Friday, May 10, 2019

Investing Versus Flipping - Who Wins Consistently?


It is hard to feel sorry for Real Estate Flippers - who hope to make a quick buck with no work.

The something-for-nothing mentality pervades our culture, and it is a dangerous mentality.  Dangerous, because in most cases, the people who engage in this sort of thinking end up losing their shirts.   In the news today, an article about young real estate flippers in silicon valley - young enough not to remember the debacle of 2009 or 1989 - are discovering what others have learned decades before - that houses are not made of gold, and real estate has other places to go but up.   They are also learning that easy money isn't always easy.

People in Vancouver are apparently discovering a similar thing, as new tax laws and regulations are slowing down the flood of Chinese investment in Real Estate in that town.   Different city, different scenario, but the same effect - what goes up dramatically in price, eventually comes crashing back to earth.  How hard a crash remains to be seen.  But apparently something is starting.

To anyone who has been on this planet for more than two or three decades, the pattern is familiar and not unexpected.  What goes up must come down.  And if you leverage yourself, you can make a fantastic amount of money if you are lucky, or lose everything you have.  It is not investing, it is gambling, and yes, sometimes gamblers win big, but most of the time, they lose.

An interesting footnote in the article is that one lady paid $25,000 for "coaching" on how to buy and flip houses.   This tells you where the real money is to be had, at no risk whatsoever.   You get ten people to attend your "flipping" seminar, and you've made more money that you would risking real cash and your credit rating buying actual houses.   Get 100 people to attend, you're making some serious dough.   Similarly, the guy putting on the HGTV show about "house flipping" isn't risking any of his cash on real estate - he make sure-fire money from advertisements for a show selling the idea of flipping real estate.

The "housing twins" probably make more money from their salaries as reality-show actors than they do as actual house flippers.

It is like the gold rush in 1849 - the people who made the real money were not the gold miners, but the folks selling them mining supplies, like Levi Strauss, who sold durable blue jeans to miners.   The support infrastructure people were who really made out, not the folks taking the big risks for long-shot payouts.   Better off to make a little money on each of a lot of small sure-thing transactions and to risk it big for a single "what if?"

It is like the shouting guy on the financial channel, shouting "buy" and "sell" to stock flippers.   He used to be an actual investor, running some sort of hedge fund.  Apparently that didn't work out very well.  So now he goes on TeeVee and shouts for other people to buy into the something-for-nothing mentality and makes millions every year in salary.  That sounds like a much better deal than risking your life's savings buying and selling stocks.

And that right there is the difference between flipping and investing.   Our society pushes the former concept as it is glamorous and shows very quick results.  You buy the right stock and overnight it doubles in value and you are  freaking genius.  But as I noted before, never confuse being smart with being lucky.   I've bought stocks that have gone up over 5000% in value - it doesn't mean I am a smart stock picker, only that if you buy enough stocks, eventually you end up picking a winner.

People want to see immediate results.   You put $100 into your IRA or 401(k) and check the balance the next week - it is up to $100.01.   Boring mutual funds and stocks aren't going to increase in value very quickly.   Many people - believe it or not - give up on investing when their $100 investment in their IRA doesn't turn into a billion dollars overnight.   There has to be a better way to make yourself rich, right?   And they are hearing, all the time, about these other people who make it big in the stock market or real estate.  Why can't they too be one of the big-time players?

The casino mentality strikes again.  And any good casino publicizes the "winners" of their games, just as the lotteries do.   No one talks about the legions of losers, the broken families, the dashed dreams, the folks who spent every last nickel at the casino and are now destitute and living on Social Security.  That isn't glamorous - but it is reality - and it is a reality that you will experience if you visit a casino often enough. Because even the "big winner" touted on the billboard, who walked away with a new (stripped) Camaro, has dumped more money into that casino over the years than he would have paid to simply buy it.  No one wins at gambling, except the house.   Good old Levi Strauss!

But what is the difference between flipping and investing?  Flipping - anything from stocks, to bonds, to houses, to antique cars, or gold or whatever - is predicated on the ability to spot undervalued commodities and then buy them for cheap and turn around and sell them for more.   It is very hard to do, without a working time machine.  In overheated real estate markets (or stock markets) where prices are going up at double-digit rates every year, it seems pretty simple - no matter what you buy and sell, it goes up in value and you are a genius.

The problem is, of course, that eventually overheated markets correct, and if you have been "doubling down" your bets all along, plowing your profits into flipping more and more of [fill in the blank] you end up being the guy still standing when the music stops.  We saw this in 1989 and again in 2009.  Some schmuck buys a condo and flips it.  He makes $20,000.  He plows that into a townhouse and flips that.  He makes $50,000.   He buys a small house and flips that, and makes $80,000.   And so on and so forth, until he is buying multi-million-dollar mansions and.... the market crashes, leaving him with a lot of debt, no buyers, and no choice but to walk away from an "upside-down" mansion that is worth hundreds of thousands less than he paid for it.   He is wiped out, utterly.

Investing, on the other hand, is buying things for the long-haul, and buying them for the income as well as the capital gains.  When you buy a property and rent it out at a positive cash-flow, it really doesn't matter if the market goes up or down - you can still afford the property and you are still making money from renting it.   Oh, right, you also get a neat depreciation deduction on your taxes, which as a young professional may knock you down a bracket or two.   Compare this to the flipper, who has to pay horrific capital gains taxes, unless he can do a Starker deferred exchange on every property.

Or with stocks, you buy a stock that pays a nice dividend.  You don't care much whether the price goes up or down from day to day, so long as those dividend checks keep coming every quarter.  Years later, you sell for a nice capital gain - because you held for the long haul, not the short-term (and your Capital gains taxes are lower as a result!  Even the IRS hates flippers!).  And over the long haul, you make more money than the buy-and-sell flipper, who after making one big score, churns his account down to zero, hoping to find "the next big thing" and then doubling down again and again as his losses mount.

Eventually, as an investor, you might sell down the road, particularly when you see the market getting overheated and the idiotic "flippers" getting into it after it has gone up in value.   Since you've held your property (or stock) for a long time, you end up making huge gains, not marginal ones.   And since you have a positive cash-flow, you aren't in the situation which most (if not all) flippers are in, where they have to sell and sell now in order to avoid paying huge debt service on their notes or because they are leveraged with options.  As an investor, if prices go down, you can simply shrug your shoulders and keep cashing those rent checks (or dividend checks), and figure you'll sell out later on when the market cycles back up.  As a flipper, you end up in bankruptcy court.

When we set out to invest in real estate, we wrote down a set of rules for investing - principles of our investment corporation.   We used these principles as a guideline to avoid getting into trouble and to avoid losing money.  What sort of principles are these?  I don't have a copy of that document on my hard drive (this was, after all, 20 years ago) but it went something like this:

1. We will never buy a property we ourselves would not live in. 
2. We want our properties to be an asset to the neighborhood they are in, not a detriment. 
3. We will not buy a property that does not have an immediate positive cash-flow. 
4. We will not buy in an overheated market.  If it costs less to rent than buy, we will not buy. 
5. We are not slumlords.  We are not interested in marginal tenants, section-8, poor credit, or exploitation of the same.  We leave that segment of the market to others (see #1 above). 
6. We are investing for the long-haul.  We are not buying real estate to flip it for a quick profit, but as a long-term investment. 
7.  We will always rent for slightly below market to attract and keep good tenants.

And so on and so forth.  There were probably other things, but I forget them.  The point is, you have to have a guiding philosophy in your business - a lodestone if you will - that provides you with a compass that points to the general direction you want to move in.   I had a similar Desiderataif you will, for my Patent practice - and on more than one occasion, reading it focused my mind and helped me make decisions as to such things as problem clients and whatnot.

But the main thing is, I made a lot of money at little or no risk to me.  Unlike the flipper with his high-interest rate mortgage, I didn't have to hope that I could "flip" my properties quickly in order to make a profit (before overhead costs ate up any gains).  My only concern was vacancy, and I learned early on to price my rents attractively so that tenants never left.

It may have been a bit sneaky, but once they rented from us, they rarely left, unless they were moving away.  Every year, when the lease was up, they would go through the Real Estate pages in the Post and realize that even if they wanted to move, they would have to pay a lot more in rent (in addition to moving costs).   So many landlords try to jack the rent every year.  Our agent handling our remaining property tries to do this, with predictable results - the tenant leaves, the property remains vacant for months, it requires painting and freshening, and eventually rents for an amount less than the jacked rent offered the previous tenant.   Net result?  Thousands in lost rental income.  Being greedy never works out!

And maybe that is the deal right there.  Pigs get fat, hogs get slaughtered, as my tax law professor used to say.  If you want to make "the big score" and make big money overnight, there is a very, very small chance you might do this.  Or you might do it for a while.  But like disarming bombs, eventually one blows up in your face.   It may not be sexy or spectacular to invest for the long haul, but overall it is a lot safer, a lot less stress, a lot less work, and oh-by-the-way, you usually end up making more money than the flippers.

I learned this lesson back in 1989.   A young attorney friend of mine, who was several years ahead of me in law school, was making big bucks as a Patent Attorney.   He also was flipping houses on the side.   He started at the Patent Office, buying townhouses and renting out rooms to fellow Patent Examiners (new Examiners are always looking for a cheap place to stay in the DC area, before that first paycheck arrives).  He moved up to houses, mini-mansions, and eventually mansions, buying them, stuffing them with Examiners, and then flipping them a year later once the development was finished.  In an era when real estate was going up as much as 30% in one year, it was like shooting fish in a barrel.

But like anything else, you have to know when to get off the merry-go-round, take your profits, and move on.   It is like the guy in the casino, who wins big at dice and then doubles-down his bet by putting it all back on the table.   He wins again, and thinks that somehow he is having a "lucky streak" and he should "ride" it.   He bets again - and wins!   And this may go on for a while, but eventually he craps out and loses it all.  It certainly looked pretty amazing - for a short while.

My attorney friend decided to put it all back on the table, buying an apartment complex in the ghetto and trying to turn it around.   The recession hit, he was stuck with a slew of bad tenants who didn't pay rent (and damaged the premises) and he lost everything.   A decade later, a developer bought the place out of bankruptcy, bulldozed it, and put up yuppie townhomes.   My friend?  He went back to being a Patent Attorney and I think he is still at it, today (while I am retired).   I looked up to him as being smart and clever, but maybe he was too clever by half.   I have to thank him, however, for teaching me a lesson by example.  A lesson that prevented me from going down the same route as he did.

And I learned this lesson again and again from other friends, who bought into the overheated market in the 2000's, and not even renting out vacant properties.  They were convinced they would make big bucks on these tulip-bulb condos and mini-mansions that they held on to them, each day looking at prices in the paper and counting up their phantom profits.   Then the market crashed and they all marched off to bankruptcy court.

Flippers always lose, because flippers never know when to quit.   Like the compulsive gambler, they keep having to gamble - frittering away their winnings until they lose it all.  And once you get into the flipping mentality, it is darn hard to get out.   As I noted before, in South Florida during the 2000's, I would go to parties where everyone was in the real estate business.   Agents, investors, mortgage brokers, home inspectors, appraisers, bankers - you name it.   And they all said the same thing - they were so heavily invested in this overheated market that they couldn't do anything else, other than to hope for a "soft landing."

Because they all knew that eventually the party had to end, they just couldn't figure out an exit strategy, and they were all so worried about "selling out too soon" and missing the "peak."   That right there was a sign it was time to leave the party, and we did.

The rest is history.