The Flip Side of Flipping

Many investors were burned this year and last by the falling real estate market. Playing the previously profitable flip game that started in about 2002 (where they would buy at a moderate price, then quickly resell for a profit at a higher price), these flippers suddenly discovered they were in trouble. Real estate they had bought (often multiple properties) was now going down in price, not up. The flippers suddenly, and disasterously, found themselves unable to resell, refinance, or make the payments. As a result, many were forced into foreclosure and some lost their entire investments.

The plight of the flippers has been well documented and noticed, and has had an undermining effect on other would-be property investors. Today, much of the “smart” money is staying out of real estate, playing it safe, so to speak.

That's unfortunate, because as the market falls in most areas, profit opportunities are arising. (The real estate market is not falling everywhere – in places such as Charlotte, NC, for example, prices are growing at close to 3 percent annually.)

However, the opportunities of today are not those of yesterday. Flipping is out. The flip-side or “holding” is in. Here's the play:

As foreclosures increase (due largely to ARMs resetting at a higher payment than the borrower can afford, forcing them out, but also in part due to investors walking away from would-be flipped properties) and lenders take over homes, increasing numbers of properties are kept vacant. (Lenders hold the properties vacant so they can resell them, something few are accomplishing.) The latest statistics I've seen indicate that something close to 3 percent of the housing stock in the country is now vacant (a multi-decade high), mostly as a result of the foreclosures. Since we never have had a real surplus of housing, that means that there are lots of people out there looking for places to live. And that means the demand from tenants for rentals is strong and getting stronger.

As a result, in many areas vacancy rates are falling and rental rates are steadily increasing. In some parts of Los Angeles, for example, residential rental rates are increasing above 7 percent annually.

The combination of falling prices, low interest rates, and rising rental rates provides a strong opportunity for investors. For the first time in nearly a decade it's becoming possible to buy “break-even” properties, even properties with some positive cash flow. Today, in many markets, it's possible with a standard down payment of 20 percent, to buy a property whose cash flow will handle your PITI (principle, interest, taxes and insurance) as well as much of the maintenance and repair costs. To make a profit, all that you have to do is buy and hold until the market eventually turns around. Then just ride the wave to higher values.

Therein, however, lies the rub for some investors: will the market turn around?

I certainly believe it will. The history of American real estate is that it has always gone higher. Historically, in fact, the real estate cycle has averaged around 14 years – 7 up years followed by 7 down years followed by 7 up and so on. If you'll grant that the current down market is about 2 years old, if history repeats itself, it should be about 5 years before things turn around. Of course, markets that fall quickly, as has real estate, tend to rebound quickly, too. So it could be much sooner.

An interesting sidelight here is that buying to hold doesn't require that you wait for the market to bottom out. All you need to wait for is a break-even property. Once you have that, you can comfortably hold it indefinitely and ride out price declines. Barring a deep recession or a depression, which would undermine even the rental market, buying to hold is probably a good strategy, as noted, as long as the property generates sufficient income to cover expenses.

Opportunities seem to be particularly strong in single family homes (not necessarily condos) as well as multi-family housing. Apartment buildings, in particular, seem to be faring well with prices falling as cap rates went up. The advantage seems particularly strong in up to 4 unit buildings where Fannie Mae and Freddie Mac secondary financing may still be available. (For larger units, lenders are requiring more “skin” – equity investments of 25 percent or more.)

Buying to hold is not a new idea. It's been the long-term road to riches for millions of Americans since the Great Depression. Yes, it's slower than flipping. But, it's also steadier.