If I had a nickel for every time I had to endure some property investor telling me about how much money they made, I’d have enough to buy a condo in Phoenix. But just for fun I decided to run some numbers on a stereotypical flipper and what conditions s/he would require to make a “profit” on a flip. Before beginning, remember the mindset: opportunity cost stays in the textbook — what is being measured is whether or not the flipper has more money in a year than when he bought. So we can calculate the approximate profit of a flipper, assuming he bought a year ago and sold today. The profit reaped is therefore:
Profit = Sales Price – Purchase Price – Interest – Expenses + Rent – Sales Fees
Sales Price – Purchase Price = Pi*(1+a), (where Pi is purchase price and a is annual appreciation)
Rent-Expenses = Pi*CR, (where CR is the cap rate (generously about 5%))
Sales fees = Pi*f, (where f is the sales fees from a sale (say about 3%))
Interest = Pi*LTV*i, (where LTV is the loan-to-value ratio and i is the mortgage rate)
It is approximated, for simplicity, the loan is interest-only (which is reasonable with a 35 year am). We sub:
Profit = Pi*(a + CR – f – LTV*i)
To achieve a positive return, a+CR-f-i*LTV > 0; solving for a,
a> LTV*i – CR + f
So we have a required capital appreciation to ensure the flipper makes money on paper, a huge psychological barrier needed to elicit a sale. We can plot appreciation versus LTV for various interest rates, assuming 5% cap rate and 3% closing costs:
So what do the numbers mean? Well at current interest rates of 4%, a flipper requires capital appreciation of 1.3% to ensure he doesn’t lose money. I ran the numbers with a 3% cap rate (typical of some detached dwellings and some condos):
And assuming the flipper keeps the unit vacant:
If the unit is at 3% cap, the 20-1 leveraged flipper requires a 3.8% annual appreciation; when the unit is held vacant, this increases to 7%.
This cursory exercise shows how leverage with low earnings requires continued capital appreciation to stave off a paper loss, a case made clear when analyzing the simple case of a flipper with a 1 year tenure under various scenarios. When interest rates go up, the required capital appreciation increases at a time when we expect increasing costs of capital to weigh heavily on upward price movement. With high leverage, interestingly, it is an absolute necessity to have prices increase, even for those with variable rate mortgages at around 2%.
