Monday, January 25, 2016 / by Bill Berning*
As a real estate investor, you have a choice: buy and hold a property or fix and flip it. The decision may not be as clear cut as you think.
When you decide to invest in real estate, you have to make the decision whether you want to renovate and resell a property (fix and flip) or want to become a landlord to offset your costs as you wait for the property to appreciate (buy and hold). Which decision is best for you depends on your goals, experience, and risk tolerance.
You have two options whenever you purchase a property as a real estate investment. You can renovate the property and try to resell it for a quick profit, or you can keep it for a longer period of time and convert it into a rental to offset the costs of ownership and maybe even create positive cash flow. Both options have upsides, but they also have drawbacks.
It really comes down your unique situation. What do you hope to accomplish by investing in real estate? Do you have any experience with buying and selling real estate, renovating, or being a landlord? And, how much of a risk you are willing to take? Before you invest, you may want to sit down with a financial planner to discuss what makes sense for you financially.
Ultimately, it’s up to you whether fixing and flipping or buying and holding makes the most sense. Here are seven things you need to consider before committing to one strategy or another.
Are you looking for a short-term investment, or are you willing to hold on to it for cash flow and the appreciation? How you answer that question is a determining factor in whether the buy-and-hold or the fix-and-flip approach is the best option for you. If you want a short term investment, you are probably best suited to flipping because ideally you would want to renovate and sell within a 3- to 6-month window.
On the other hand, if you have the patience, buying and holding is a good strategy. Not only can you wait for the property to appreciate, but if you have tenants, you can create a steady stream of positive cash flow to cover the expense of holding on to the property in the meantime.
There is always a risk when you invest, but fixing and flipping tends to be a little riskier than buying and holding because your profits depend on keeping renovation costs and soft expenses, such as finance charges and utilities, to a minimum. Plus, as with any renovation project, unanticipated challenges can blow your budget.
But, if you are willing to take the risk, you could end up with a bigger payday, especially if you buy an undervalued distressed property. You also obviously reap the financial benefits sooner than if you sell in a few months versus hold a property for years.
Holding onto a property gives you the option to ride out a down market and sell for the maximum profit. Again, you have the potential for positive cash flow. The downside to the buy-and-hold strategy is that if you need cash right away, you might have to sell for a loss.
Successfully buying and holding properties depends on renting the property out to cover your expenses. Buy well, and you may be able to not only cover your expenses but also turn a tidy profit every month. That extra income can be used to pay down the mortgage on the property, which in turn means a bigger payout when you sell.
With a house you intend to flip, the cash flows out. Period. There is no opportunity to create a monthly income from the property, but then again, the plan isn’t to sell as soon as possible.
Tenants can be a blessing and a curse. Their rent helps cash flow the property, but it takes time and energy to manage rental properties. Besides paying the mortgage and other expenses, you have to market the property when it’s vacant, screen tenants, collect rent, evict the tenants that don’t pay, and so much more. You earn every penny that a rental property generates.
If you plan to flip the house, though, you don’t have deal with tenants, and that can be a plus - especially if you don’t have the personality or patience for it. (Hiring a property management company can alleviate the stress and work of a rental property, and it can make buying and holding an option for someone that doesn’t want to deal with tenants.)
Even in the wake of lending law reforms, it’s much easier to get long-term financing for a rental property than for a property you intend to fix and flip. If you don’t have the cash to purchase a property outright, short-term financing, or hard money loans, can be expensive. Some hard money lenders charge up to 20 percent interest.
That makes it even more imperative that you keep the renovations on schedule when you flip properties. Every month you fall behind schedule, you risk a hefty payment to a hard money lender, assuming you have to go that route.
The cost of selling
At some point, you will likely sell the investment property, and when you do, you will have to pay real estate commissions, typically 3 percent to your agent and 3 percent to the buyer’s agent. The seller is also responsible for title insurance, closing fees, recording fees, and possibly other expenses such as HOA transfer fees.
Regardless of whether you buy and hold or fix and flip, when it comes time to sell, you will have to pay these fees. The difference is when you pay. When you flip, you are paying those fees within a few months of your purchase. If you’ve mismanaged the renovations or had unexpected expenses that have blown your budget, these closing costs may cut deeply into your profits.
Short-term capital gains (gains on assets owned for less than one year plus one day) are taxed at a higher rate than long-term capital gains. The rate depends on your tax bracket, but the short-term rate will be higher. If you are flipping properties, you need to factor the tax implications into your budget.
Buying a property and holding it for more than a year and a day will reduce your tax burden. Keep this in mind when planning what investment strategy.