When looking for value-add real estate projects, investors typically have two main strategies: to fix and sell the property within an expedited timeline (what’s commonly referred to as the Fix & Flip), or to fix the asset and keep it for a longer period, eventually renting it out and generating a passive income over a longer time horizon (a Fix & Hold). Each strategy has its pros and cons, and it is ultimately up to each investor to decide what to do, depending on their financial goals. Let’s go through a quick overview of each.
Fix & Flip:
House flipping sounds simple in theory: you buy an old house in need of a rehab, renovate it, and then sell the house for a profit (usually within the span of a year or two). This highly popular type of real estate investment can generate attractive returns when done correctly, but it usually comes with challenges. It is not uncommon to run into issues you weren’t previously aware of, or to find yourself over budget and / or past deadlines, so it’s generally good to assume a fix & flip will cost more and take longer than initially planned.
Let’s look at some of the pros and cons.
Pros:
- Short Time Horizon. Fix & Flips are usually short-term investment projects, with exits within 6 - 24 months, thereby providing relatively quick liquidity. These types of investments are therefore less risky, because you don’t have to worry about depreciation of property values in the area, and many other costs that come with owning an asset long term.
- Peace of Mind. You don’t have to worry about renting out a property and retaining tenants. That said, you DO need to make sure you sell the property at a price that will bring you a healthy profit.
- Liquidity. You can reinvest profits into other strategies to diversify your portfolio.
- Access to Leverage. Many private lenders are comfortable with fix & flips because of their short time horizon, so quick financing should be easily available for qualifying projects.
Cons:
- Taxes. Holding a property for under a year means your income could be taxed as ordinary income, rather than as long-term capital gains, which can mean as much as a 15% difference for individuals falling within the highest tax brackets.
- All Expenses; No Immediate Income. You will have holding costs such as taxes, maintenance, utilities, and insurance that you must pay while you are renovating the property, with no income to offset them.
- Things Usually Don’t Go As Planned. As previously stated, with this strategy, it isn’t uncommon for investors to find themselves over the budget and past certain deadlines. This can cause stress especially if under a tight budget or timeline.
Fix & Hold:
The fix & hold strategy begins similar to a fix & flip: you find a property that needs to be fixed up. However, instead of selling it immediately for a profit, you rent it out and become a landlord. If you are able to rent your unit(s) to reliable tenants, you can expect a predictable cash flow as the asset (hopefully) appreciates over time.
With this strategy, you have options: you can be as little or as much involved as you want. You may need to be hands-on during the renovation phase, but you can opt to purchase a property in good condition, so that any necessary renovations are cheaper and faster. Also, once the property is rented out, you can choose to hire a property manager to handle all of your tenants’ needs, so you don’t have to worry about fixing broken pipes in the middle of the night.
Let’s dig into the pros and cons of holding onto an investment property.
Pros:
- Cash Flow. Rental income provides you with passive income, which you can use to: (1) pay down your mortgage, and (2) pay for maintenance, insurance, other expenses. Any funds left over are profit.
- Tax Benefits. When you hold onto a property, the tax code allows you to not only depreciate it, but also write off certain expenses, which will lower your taxes. Even better, you can also defer some of your tax liabilities indefinitely if you take advantage of 1031 exchanges to invest in even more properties.
- Building Equity. The value of building equity is that you can use it as cross collateral when you are applying for a loan to buy another property.
- Value Appreciation. Generally speaking, property values tend to increase with time. Real estate is known to be one of the more resilient asset classes, which is why so many serious investors make sure to include it when building a diverse portfolio. That said, 2020 was an aberration, driving overall inventory in the U.S. to an all time low and driving property values higher – translating into high entry points which may (or may not) correct later. As you’ll probably want to hold onto the investment for 10+ years (that’s how long it usually takes for natural appreciation to become significant), you will have to research the specific market you are interested in and determine the anticipated appreciation for that area.
- Bank Financing. Although you may need to start with a private loan if you want to purchase quickly or need capital for the renovations, after your property starts generating cash flows, you should be able to secure lower-cost bank financing for your mortgage.
- Increasing Rents. Again, you’ll have to pay attention to local circumstances and do some market research, but, generally speaking, you should be able to increase rents year over year.
- Scalability. Because you have passive income and are building equity, you have more options available to you as a real estate investor to scale your business. You can use the passive income to fund other real estate projects (whether short or long term), and use your equity in refinancings or as collateral for additional mortgages.
Cons:
- Renters. No one ever said being a landlord is easy! With a rental property comes the trouble of finding, screening, and retaining great tenants for your properties, which can be a costly and time-consuming process, not to mention additional legal liabilities. In addition, if you have long-term vacancies, you will end up paying property expenses out of pocket, which can add up quickly.
- Property Management. By law (and also to keep tenants happy), you have to keep the property habitable and in working condition. You are responsible for replacing appliances and fixtures as they deteriorate over the life of the property. You can also hire a property manager, but this comes with an increased cost.
- Illiquidity. Unlike fix & flips where you get your capital back quickly, holding a property ties your capital to the asset for an indefinite period of time.
Both strategies can provide sizable returns to investors, but it is up to each investor to consider these and other factors to determine whether to Fix & Flip or to Fix & Hold. As we have seen, some of the most important things to consider include how involved you want to be with the project, how much time you have on your hands, whether or not you’ll need a passive stream of income, and how quickly you need liquidity. The choice is personal.