How is flipping houses profitable? by J Scott

Answer by J Scott:

I'm a professional house flipper who has rehabbed/flipped and built over 150 houses.  I'm also a best-selling author on the topic (The Book on Flipping Houses  and The Book on Estimating Rehab Costs).

There are two main ways that house flippers are able to overcome the (very real) problem that most renovations don't increase the value of a property by at least 100% of the cost of the renovations:

1.  First, most house flippers are skilled at buying well below market value.  If you buy a house that requires $50K in renovations for $50K below market value (value after renovations), then like you surmised, there is no profit to be made — after the renovations, the house is worth what you paid plus what you spent in renovations.  This is what many homeowners will do when they purchase a house. 

But, an investor would attempt to buy that same house for (as an example) $200K below market value (value after renovations), instead of just $50K below market value.  That way, after the investor puts $50K into renovating the property, he still has $150K in equity.  Some of that will get eaten up by fixed costs (purchase costs, holding costs and selling costs), and the rest of that equity is profit in the investors pocket.

One reason a smart investor can purchase properties well below market value is by focusing on properties that have little demand (i.e., little competition for the investor).  As an example, a house that requires $50K in structural work to be inhabitable might be so difficult for other buyers to purchase that a smart investor can pick up that property for much, much less than $50K below market value (and keep the spread as profit).

Now, you might wonder why a homeowner (or another investor) wouldn't come in and pay closer to market value, spend $50K on structural repairs and then have some equity in the house.  The answer is that, if a house is in very poor condition, a homeowner will likely be unable to get a loan on the property; without cash, a homeowner can't compete for this type of property against an investor who does have cash.  And other investors are often scared of properties with major issues, so even other investors are often not competition for the properties in really bad condition.

In other words, most cosmetic repairs don't pay for themselves in value added to the property; but, other types of repairs (structural, additions, basement finishing, etc) can often more than pay for themselves because there is little competition and the investor can pick up the property for a great price.

2.  The second way that an investor can overcome the issue of renovations not paying for themselves is to do the types of renovations that DO pay for themselves.  There are certain types of renovations that — because they change the fundamental demand for the property so greatly — can easily add more value than they cost. 

Some examples here are additions (adding square footage), changing floorplans (making a house more functional), adding bathrooms or bedrooms (changing the buyer demographic), tearing down and rebuilding, etc.  These types of renovations put the property in a new category, where the value of the house isn't incrementally increased, it is increased via step-function to a new class of property.

Because these types of renovations are difficult, risky, require experience, require vision, require cash, etc., most homeowners won't undertake these types of renovations and therefore can't "unlock" all the additional value themselves.

So, to summarize, the two ways that flippers make money in this business are to make money when you buy (i.e., purchase so far below market value that you have equity after the renovations) and/or make money when you sell (i.e., increase the value so much with the renovations as to put the property in a new class when you sell).

How is flipping houses profitable?