How Much Leverage are House Flippers Using and What Does it Mean for Your Real Estate Investments?
Did you know that in 2017, investors flipped over 200,000 single family homes and condominiums? What’s more, over 138,000 investors flipped a single home - the most impressive numbers in over a decade, representing nearly 6% of all single family home and condo sales.
But if you invest in real estate, what do these numbers actually mean for your investment values? It’s important to know that whenever you talk about house flipping, you also have to consider how much leverage is involved in this type of business model. Depending on the market, leverage can either increase returns or drastically inflate losses.
But this also shows a severe hole in their reasoning. The only item they captured is whether or not the home had a loan on it -- and they only looked at one of the financing channels available, despite there being many options beyond traditional loans.
For example, you could follow the route that Attom looked at, and get a loan on the home you want to buy.
Or you could pay cash for it and then put financing on it after you close the sale.
Or you could get a loan on another investment property you own through a cash out refinance
Or you could get a cash out refinance or home equity loan on your current primary home
Or you could leverage other assets, like borrowing against a 401k, a life insurance policy and so on…
So their finding of only 35% of all properties using financing is seriously underestimating the amount of leverage being used in the market. In all honesty, that number is probably closer to 60-70%.
But there is a downside to this investment model, in that although it can be used to amplify your gains, it can also considerably increase your losses as well. Let’s look at two examples, one where an investor used leverage, and one where they did not, to help better illustrate the situation:
The Unleveraged Borrower has 100k to invest. They could hypothetically go out, buy a house for cash, fix it up and sell it. But if the market turns bad, they’re essentially stuck with a house that they can either hang onto in hopes that the market will improve, or rent it out and recoup some of their investment over time. This isn’t the best use of their time or money, but it’s a safer bet than using leverage in a down market.
The Leveraged Borrower also has 100k, but instead of buying just one $100,000 house, they’ll buy 10 houses and put down $10,000 on each house, using 90% financing on the others. This strategy is excellent when they can easily sell these houses, such as in a highly competitive real estate market.
However, if they cannot sell them or the market turns poor, the lenders are going to want their funds since most hard money loans are short term loans. Even in the best of situations, there’s simply no way for the borrower to have the cash flow to keep ten houses afloat. Rent values would be higher than what the home was worth and they’d be underwater on their investment. This is precisely the thing that happened to many investors during the last recession
And this is precisely why we fund our hard money loans with cash -- not leverage!
So as you can see, leverage is really good when we have an uptick in the economy and houses are selling...but also incredibly risky if the market turns sour. Even during the recession, the amount of leverage spiked right before it fell. And even though, as of this writing, we’re not in a recession, no one realistically knows how much of a role leverage is playing on the market.
Yet even so, house flipping is hitting all time highs despite the fact that it should be at an all-time low. If you’re looking to invest in real estate, the last thing you want is a liquidity squeeze -- so look for lenders that fund with cash -- no leverage! It’s for your own well-being and financial peace of mind.
But if you invest in real estate, what do these numbers actually mean for your investment values? It’s important to know that whenever you talk about house flipping, you also have to consider how much leverage is involved in this type of business model. Depending on the market, leverage can either increase returns or drastically inflate losses.
The Use of Leverage - And What Reports Aren’t Telling You
The report linked above, commissioned by Attom Data in 2017, looked at all the properties sold within a year that used financing. They then took this data to determine what percentage of those homes were flipped.But this also shows a severe hole in their reasoning. The only item they captured is whether or not the home had a loan on it -- and they only looked at one of the financing channels available, despite there being many options beyond traditional loans.
For example, you could follow the route that Attom looked at, and get a loan on the home you want to buy.
Or you could pay cash for it and then put financing on it after you close the sale.
Or you could get a loan on another investment property you own through a cash out refinance
Or you could get a cash out refinance or home equity loan on your current primary home
Or you could leverage other assets, like borrowing against a 401k, a life insurance policy and so on…
So their finding of only 35% of all properties using financing is seriously underestimating the amount of leverage being used in the market. In all honesty, that number is probably closer to 60-70%.
Why Does Leverage Matter So Much?
In the grand scheme of things, leverage can help you grow your returns significantly. It allows you to do more transactions with the use of additional funds from lenders and investors than you could otherwise possibly do.But there is a downside to this investment model, in that although it can be used to amplify your gains, it can also considerably increase your losses as well. Let’s look at two examples, one where an investor used leverage, and one where they did not, to help better illustrate the situation:
The Unleveraged Borrower has 100k to invest. They could hypothetically go out, buy a house for cash, fix it up and sell it. But if the market turns bad, they’re essentially stuck with a house that they can either hang onto in hopes that the market will improve, or rent it out and recoup some of their investment over time. This isn’t the best use of their time or money, but it’s a safer bet than using leverage in a down market.
The Leveraged Borrower also has 100k, but instead of buying just one $100,000 house, they’ll buy 10 houses and put down $10,000 on each house, using 90% financing on the others. This strategy is excellent when they can easily sell these houses, such as in a highly competitive real estate market.
However, if they cannot sell them or the market turns poor, the lenders are going to want their funds since most hard money loans are short term loans. Even in the best of situations, there’s simply no way for the borrower to have the cash flow to keep ten houses afloat. Rent values would be higher than what the home was worth and they’d be underwater on their investment. This is precisely the thing that happened to many investors during the last recession
And this is precisely why we fund our hard money loans with cash -- not leverage!
So as you can see, leverage is really good when we have an uptick in the economy and houses are selling...but also incredibly risky if the market turns sour. Even during the recession, the amount of leverage spiked right before it fell. And even though, as of this writing, we’re not in a recession, no one realistically knows how much of a role leverage is playing on the market.
Yet even so, house flipping is hitting all time highs despite the fact that it should be at an all-time low. If you’re looking to invest in real estate, the last thing you want is a liquidity squeeze -- so look for lenders that fund with cash -- no leverage! It’s for your own well-being and financial peace of mind.
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