House Flipping as an Evolutionary Response: Pt. 1

Summary: House flipping was an extremely specialized business model that was an evolutionary response to a set of unique conditions that existed from 2001 to 2005. While this model is unlikely to survive in normal circumstances, it was extremely well suited to thrive and reproduce during this period.

Flipping as a business always seemed stupid to me. The model has two common variations:

1. Purchase a new home from a builder prior to completion and then immediately sell for a profit when the home is complete.
2. Purchase an existing home, do some cosmetic work, and sell it for a large profit after a few months.

Let's look at them in turn. The first model basically involves purchasing an item at retail from the producer and then reselling it to the end customer. If this sounds silly, it is because it is silly. Think of doing this with any other product - say a car. Imagine a business model which involves going to your local Honda dealer, buying an Accord, sitting on it for a few months and then listing it on Craigslist or whatever and hoping to earn a profit. Add to this the fact that the dealer can offer customization, financing and that you must pay a large transaction fee and it is self-evident that this is recipe to lose money.

What about the second variation? This is the one that numerous TV shows (Flip this House, Flip that House) espouse as the path to riches. However, looked at closely, this model intentionally violates several housing rules that have been accepted until the bubble. Look these rules of thumb up in any older housing book, they are:

1. In general, you will lose money if you hold a house for less than three years (transaction costs will more then eat up any gain). In other words, expect to lose money if you hold for less than three years.
   
2. In general, the only renovations that cover their costs are flowers, paint and lawn. You will not make back money spent on kitchens, appliances, roofs, etc.

So, put together, the second flipping variation is to basically do exactly the opposite of what has up until now been considered smart home selling.

Given the inherent silliness of this behavior as well as the strong likelihood of flipping leading to large losses (as they in fact are as documented by Bubble Markets Inventory Tracking or Sacramento Flippers in Trouble), why did so many people become flippers? That will be the basis for the next post but it has to do with an evolutionary response to extremely unusual circumstances.