How I Explain Profits in Flipping: It’s Not What You Think

How I Explain Profits in Flipping: It’s Not What You Think

When most people think about house flipping, they imagine rehabbing a property, making it look pristine, and then selling it for a hefty profit. However, the reality of making money as a flipper is quite different from what you see on TV or read in flashy articles. The truth is that rehabs often lose money, and it’s the discount at the time of purchase that truly creates profit.

The Myth of Rehab Profits

Let me share a story about Gary, a new investor from Orlando. Gary works as a business analyst and recently received a six-figure inheritance. Eager to grow his retirement portfolio, he decided to dive into the world of flipping houses. He had done his homework—researching properties, estimating rehab costs, and studying the market. When Gary came to my office, he was laser-focused: “All I want to do is flip houses,” he told me. “I don’t want any rentals. I don’t want any other options. I just want flips.”

I appreciated his clarity, as most investors aren’t so sure of what they want. However, as we talked, I noticed a common misconception in Gary’s approach. He believed that the profit in flipping comes from the rehab. He thought that by adding high-end finishes, the value of the house would skyrocket. While there’s a grain of truth to that, it’s a classic case of confusing correlation with causation.

The Real Source of Profit: Purchase Discounts

The reality is that the profit in a flip comes from purchasing the property at a significant discount. This discount is what creates the opportunity for profit, not the rehab itself. Rehabbing the property allows you to realize the potential of that opportunity, but without a discount at the time of purchase, any rehab you do will likely lose money.

To help Gary understand this concept, I gave him three examples:

Example 1: The Pool Myth

Imagine you put in a pool that costs $40,000. Gary guessed it would add about $45,000 in value to the home—a reasonable assumption if you’re considering the time and effort involved. However, in reality, the value might only increase by $13,000. This means you would lose $27,000 on the pool alone. This example hit Gary hard, making him realize that rehabs often don’t create value; they lose it.

Example 2: High-End Finishes Don’t Always Pay Off

Let’s say you buy a house in a neighborhood where most homes are around 1,500 sq ft and sell for $200,000. You purchase a similar property for $175,000 because it needs work. You then invest $75,000 in high-end granite countertops, solid wood floors, and smart home features. Now you’re $250,000 into the property. Do you think you’ll be able to sell it for $300,000? Unlikely. The appraiser won’t justify a $300,000 value in a neighborhood where all the comps are selling at $200,000. In this scenario, the rehab will cause you to lose more money than if you had done nothing.

Example 3: The Cost of New Construction

Consider a vacant plot of land in the same neighborhood. The cost to build a new 1,500 sq ft home might be around $180,000. Assuming a 15% sweat equity, that adds up to $27,000, putting the value of the lot at a negative $7,000. But lots don’t sell for negative prices. This is another case where the market discounts the sweat equity and costs, demonstrating that discounts at the time of purchase are where profits truly lie.

The Critical Role of Comps in Flipping

One thing I emphasize when teaching new investors like Gary is the importance of understanding comparable sales, or “comps.” Comps are recently sold properties similar in size, condition, location, and features to the property you’re considering flipping. Comps are vital because they set a benchmark for what your property might realistically sell for after rehab.

In Gary’s case, he initially thought that upgrading a property would naturally increase its value significantly beyond the neighborhood comps. However, this assumption is a common pitfall for novice flippers. No matter how much you invest in upgrades, your property’s value will largely be dictated by the surrounding properties’ sale prices. Over-improving a house can actually hurt you because you end up investing money in features that buyers in that area aren’t willing to pay a premium for.

For instance, if every house in the neighborhood sells for around $200,000, and you pour money into upgrades hoping to sell for $300,000, you’re setting yourself up for disappointment. The market simply won’t support that price, and you’ll end up with a property that sits on the market, costing you more money every day it doesn’t sell.

The Psychology of Homebuyers and Market Dynamics

Understanding the psychology of homebuyers is crucial in the flipping business. Many buyers are not looking for the most luxurious home; they want a good deal. This is why properties that are priced competitively, in line with neighborhood comps, sell faster and more consistently than those priced higher due to excessive rehabs.

This market dynamic is why rehabs often don’t pay off as expected. Buyers will only pay what the market dictates, regardless of how much you’ve invested in the property. It’s a tough pill to swallow, but once you understand this, you can strategize accordingly.

Another factor to consider is that most homebuyers are not investors; they are end-users. They care about the home’s aesthetics and functionality, but their willingness to pay above market value for upgrades is limited. This is why the return on investment for luxury finishes is often lower than expected. The market tends to reward essential repairs and updates that bring a property up to par with its comps rather than extravagant improvements.

How Builders Make Money

Even after understanding the concept, Gary still had questions. He asked how builders make money if new construction isn’t profitable. The answer is that builders buy land at steep discounts and sometimes hold onto it for long periods, allowing it to appreciate. They also benefit from economies of scale—buying land by the acre and selling it by the lot, similar to how a bar buys whiskey by the barrel and sells it by the shot.

Builders also profit from another critical aspect: controlling costs. They typically have established relationships with suppliers and contractors, allowing them to get materials and labor at reduced rates compared to what an individual flipper might pay. This control over the cost side of the equation is crucial because it allows them to maintain profitability even when selling at prices dictated by comps.

Moreover, builders often work in markets with different dynamics than flippers. For instance, they may be involved in large-scale developments where the land value appreciates as the development progresses. They might also focus on emerging markets where new infrastructure is being developed, making the land more valuable over time.

The Psychology Behind It

Gary’s next question delved deeper into the psychology of it all. He asked why rehabs add less value than they cost. The answer lies in the concept of financial versus psychological payoffs. Most homeowners renovate their homes for personal satisfaction, not to make money. This psychological payoff influences the market to price rehabs lower than their actual costs. It’s similar to how we pay teachers or caregivers—they may not be well-compensated financially, but they gain immense psychological satisfaction from their work.

In the world of real estate investing, psychological payoffs can cloud judgment. For instance, a homeowner might add a luxurious kitchen with the best appliances, not because it will increase the resale value but because they want to enjoy it themselves. When that home eventually goes on the market, the owner might be disappointed to learn that buyers aren’t willing to pay a premium for those personal touches. The market values what it values, and personal tastes often don’t align with what the market is willing to pay.

This disconnect between cost and value is why flippers need to stay objective. The goal is not to create your dream home but to create a home that sells at a profit. This often means making cost-effective improvements that appeal to the broadest range of buyers, not necessarily the most luxurious or personal ones.

The Flipping Show Fallacy

At this point, Gary asked why flipping shows on TV focus so much on the rehab. The answer is simple: entertainment. Watching someone smash through drywall with a sledgehammer is exciting. Watching someone run numbers on a spreadsheet? Not so much. Real-life rehabs are far less glamorous, and profits don’t come from making a property look pretty—they come from buying it at a discount.

Flipping shows often create a misleading narrative, suggesting that the more dramatic the transformation, the higher the profit. However, they rarely dive into the financial nitty-gritty that reveals the true source of profit. In reality, the most crucial part of a flip happens long before the sledgehammer swings—during the purchase negotiation.

These shows also often gloss over the holding costs, financing costs, and the real risks involved in flipping. They make it seem like anyone can walk into a property, make a few cosmetic changes, and walk away with a fat paycheck. But as anyone who has been in the trenches of real estate flipping knows, the reality is much more complex.

The Importance of a Solid Exit Strategy

Another critical lesson I imparted to Gary was the importance of having a solid exit strategy before purchasing a property. Flipping is not just about buying low and selling high; it’s about understanding your market, knowing how long it will take to sell the property, and planning for contingencies if things don’t go as expected.

For example, what if the market cools down, and homes in your area start sitting on the market longer than expected? Do you have the financial reserves to cover holding costs for an extended period? What if interest rates rise, making mortgages more expensive and reducing the pool of potential buyers?