Big Renovation Projects: Should You Flip It Or Hold It?
At first glance, if you look at flips, they can look pretty good. You put in $100,000 of renovations, and your property goes up by $250,000. So, it looks like you’d make a good $150,000 in just half a year.
But it’s not that simple. Real estate has high transaction costs, plus land transfer taxes and capital gains. If you start crunching more numbers, you’ll find that your net returns after everything might only be around $30,000. You might think, “That’s okay for a side hustle. If I do more projects, they’ll start adding up. And because I’m flipping, I’ll be able to do a lot more projects than just buying and holding real estate and waiting for the rental income and market appreciation to slowly build up.”
Our goal at Elevate is to help you invest smarter. I think investing should be mostly passive, and if you’re putting in a lot more effort and taking on bigger and possibly riskier projects, then you should be compensated a lot more for it.
So, how do you think big flips actually compare to buying and holding? Is it actually worth the extra work and risk? Let’s find out!
Big Renovation + Flip
In case you don’t know, a real estate flip is when you buy a home that needs work, renovate it, and then, once you’ve made it much nicer, you sell it again for a higher price, hopefully for a profit. I’ve already made a video talking about why you shouldn’t flip houses. The reason is that most of the time, the costs end up being higher than your gains.
If you crunch the numbers, you’ll find that smaller flips typically lose money. So right off the bat, if you are thinking of flips, they have to be major projects to even make money. As I mentioned already, the returns per project rent are not particularly high, but they do add up if you can complete a large number of them in a short period of time, say 10 years. But instead of me just talking about it, let’s go right into the numbers to see what the returns look like if you have around $400,000 of capital for house flipping.
With this budget, you can buy a $1.2 million house with a 20% downpayment and then put the rest into a $100,000 renovation that takes around 6 months. And then if you sell it right after, you might end up seeing it off your books by the end of nine months.
For this project, let’s assume you make $150,000 in value add appreciation plus $26,000 in market appreciation. If you add them up, it looks like a very good $176,000 gain in just 9 months.
But like I mentioned, we can’t forget about the costs. When you buy and sell a house, you have to pay for interest, selling and legal fees, land transfer tax, and capital gains tax, all of which add up to $143,000.This means your actual net returns end up being only $33,000.
If you add that to your initial capital, you have $415,000 to work on your next flip and you can continue flipping houses once a year until you reach year 10. You’ll find that your capital will start growing and the projects you can take on get bigger and bigger, and so your net returns on future projects will grow. By year 10, the net return is $67,000 for the project. And if you add up the returns from projects 1 to 10, you’ll see a total return of $483,000, or an annual ROI of 8.5%.
Now, if you think about it, if you put the $400,000 of capital in stocks, you’d be able to make on average around 8% ROI per year, or 6% after taxes, and it’s a lot more passive. Given that you are investing with leverage and you’re putting in a lot more work for flips, the ROI should be a lot higher than 6%, but the expense and tax ratio are so high for each project.
Big Renovation + Hold
So let’s see what returns look like if you don’t sell every year. Instead, you would do a similar-sized renovation project and then keep it and rent it out after you finished.
If we kept the property after renovating and then rented it out, on top of getting the $176,000 in renovations, we’d also continue to get market appreciation and rental income. Now, if we use a 4% annual appreciation and a 4% net rent yield for returns, you’ll find that the total gross returns from value-added appreciation, 10 years of market appreciation, and 10 years of rental income total a very big $1.25 million.
The costs for selling don’t go up as much, so the expense ratio is a lot less if you hold real estate for 10 years, and therefore the net return would be $554,000. In other words, keeping this one property for 10 years will make you more money than flipping 10 houses in 10 years!
But that’s not all. If you get enough equity built up, then you can also refinance the property and take out extra cash so that you can use the money to buy a second place without selling the first one. You might not be able to buy the second one as quickly as before. Right after renovations, your property price has gone up to $176,000, and 80% of that is around $140,000, so it’s not enough money yet.
In fact, you’d have to wait 6 years to get an extra $255,000 from market appreciation, which will give you $396,000 to reinvest in a second property if you want to do another big renovation again. After deducting expenses and taxes, you’d make $334,000 from a similar-sized renovation and hold onto it from year 6 to year 10. Adding the returns for both properties together, we’re looking at a total return of $889,000. So here, we have a much more passive investment strategy and much better returns, which is a win-win solution!
Turnkey + Hold
We now know that a big renovation and holding it is better than flipping. But what about investing in turnkey properties as a long-term investment? How would they be compared?
With the same budget, you can actually afford a bigger purchase because there are no renovations needed. Instead of $1.2 million as a purchase price, you can buy a property that’s $1.6 million. A bigger purchase means more absolute appreciation and rental income. After selling it in 10 years’ time and deducting expenses and taxes, you still make $570,000.
So get this: your returns on one turnkey property are actually higher than doing 10 flips or even a big renovation as a long-term investment. How does that make sense?
The main reason is leverage. If you are purely looking at buying and holding without renovations, your loan-to-value ratio is 80%, so you’re buying the property with a lot of borrowed money. After renovations and before refinancing, your loan-to-value ratio becomes 70% because you put in cash for the renovations and you bumped up your property price by upgrading the property.
As you can see from this example, lower leverage can make a big difference in returns. But of course, that’s something that can be solved if you want your money to work harder. If you are able to refinance, then you can increase your leverage, buy a second property, and make more money with that. And when you do that, you will see higher returns compared to investing in turnkey properties.
The last question is, what will the turnkey investment look like if we are about to refinance it during the 10 year period to buy a second place as well? Because we’re only relying on market appreciation, the equity we can refinance in year 6 would be less than what you could take out if you did a big renovation upfront. At year six, we would have $345,000 to reinvest, which is still enough for a smaller investment where the net returns are $219,000 between year 6 and year 10.
If we add up the two property earnings together, we will see a total return of $733,000 or an ROI of 192%. This is in line with what we expect for turnkey properties, where they’re supposed to generate lower returns compared to investments with renovations required.
So if we take a step back and learn from these examples, there are 3 key things that I want to highlight:
The first take away is that buying and holding, even choosing the most passive type of real estate investing with just one turnkey property, will generate better returns than flipping houses continuously, based on the same budget and investment timeframe.
That doesn’t mean that putting in sweat equity isn’t worth it, because it can be a really good idea still. If you are up for a renovation project, then I recommend that you buy and hold instead of selling right after renovating. This will lower your expense and tax ratio, so you will generate better returns on the project.
The third thing you should know is that renovations actually lower your leverage if you are using more of your own money for renovations. Lower leverage translates to a lower ROI. So if you want to maximise your returns, then you’d need to refinance to bump your loan-to-value ratio back closer to 80% and make your money work a bit harder.
How We Can Help
We’re big believers in renovating and long-term holdings, and if you want to chat more about this, we’re ready to help! We can look at your requirements and preferences and then match you up with the best investment property that fits your needs. After we help you buy it, our team also provides renovation guidance, leasing and property management if you need it. Just connect with us if you want to learn more about our services!
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