THE CHALLENGING ROAD AHEAD?
The Bottom Line is the Bottom Line
By Rick Sharga
The fix-and-flip market hit what was probably an all-time high in the first quarter of 2022. According to ATTOM’s first-quarter 2022 U.S. Home Flipping Report, 114,706 single-family houses and condominiums in the United States were flipped in the first quarter, representing almost 10% of all home sales in the quarter — the highest level since at least 2000. The first quarter total was up from 6.9% during the fourth quarter of 2021, and from 4.9% in the first quarter of 2021.
The jump in the home-flipping rate during the first quarter of this year marked the fifth straight quarterly increase. It also represented the largest quarterly and annual percentage-point gains since 2000.
Conditions in the housing market for the past two years have been ideal for fix-and-flip investors, who traditionally do very well when conditions include high demand from homebuyers, low supply of homes for sale and rapidly rising home prices. All three of those characteristics have been in abundant supply over the past few years. Demand was driven largely by demographics as the largest cohort of Millennials (the largest generation in U.S. history) has crept closer to prime homebuying age.
Homebuilders have grossly underbuilt since the end of the Great Recession, leading to an historic undersupply of housing. This supply and demand imbalance led to rapid home price acceleration.
The COVID-19 pandemic actually accelerated some of these trends: the Federal Reserve acted to keep interest rates lower in order to bolster the economy through the pandemic-driven recession, leading to the lowest mortgage rates ever recorded, further fueling demand. Prospective homebuyers leapt at the chance to become homeowners because of how affordable these interest rates made homeownership.
People having the newfound ability to work from home fled from rental properties in high cost, high tax cities to buy houses in more affordable locations. All of this activity exacerbated the supply/demand imbalance and drove home price appreciation into the high double-digit range (over 40% annually in markets like Boise, Idaho and over 30% in St. Georges, Utah) with little impact on affordability because of the low mortgage rates.
High demand. Low supply. Rapidly rising home prices. A perfect scenario for flipping.
But if you are a fix-and-flip investor, hold off on popping that champagne cork just yet, especially if you are just getting started in the field. It is possible that the first quarter numbers represented a peak for this cycle rather than heralding an even stronger market yet to come. There are several possible storm clouds on the horizon for flippers, and they all bear watching.
Profits and Profit Margins are Shrinking
While the ATTOM report highlighted the dramatic increase in the number of properties flipped, it also showed that as home sales by investors spiked, the gross profits on those deals remained below where they were a year ago, and in a more striking trend, profit margins dipped to their lowest point since 2009.
Among all flips nationwide, the gross profit on typical transactions as reported by ATTOM (the difference between the median purchase price paid by investors and the median resale price) stood at $67,000 in the first quarter of 2022. While that was up 5.5% from $63,500 in the fourth quarter of 2021, and represented the first increase since late 2020, it was 4.3% less than the $70,000 level recorded in the first quarter of 2021.
Profit margins, defined as the gross profit divided by the original purchase price, fell for the sixth quarter in a row, as the gross flipping profit of $67,000 in the first quarter of 2022 translated into just a 25.8% return on investment compared to the original acquisition price. The national gross-flipping ROI was down from 27.3% in the fourth quarter of 2021 and from 38.9% a year earlier. It sat at the lowest point since the first quarter of 2009, when the housing market was slumping from the effects of the Great Recession in the late 2000s. This return on investment also was less than half the peak of 53.1% for this century, which hit in late 2016.
Gross profits and profit margins declined despite record sales prices on flipped properties — the median price of homes flipped in the first quarter of 2022 increased to another all-time high of $327,000. That was up 10.5% from $296,000 in the fourth quarter of 2021 and 30.8% from $250,000 a year earlier. Both increases stood out as the largest for flipped properties since 2000.
So how could profit margins decline even as resale prices on flipped homes continued to shoot up? Essentially, fix-and-flip property prices appreciated more slowly than investors had anticipated when they purchased them. Rising mortgage rates are beginning to slow down home price appreciation, and buyers have become more selective – and less willing to outbid other buyers for properties. This is having a predictable impact on profit margins for investors.
Not included in the ATTOM analysis — but putting even more pressure on flipping profits — are the rising costs of materials and labor. Limited availability of both labor and building materials is also extending the time needed to make repairs, which is likely increasing holding and financing costs for investors. The bottom line is that the bottom line is getting tighter, and fix-and-flip investors need to sharpen their pencils when it comes to valuing a property and estimating repairs in order to avoid a financial catastrophe.
Demand Appears to be Weakening
Rising costs and slowing home price appreciation are worrisome, but what about the buyers?
From all indications, demand is beginning to weaken pretty significantly:
» May marked the tenth consecutive month of existing home sales being lower than the prior year’s and the fifth consecutive month of lower sales than the prior month
» Pending home sales — an indicator of future closings – has declined on a year-over-year basis for 12 consecutive months
» The Mortgage Bankers Association Purchase Loan Application Index, which tracks how many prospective homebuyers are applying for a loan, is running about 20% lower than both 2019 and 2021 (COVID-19 made 2020 numbers too much of an aberration to be included)
» Price reductions on listings are accelerating rapidly after being virtually non-existent over the past 24 months
» And California home sales, considered something of a bellwether by many housing market analysts, were off by 27% in June according to the California Association of Realtors, and down almost 11% year-to-date
Affordability — or, more accurately, limited affordability — appears to be the culprit. Rates for a typical 30-year, fixed-rate loan have effectively doubled from sub-3% to almost 6%. Coupled with home prices increasing at 15% or more over the first half of the year, a prospective buyer would find himself or herself paying 40-50% more a month for the same house they might have purchased a year ago.
While some buyers will downsize their target properties and look for less expensive homes or locations, many others will simply decide to wait for the market to settle down a bit and rent instead.
Given that, after surpassing six million sales of existing homes and over 760,000 new homes in 2021, forecasts for 2022 are down significantly. At the current pace of sales, there will be approximately 5.4 million existing homes and roughly 700,000 new homes sold over the course of the year, which translates to over 650,000 less sales opportunities for flippers.
The good news is that slowing sales will also lead to slower home price appreciation — probably down to between 3-5% by the end of 2022 — which should improve affordability slightly and stimulate more demand. But those lower rates of appreciation should also be a cautionary note for flippers who sometimes over-estimate the ultimate market value of the home they are flipping.
More Homes Available, and for More Time
We noted above that the ideal environment for fix-and-flip investors is characterized by high demand, rapidly rising prices and low inventory. And if you have read this far you know that demand appears to be weakening, and that higher interest rates are slowing down home price appreciation. Unfortunately for flippers, inventory levels also appear to be rising for the first time in several years, and properties are not selling as quickly as they had been until recently.
Inventory of homes for sale has been in decline for several years, and homebuilders have underbuilt relative to population trends for the better part of a decade. But according to an analysis by Altos Research, inventory levels have climbed for four consecutive months, and should continue to climb into the Fall. The National Association of Realtors (NAR) similarly reported that inventory levels were up to 2.6 months in May – still less than 50% of normal levels, but well off the cyclical low of 1.5 months reached several months ago. While not yet back to market equilibrium, the days of dramatic home shortages appear to be behind us.
Homes are still selling quickly once they are listed, in about 16 days according to the NAR, but the percentage of “instant sales,” properties that are under contract immediately after being listed, has dropped by about half – from 36% of all sales in December to just over 18% in July according to Altos. And fewer properties are selling above list price than at any time in the past several years. So, flippers need to factor in extra time to list and sell properties, and price them to sell in an increasingly-picky market.
The Bottom Line is the Bottom Line
The number of flips, and the profit on those flips, seems likely to have peaked for the current housing market cycle as demand weakens, inventory increases, and home prices likely plateau (and maybe even decline slightly in some markets). This will make things challenging for novices.
But for fix-and-flip investors who know what they are doing — accurately valuing properties and estimating repairs — there are still opportunities to be had, and solid profitability for
their bottom lines.
