
The buyer still follows the same example as in the above subsection and this is only for 1 year instead of 5. Let’s see how the math works out.
You still sell at 10.5% interest with 20% down from the buyer (thus the note is secured by 20% equity position). You receive twelve payments of $1000 from the buyer. Then let’s say you sell the note at 90% to face value because it is a performing asset with equity.
Face value of the note is: $114,400 (we are using an interest only note) Discounted by 90% gives a note purchase price of: $103,000.
Your profit will be the sum of all monies which came in over the year. Down Payment + Interest Payments + Sales Price – (Purchase Price) = $28,600 + $12,000 + $103,000 – $100,000 = $43,600
Don’t forget you are paying taxes on the principal gain which is the above value minus Interest Payments and Original Purchase Price. Thus, $28,600 + $103,000 – $100,000 = $31,600 for capital gains tax.
Your tax rate of 15% says you will pay 0.15 * $31,600 in taxes = $4740.
Your total profit would be $43,600 – $4,740 = $38,860
In theory all three of these short-term (or near short-term) techniques can be very beneficial to the investor. The first technique explains the Flip Process. It may appear that the money is not too great in this average deal, but one can not forget that you can do multiple deals. Thus, it comes down to the Flow of Money.
This can be summarized in saying that once you close a deal you already have another deal coming along. You simply buy another property and repeat. Although this does require a lot more effort the actual reward can be astounding. It can also be equally detrimental when you make one or two bad moves.
For a quick sale you must have multiple Exit Strategies. In our next article we will discuss Long-Term Strategies.
Happy Investing!
I hope this helps everyone in explaining the Basics Exit Strategies. For more information visit us on the web at: http://www.tridentinvestmentsllc.com.
Kevin A. Dunlap Mgr. Trident Investments Group, Office: (702) 516-5698 Cell: (702) 591-1784 Email: Kevin@TridentInvestmentsLLC.com
Kevin is a real estate investor for 8 years with specialties in lease options, creative investing, bulk bank purchases & sales, apartment complexes, and buying outside your region of residence. He has operated over 4 investment companies over this time and is currently residing in Las Vegas, NV.
About the Author
Kevin is a real estate investor for 8 years with specialties in lease options, creative investing, bulk bank purchases & sales, apartment complexes, and buying outside your region of residence. He has operated over 4 investment companies over this time and is currently residing in Las Vegas, NV.
admin: Sell-Rent-hold? you need an exit plan for all investments!
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