The Real Estate market provides more than one opportunity for investors to make money. When considering starting a business to invest in real estate the question will arise whether to rent the property or flip it and take profits. There are pros and cons for both techniques and it also depends on the goals of the investor. With this comparison we are keeping it simple and using a single family home as opposed to multi-units that could increase the monthly income using one property.
Over time property increases in value and the owner can access this value called equity. An investor can borrow against this equity to fund other projects in or around real estate. The own and rent option offers a source of cash flow on a monthly basis and this will rise with inflation. Not to mention there are some tax benefits involving the mortgage interest.
The safer method of investing would be flipping houses instead of renting them. It’s a safer investment strategy because the property is only at risk for a short period of time. Although flipping requires using capital to increase the value of a property by repairing or rehab before sale. We look at some of the differences between the 2 investment strategies so an educated guess can be made.
Capital and Cash Flow
Capital is considered a business asset and is used to generate profit through investment. In the case of flipping houses, capital would be money used to pay for a down payment, materials and labor to fix the property before sale. The capital source could be from savings, loans or refinance and existing equity. It’s defined as capital because it is being used in the process of generating a profit which happens later when the house is sold or flipped.
Cash flow is different then capital as it is more about the money flowing in and out of the company. This represents more of the business financial changes called the “opening balance” and the “closing balance” over a period of time. Cash flow is clear when renting properties as the intention is to own the property and rent it out, the monthly rent is considered cash flow.
The business must generate income to show profit and we just explained the difference between capital and cash flow. There are 2 broader terms we should define, “active” and “passive income”. House flipping will require an initial capital investment, time and labor to provide a final sell-able product. This is an “active income” because it requires work to find and flip houses but can result in large profits over short periods of time. Renting property is a different aspect where there might be an initial capital expense to purchase but the end result is to generate cash flow and realize profit over time. We call this “passive income” as it generates wealth over time through rent and building equity in the property.
Flipping Houses
Flipping a house requires the investor to find a distressed property, estimate the repair costs, collect or find the capital to purchase, buy it, rehab and sell it in a short period of time, preferably less than 6 months.
Simple Example using 70% rule:
| After repair Value (ARV) | $100,000 |
| Purchase price (70% of ARV) | $70,000 |
| Total repair & capital cost | $14,000 |
| Total Profit (after sale) | $16,000 |
This is an extremely simple example because it does not include things like loan interest payments and price changes due to negotiation and inspection results or your own personal time and labor.
What we do see is that a capital investment to flip a house of $14,000 resulted in a profit of $16,000 when the property is finally sold. If we completed 1 flip per year, our business profit would be $16,000 minus taxes. The following year we would have this profit, or capital, to help fund a larger project.
What if you were able to finish a fix and flip like this every month ?
Active Income
In our example the $16,000 would be considered “active income” because work was necessary to make the money. Flipping requires a higher commitment of time and capital and results in a higher profit over a shorter time period.
May require partners or investors
Not included in the example is how the investor put together $84,000 to pay for the house and rehab costs before selling it for a profit. Flipping houses requires the investor to partner with someone who can help fund the project or to request a loan, such as a hard money loan, to cover the purchase and rehab costs of the project. In this case the lender will charge a high interest rate and be payed monthly until the project is complete.
A partner could be financial or they could provide some other work that the investor cannot provide such as labor or a specialty. Professions such as brick layers, electricians, HVAC, plumbers, real estate agents or general contractors can be partnered with to reduce costs but with a cut or split into the profits. A key point here is that learning to manage labor properly can really help the investor keep more of the profits.
Profits realized faster
We have been referring to a single house flip and the profits produced. The time it takes to rehab and sell a single house, this can extend from 4-6 months on average depending on the work needed and the labor availability. If you flip 2 houses a year then the profit is double that annually. The professional flipper may be closing sales every month multiplying profits by 12 or more inside of a year. At this point there is usually a team doing much of the searching, estimating and buying for each property.
No property & tenant management
One of the biggest benefits of flipping houses is that the property is sold to someone else. This means there’s no more maintenance or repairs to be done and all loans are paid. Unlike the rental property we do not need to prepare for managing the house or getting tenants in as soon as possible. Once the house is sold it is no longer the investors concern.
Costs are estimated
When flipping houses it is common knowledge that the profit is decided on the purchase of the property not the sale. What this means is that doing a poor job of estimating rehab costs can dramatically reduce your profit after the house is sold. During the rehab there can be missteps and mistakes that were not covered by the estimate. A large mistake made by one contractor could reduce the profit to zero.
Higher taxes
This section is not considered tax advice, we are not tax professionals. You must consult a tax pro for advice on these issues.
There are plenty of tax strategies that we cannot go into here but regarding the lump sum profits, the taxes would be applied to the full amount. We would pay taxes on the total profits for that year if the money was not used for something else to offset the tax bill. Usually the house flipper will use profit to rehab another property or a larger project to help offset taxes and increase the profit margin. This is another important aspect when comparing the rental verse flipper strategy.
Renting Houses
Renting houses involves retaining ownership of the property and charging rent for someone to live or work there. The business model is simple where the rent covers the monthly loan, tax and insurance costs for a mortgage and the remaining monthly payment is called passive income. This provides passive income as cash flow for the owner and over time the property will also accumulate equity to add the to total value of the house.
Simple Example:
| Purchase Price | $100,000 |
| Rent | $1000/month |
| Mortgage, Tax and Insurance | $700/month |
| Cash Flow | $300/month |
Here is another simple example, these numbers do not include things like the real cost of purchasing the property or closing costs. This could also be a distressed property that needed fixing, or we needed a $20,000 down payment to be approved for the loan.
Buying this house as a rental will provide a passive income or cash flowing into the business of $300/month or $3600 per year. This will continue year over year and eventually there will be equity that we can borrow from to purchase another property. The work involved will require the initial purchase and any maintenance and management of the property. This means collecting rent payments, any repairs or maintenance to the property and other costs that may need to be addressed over time.
Passive Income or Cash Flow
Passive income refers to income that continues to flow in even after the work has been completed. Some examples of passive income is writing an app, publishing an eBook or in this case renting property. As a comparison the passive income is usually much less annually than the flip example we provided but it may require less work as well.
Property & tenant management
Renting provides cash flow or a passive income but has it’s own requirements to keep this cash flowing. Renters can live in a house for months or years depending on their life changes, careers and financial situation. Managing the property also includes keeping renters happy with maintenance and repairs as well as moving them in and out of the property.
Managing tenants will include:
- Lease agreement and legal documents
- Running tenant background checks and work verification
- Collecting rent payments (if not automated)
- Handling evictions
- Managing renter complaints and repairs
- Finding new tenants
We are discussing a single family home and in this case lease agreements are usually negotiated for 1 year. This means there is a likelihood of looking for a new renter once per year assuming you do not need to evict earlier. During the course of that year there may be complaints or maintenance required but hopefully this is not a weekly or even monthly issue.
Tax deductions
This section is not considered tax advice, we are not tax professionals. You must consult a tax pro for advice on these issues.
One of the benefits of holding a mortgage for the rental property is the interest paid on the mortgage may be deductible. For a $100,000 this can be a nice reduction in taxes each year. This return will not be realized until taxes are filed each. I think it should be included in a comparison with flipping houses.
What if you own and rent 4 or 5 houses?
Another tax consideration is when paying for repairs to maintain the property, this may also be tax deductible for each calendar year. These should be discussed with a tax professional as I found that some maintenance and repairs may be considered improvements to the IRS and therefore not tax deductible.
Building Equity
Over time the property value will appreciate and between this and the mortgage, slowly build equity in the property. The equity depends on market conditions but the value can be used at a future date to refinance and purchase a second rental property. This process is how the investor can build a portfolio of rental properties and maximum cash flow without using their own money.
When flipping fails, Rent
Not every fix and flip works out and sometimes the first one can be a very costly mistake for the new investor. If the investor begins a flip and for whatever reason the cost over runs the project or there are issues with contracting and the project will not be completed on time, there is the option of renting the property instead of flipping. This solution is to secure a full 30 year mortgage to payoff any short term hard money loans and change the overall plan to rent the property.
Flip or Rent?
Some investors are attracted to real estate as they spent time rehabbing properties as a job or working as a contractor doing similar work. The decision to flip houses may be easier for someone used to doing home improvement that would like to get in and get out.
On the other hand renting property may be more attractive to someone who wants to build a portfolio and benefit from a monthly income.
Here are the pros and cons for each strategy in an easy to read list:
Fix and Flip Pros
- Flipping provides a higher profit per property
- Capital can be borrowed for buying, fixing, repairing and short term interest payments
- Flipping is temporary, no attachments after sale
- Projects usually only last 6 months
- Profits can be immediately used or spent on another flip
- Few legal concerns outside of the contractor work
Fix and Flip Cons
- Risk of time and capital loss
- Short term capital gains tax
- Time sensitive projects can fail
- Long search period to find distressed houses
- Problems selling can reduce profits
Renting or Buy and Hold Pros
- Cash flow is monthly income, long term profits
- Equity increases over time and so does the portfolio value
- Values and rent offset inflation
- Property can be borrowed against for repairs or another rental
- Tax benefits from mortgage interest
Renting or Buying and Hold Cons
- Property maintenance and repairs
- Tenant approval, management and eviction
- Longer term to realize profits
- Tax benefits
Flip or Rent?
The choice seems to depend on whether the investor wants to be involved over the short period or build assets over time. The cash flow from one single family home may take years to match the profit realized from flipping the same house. There is a serious commitment required to choose either but I think the best might be to combine them.
In my opinion the best solution seems to be to combine both strategies to benefit for the short and long term. The balance will support the investor during good and bad times as well as provide an opportunity to choose projects or turn them down. This also makes your portfolio more resilient to big changes in the real estate market that cannot be foreseen while you are paid a monthly cash flow to support your business.
Related Questions
Is flipping houses passive income? No, passive income is income that does not require active work. Flipping houses requires work (active income) to find, fix and flip the property before seeing the profits.
Are rental properties a good investment? Rentals are good as along term investments where they save on taxes and build equity. It requires managing the property and phone hours.