Summary: In this article, we will compare two very different real estate investment strategies: flipping houses vs renting. You will learn the pros and cons of each, the difference between passive and active income and which investment strategy fits your lifestyle and aligns with your financial goals.
Introduction
The long-time debate continues: flipping houses vs renting? Which one is right for you? The short answer is, it depends entirely on what your goals are. Your timeframe on flipping a house is usually around six months and can make you a lot of money on just one deal if you do things right.
Gross returns around 48% sound good? Yes! How about 20% to 43% of your gross profits going toward expenses and taxes? No! Flipping houses has its own unique pros and cons list, just as renting does. There are so many variables that go into both types of real estate strategies. This article should help clarify which real estate path you should venture down, based on your goals.
The Difference Between Passive Income (Rentals) and Active Income (Flipping)
When deciding between flipping houses vs renting, let’s first break down the difference between passive and active income.
Passive Income is money you receive every month from your investments. Regardless of where you are or what you’re doing, that income keeps coming. An example of passive income would be owning a rental property and receiving rent checks every month.
Active Income is earning money through day-to-day work. As soon as you stop working, income stops coming. An example of active income would be the money you earn at your day job and/or income from flipping a house.
Flipping is Not Investing
You may be scratching your head at this statement. Flipping is not investing because while it’s possible to earn a ton of money doing it, you are having to earn it. Flipping a house requires a great deal of work. Even if you’re not the person physically doing the labor to fix up the house, you still probably oversee the project, coordinate with contractors, get your plans approved by the city, buy insurance, set up a timeline and budget, etc. You are spending time and energy to flip a house which is why it’s considered active income.
By definition, investing is the act of committing money or capital to an endeavor (business, stocks, real estate, etc.,) with the expectation of obtaining an additional income or profit.
I’m not trying to discourage you from going house flipping route. I’m simply saying that it should be considered a business and not an investment. If you are planning on keeping your day job and flipping a house on the side, be aware that most or all of your “free” time will likely be spent working on this project. The best thing you can do before becoming a house flipper is learn everything you possibly can about how to flip houses and make a profit.
The Pros and Cons of Flipping
As with most things, there are pros and cons to flipping houses. Understanding the unique aspects of house flipping will help you understand if the pros outweigh the cons and if you should move forward with this strategy or not.
Pro #1 – Quicker Returns on Your Investment
Your capital is tied up for a shorter period of time than buy-and-hold properties. As previously mentioned, the average timeframe on a house flip is around six months. Keep in mind that this is an average. If this is your first experience flipping a house, expect to encounter a few bumps in the road, which may very well extend your timeframe. The faster you can flip a house, the greater return on investment (ROI) potential.
Pro #2 – No Long-Term Property Management
A major draw to flipping houses is that as soon as the remodel is complete and the property is sold, you can wash your hands and move on (hopefully with a lot of cash in your pocket). You don’t have to worry about finding tenants, collecting rent checks and maintaining the property. You basically avoid the hassles of being a landlord.
Con #1 – Inconsistent Income
This is where you need to look at the opportunity cost of flipping. Opportunity cost is an economic term meaning, “what you give up in order to gain something else.” In other words, if your full-time job is flipping houses, you’re giving up steady, consistent income from working in another career.
Of course it’s possible to make money flipping, however, it will be important to figure out if the money you earn through flipping will produce more or less income than your current day-job. Flipping is creating active income and as soon as you stop actively working, income will stop coming in.
Con #2 – Taxes
Flipping comes with extra cost from buying and selling, including taxes on capital gains. Closing costs when both buying and selling a property can add up and cut into your overall return on investment. The self-employed pay the highest income taxes, as much as 43%. Without getting into too much detail, you should expect to pay an additional 15% on top of your normal taxes.
There’s a big difference between short-term and long-term capital gains tax rates. If you own a property for less than a year, you can expect to pay a capital gains tax rate based on your earned or “ordinary” income.
For a more detailed breakdown on how passive and active income is taxed, check out my article here.
Rental Property is Passive Income
As previously mentioned, flipping can earn a lot of money in a relatively short amount of time. Whereas renting an investment property usually produces less upfront income, but generates income consistently over a long period of time. In other words, your rental property will produce passive income, especially if you hire a property management team to handle finding quality tenants and maintenance.
The Pros and Cons of Renting
Owning rental property has the potential to generate great returns, especially if held over several years. While you won’t be enjoying a lump sum of cash, like flipping a house might produce, you will be collecting consistent income in smaller amounts for as long as you choose to own and rent out the property. Let’s discuss the pros and cons of renting.
Pro #1 – Ongoing Monthly Income
Buying rental property is a long-term investment. If you were injured and unable to work, you would still be receiving monthly income from your rental. Passive income can allow you to become financially independent, build lasting wealth and retire.
Pro #2 – Your Property’s Value Should Increase Over Time
Real estate benefits from inflation. As long as you purchase in the right place at the right time, rents and cash flow will likely rise with inflation. The longer you hold onto your rental property, the more equity you will build. As the value of your rental increases in value year after year, so can your rents.
If you decide to sell the property down the road, you can enjoy a sizeable return. This is especially true if you purchased at the right time (during a buyer’s market) and sell at the right time (during a seller’s market). A seller’s market occurs when there is a shortage of housing on the market, with a large number of people looking to buy or rent. This is the best time to sell, as you’ll likely get more than your asking price, based on supply and demand.
Pro #3 – Investment Property Has Tax Incentives, Flipping Does Not
Investment income is usually taxed at 15% (20% if you make a lot of money). If you compare this tax rate to flipping income at 25-43%, you’ll see just how much money you can save.
Rental property owners can also write off expenses such as, repairs, maintenance, driving to and from the property, the cost of a property manager, the list goes on and on. But, your single biggest advantage is writing off depreciation of your asset. Depreciation can potentially save you thousands of dollars a year in taxes.
Con #1 – Risk of Vacancy
You may be thinking, all of this sounds great, but what if I can’t find quality tenants and my rental sits vacant for months? As with any type of investment, there is always some degree of risk. In certain instances it can be difficult to keep your rental filled for long periods of time. While your rental is vacant, you are obviously responsible for covering the mortgage.
When investing in a rental property, you need to account for and even expect between one to three months of vacancy per year and add that variable into your budget. If you can’t afford to pay, let’s say two mortgages for three months out of the year, you’ll want to put more money away before buying a rental property.
However, there are several ways to minimize the chance of your property sitting vacant. This article provides helpful tips for landlords and property owners.
Con #2 – Not all Rental Property is Passive
I know I said that rental property is passive income. However, there are caveats to this “passive income” idea. You could be actively trying to find deals on rental property, researching the best markets, managing any updates or repairs, etc. If you are planning on managing the property yourself, consider your rental both an investment and a part-time job.
In order to make your rental property a true investment, hire a management company to handle the day-to-day tasks, like finding quality tenants, securing rent checks and responding to any maintenance requests.
2 Strategies for Flipping Houses
There are two main strategies for flipping houses. The first is, buying a house or apartment below market value due to financial distress. The second is buying a true fixer-upper.
Investors using the first strategy should identify properties where owners are unable to maintain, manage or have over-leveraged and are facing the risk of defaulting on their loan.
Investors looking into fixer-uppers should be prepared to invest additional capital for repairs, maintenance and improvements. The idea is to increase the value of a property by fixing it up, turning around and selling it.
Want to learn more about flipping? Read one of the top 5 books on flipping according to Modest Money.
Rental Real Estate Investing
Let’s say you find a property you are interested in buying and renting out. Before purchasing, you will want to sit down and calculate your rental earnings. Research average rents in the area, with other properties similar to yours. This will give you an idea of how much rent you can charge and whether you’ll be making money or losing money. If the numbers work in your favor, you may then choose to move forward with the investment.
What makes the renting or buy-and-hold strategy lucrative in real estate investing is the hold part. The longer you hold onto your rental property, the more equity you build, in addition to the monthly income you receive.
Flipping is Your Business, Rentals are Your Investments
Like I mentioned above, flipping is more of a full-time job than an investment strategy. If you plan on flipping the house yourself, expect to spend countless hours putting in new floors, windows, updating the kitchen, bathrooms, exterior, etc. If you plan on hiring a contractor to do most of the work, plan on spending a great deal of time overseeing and managing the project.
Use Flips to Generate Cash for a Rental Property
If you can’t afford to purchase a rental property right now, you may consider flipping a house first and then using that money as leverage to buy-and-hold another property as a rental. Investors can borrow against their equity or leverage other projects with their current one. Leveraging your equity makes this strategy a much more cost effective option for financing.
Conclusion
After reviewing the pros and cons of each real estate strategy, you should have a good idea of which direction is best for you and your financial goals: flipping houses vs renting. If you like getting your hands dirty and consider yourself to be a very handy, resourceful person, and like the idea of possibly a quicker return, then perhaps flipping is the best strategy for you.
If you prefer the idea of passive income, while keeping your full-time job, and handing the reins over to a great property management team, then investing in rental property may be the best fit for you.
People have found success in both flipping houses and renting them out. If you would like more information and resources about real estate, including, where, when and how to invest, check out the “Learning” page on our website for dozens of helpful tools and tips.
Sources
- https://morrisinvest.com
- https://www.investopedia.com
- https://homeguides.sfgate.com
- https://finance.zacks.com
- https://www.realtor.com
- Fettke, Kathy. Retire Rich with Rentals. 2014.
