4 Reasons Why You Shouldn’t Flip Houses In Toronto (& Why Zillow Offers Paused The iBuying Program!)

4 Reasons Why You Shouldn't Flip Houses In Toronto (& Why Zillow Offers Paused The iBuying Program!)

Here on our Elevate team, we don’t like flipping houses. After taking a closer look at Zillow’s financials, I’m going to tell you that flips were a losing business for Zillow, even when prices were on the rise. Watch this video as we discuss the top 4 reasons why we don’t like to flip houses along with Zillow’s house flipping business numbers to back up our reasoning.

1. Flip Profit Margins Are Slim

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.

2. Flips Are More Risky Than Rentals

Let’s move onto the second reason we don’t like flips and that’s because leveraging real estate over a short investment timeframe is actually super high risk. Chances are you’ve heard amazing success stories about house flipping. But what you probably don’t realise is that the majority of their incredible gains come from massive, unanticipated short-term appreciation gains rather than actual flips.Bringing this closer to home, this could have been the case if someone chose to flip a house in Oshawa, for example, where prices have gone up over 50% since last year. But having said that, prices can definitely swing both ways, and so if prices swing down 50% instead at 4 times leverage, you’re looking at a 200% loss-so flips can be very, very dangerous.

If you continue to read into Zillow’s financial reports, you can also sense the shakiness that Zillow feels about their Zillow Offers segment, stating that it is an unproven business model and could fail to achieve expected results and hard financials. Following that statement, they list a number of specific risks:

  • Holding costs go up if renovations take longer than expected
  • Labour issues and costs of renovations
  • Short-term price fluctuations which might translate to a loss

The flipping business is high risk, and thin margins mean there’s no buffer for profits, once you throw in the possibility of lower appreciation and higher costs. In my opinion, Zillow Offers has already faced their ideal situation in 2020 with higher than normal appreciation combined with low borrowing rates. But even then, they still saw a loss. So moving forward, if appreciation goes back to more average levels, interest rates start to rise, combined with persistent higher renovation and holding costs, Zillow Offers will just see even bigger losses if they continue to operate.

3. Flips Get Taxed More

Next on our list are tax implications. Specifically, capital gains on flips are not treated the same as a long-term real estate investment because the government doesn’t like flips either. So to crack down on this, gains from flips are considered active income, which means the entire gain amount is subject to income taxes at your personal tax bracket. Note that this is different from holding long-term real estate investments, where only half of your capital gains are taxed at your personal tax bracket. So if we go back to the first point where where I mentioned you’ll need to 2.5x your reno cost with two flips a year to get the same ROI as a rental property, this is actually only true before taxes. Once you deduct taxes, a rental property still gives you more money in your pockets.

It also looks like the government is planning on further cracking down on speculative real estate activity. On the Liberals website, we see that they plan on establishing an anti-flipping tax on residential real estate that’s held for less than 12 months. So here’s an extra warning that there are likely more negatives for house flippers ahead.

4. Flips Lack Scalability

The final reason we don’t like flips is the lack of scalability. On top of paying for renovations, which are already hefty, flippers also need to cover all of the operating expenses and hold costs out of pocket until the time of sale. So, from the bank’s perspective, this makes flips much higher risk, so it’s less likely that they will offer you many more loans until you complete your existing flips. In fact, tapping out from the financing side quickly is something that affects big players like Zillow, too, and they specifically highlight this as one of the risks that will halt their flipping business.

Now, even if you can get mortgages for multiple flips at one time, chances are you won’t be able to scale as quickly as rental properties because it’s just hard to manage so many active flips all at once. Again, this is also happening to the big players, with Zillow stating that labour shortages are a reason they’re pausing their flipping business right now. On the flip side (pun intended), scaling is a lot easier for rental properties, and that’s why it’s more likely to see individual investors have 5, 10, or even 15 properties under their belt. With a rental property, your passive rental income offsets your operating costs, so this makes the banks feel more comfortable lending more money to you, which helps you achieve much better financial scale compared to flipping houses. 

The Better Way To Invest In Real Estate

A turnkey investment property is a base case which already generates pretty great returns, but you can actually get the best of both worlds by merging the two investment models together to generate even better returns. Basically, you’d buy a property that needs major renovations just like a flip, so that you can capture the value add appreciation that flips are looking for. 

But instead of selling, you’d rent out the upgraded property so your value add appreciation doesn’t get crushed by selling fees right away and you’re also able to benefit from rental income and appreciation passively after that. Of course, you’d have to pay those selling fees down the road when you sell. But since your investment timeframe is much longer, selling fees are spread across many more years, which means there would be a much lower negative impact on your bottom line.

After this, we incorporate scaling into the picture by refinancing your upgraded property at its new fair market value so that you can tap into the value add gains without selling. This allows you to keep your first property, get all the benefits of a rental property and a flip without the disadvantages, and use the value add gains to buy your next property and repeat the process for many more properties to come. 

The takeaway here is that renovation projects are great because they have value-adding benefits when you have time to do them. But if you do, you should hang onto them so your gains don’t get crushed by selling fees immediately. And if you want to tap into those gains more effectively, refinancing then reinvesting is the best way to go.

How We Can Help

Now that you know what the best way to go about it, we’re here to help you put it into action. We’re big believers in long term real estate investing, and we can take a look at your requirements and preferences and then match you up with the best investment property that fits you. We also provide renovation guidance, leasing, property management, and will review your portfolio when you’re ready for your next property. Just connect with us if you want to learn more about our services!

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