The first reason we don’t like flips is that profit margins are actually very slim, primarily because there are high costs when you transact real estate, and this makes a big difference when you have a short investment timeframe with lower total returns. Let’s look at an example where you buy a $1M house, put in $100K in renovations for half a year before selling it. In the current environment, the most likely scenario is that you’ll be able to sell the property for $1.2M. In other words, you double your renovation cost and make $100K.

But after you deduct closing costs of around $35K, which consist of land transfer taxes and legal fees, plus selling fees of around $63K, which include agent and legal fees, you are left with a tiny profit of $2,000. That’s not all. In that half year timeframe, there’s also $8K in interest expenses assuming a 2% interest rate and $5K in other holding costs. And so before even factoring in the time you spent managing the renovations, you’re already at a net loss of $11K. In other words, in the typical case, we’re not just expecting slim returns, but flipping is a money-losing activity!

If you compare this with a longer term average Toronto freehold rental property that generates 4% in cap rates, 4% in annual appreciation, minus 2% in interest expenses, you’re looking at 6% returns, and at 4x leverage, you’d get an annual ROI of 24%, which is much, much better than flipping. Of course, there are still transaction fees, but they are diluted because your investment timeframe is much longer. So holding a property for 10 years means these fees are effectively 20 times less than just holding it for half a year.

So what type of flip generates a comparable 24% annual ROI? After crunching some numbers, I found that you’d need to find a property where you can 2.5x your renovations, which is rare in our current markets, and do two of these per year. But even at this point, you still haven’t factored in your cost of time, the higher risks of flipping, and higher tax implications of flipping. So basically, flips are not worth it from a financial standpoint, which made me curious to see how Zillow was doing it. Perhaps they have better scale and cost efficiencies, so I went right to the financial statements.

Just to give you a quick overview, Zillow has three main revenue segments. Their home segment is Zillow Offers, aka their flipping business, which makes up the biggest part of their total revenue, at 50%. Then, they have their IMT (internet, media, and technology) segment where it’s their commissions and ad revenue business, making up 47% of their revenue. And finally, the last part is their very small mortgage loan business, which makes up 4% of their revenue.

Flip revenues look great, but we already mentioned that our biggest issue with flips are their costs, so I continued digging into Zillow’s EBITDA. And, lo and behold, their home flips result in a $241M loss after expenses.In other words, the costs exceed their revenues by 14%, which is the main reason Zillow has been at a loss in 2019 and 2020. One other interesting thing to note is that their expense ratio decreased a bit from 2019 to 2020, which might indicate that they’re improving their processes. But given that they continue to face labour and supply shortages, I personally feel that this was actually because of a higher than normal short-term appreciation in 2020. Either way, Zillow offers continue to be a losing business, which is why they’re pausing their flips.