After considering the pros and cons of house flipping and renting as well as taking into account what your real estate and financial goals, it may be easier for you to decide which business model suits you best.
Investing in real estate has always been considered a safe, stable and profitable investment vehicle. While it has its negatives, as do all investment types, its negatives are, generally speaking, not as bad when compared to other investment options or types.
One good thing about investing in real estate is the fact that, unlike many years ago, you usually won’t need to have the entire investment amount needed to buy a property as most banks and finance institutions will finance the bulk of the purchase price of the property. One of the main requirements for this to happen, however, is for the individual to have a good credit score. This is perhaps one of the reasons why more people are looking to enter into this industry.
For anyone looking to invest in the real estate industry as a business by way of purchasing a property, one dilemma they sometimes face is deciding what business model to go with.
Generally speaking, the two options available to you are either to purchase a rental property or to invest in a rundown property and then spend the time, money and other resources to refurbish the property, then sell it for a profit. This model is generally referred to as “house flipping.”
Once the decision has been made to invest in a real estate property, the question then becomes, which of these two models should you go with?
The best answer to the above question, as is the case with most situations, is that it depends. There are several things that you will need to take into consideration to help you determine what model to go with. Some of these things include the specific goal you are trying to achieve, the situation in the local real estate market, your specific financial situation and more. Also, it is just as important to weigh the pros and cons of both models.
When we talk about renting a property or flipping it, there is one common denominator – income.
There are two different types of income: passive income and active income.
Passive versus active income
Passive income can be defined as the income you receive without doing any active, physical, or ongoing work, whereas active income is that which is received from engaging in an active or ongoing activity or work. An active income, for example, would be your monthly salary from a job or business that you actively and physically participated in, in order to generate the income. While a passive income might be the monthly interest you earn from a savings or investment account with a bank.
By definition, passive income appears to be an easier and more convenient means of income.
Is flipping houses a passive or active income?
Flipping houses cannot be considered to be a source of passive income mainly because it does not involve ongoing income and also because it usually requires a significant amount of work that you will have to undertake. When you flip a house, you will usually spend money to buy and refurbish the property, take steps to find buyers, then sell it for a profit. Once that property is sold there will be no other income earned from it, so in that sense, it does not meet the test of being passive or ongoing. There is also the fact that actual physical work has to take place before the income can be gotten.
Is renting a passive income or active income?
The income from a rental property is an example of passive income because the income is being received on an ongoing basis, and also because there is little to no actual physical work that is done in order to earn the income.
However, it is not as simple as it seems. Let us explore the advantages and disadvantages of renting.
The advantages of renting a property
1. Ongoing monthly income: When you rent your house or property, you receive an ongoing monthly income. This income is not affected by your ability to work and should you no longer be able to work your day-to-day job, you will still receive your rental income. Additionally, you could decide to outsource the day-to-day management of the property, thereby absolving you of any actual physical work.
2. Appreciation: Properties usually appreciate over time and when this happens, you increase your equity and in turn, your rental income could increase. Depending on the price and location of your property, its value can appreciate by an average of 3.7 % over a year.
3. Lower mortgage Payments: Renting your property is a smart way to lower your mortgage payments. When you rent out your property, you are receiving a passive income that could be used toward your mortgage payment on the property which effectively lowers it. This minimizes the burden on a homeowner and makes it easier to settle your mortgage over time.
The disadvantages of rental properties
1. Bad tenants: Bad tenants can make renting your property a nightmare. Your tenant could suddenly decide to stop paying rent and if that happens, it could be a long and arduous process to evict such a tenant. While various states have different laws around how to deal with non-paying tenants, generally, the process involves various steps like having a valid reason or justification for wanting to evict, being familiar with the specific eviction laws in your state, filing the eviction with the court and attending the court hearing, giving a formal eviction notice, then evicting the tenant.
For example, in New York state, a landlord has to give a tenant a 14-day notice or demand for rent, after which the landlord will need to go to court and win that case before he or she can evict a tenant for failing to pay rent. In some instances, such a landlord might need to seek the advice and services of a New York real estate attorney to help or guide them in this court process.
2. Management: Renting a property requires maintenance of the property. If you are going to manage your property by yourself, you need to be prepared for this. Self-management of such property may potentially make your rental property an active source of income as opposed to a passive one, depending on the amount of ongoing work you need to do while managing it. For example, you will need to be able and available to do or oversee repairs to the property, fix anything that requires fixing and ensure that your property is in a livable condition, and more.
3. Taxes, Fees and Insurance: Irrespective of whether you have tenants in the property or not, you will still have to pay the required property tax and other fees, as well as any property insurance which you may sign up for. In the unfortunate situation where there is a local or national property bubble or any other situation that reduces your ability to get paying tenants, you still will be liable for all these payments, even though you are not receiving any rental income.
The advantages of flipping
1. Quick turnover: You can make a quick turnover by flipping and using the capital for another investment. The return on investment can be worthwhile, depending on your location and the state of the property market. The sooner you sell, the better.
2. Avoid long-term property management: When you purchase a property with the intention of flipping it, you may incur some costs when refurbishing it. However, the sooner you flip the house the better as you avoid the long-term management or maintenance costs that comes with holding a property.
The disadvantages of flipping
1. Stand to make a loss: You potentially stand to make a loss if you are in a hurry to sell and put your property on the market at the wrong time. If you spend more on rehabilitating your property and place it on the market, you may not recoup your total investment amount. And, the longer a property remains unsold, the potential exists that it may fall victim to something like a housing bubble which may reduce the value of local properties.
2. Holding cost: As a property owner, there are several holding costs involved such as utilities, maintenance and taxes. If you cannot sell your property as early as you anticipated, you could spend a sizable amount on holding costs and this could affect your profit margin when you eventually sell.
3. Short term capital gains tax: One of the main disadvantages of flipping a home when you have owned it for less than a year is the short term capital gains. You will still be taxed as if it were a normal income, at your regular marginal income tax rate. Essentially, you will keep less of your profit from flipping the home.
4. Unanticipated Costs: One of the biggest disadvantages of house flipping is the issue of unexpected costs when you begin the process of renovating the property. When you buy a run-down property, you can never really know the full extent of just how rundown the property is, and even the best construction professional will not be able to tell you with absolute certainty, all the defects in the property and their associated costs.
This can ultimately mean your profit margin might potentially be reduced, when you eventually do sell the house.
After considering the pros and cons of house flipping and renting as well as taking into account what your real estate and financial goals, it may be easier for you to decide which business model suits you best. If you consider yourself someone who is hands-on, enjoys short-term projects like renovating a house, and enjoys a quick return on investment, then flipping is for you. However, if you don’t like the idea of getting your hands dirty and can afford to invest in a property long term, and are more interested in a long-term passive income, then a rental property is likely to be suitable for you. With both options, it’s important to consider what can go right or what could go wrong in order to plan ahead and yield a positive and profitable outcome for your business venture.