Flipping as an Evolutionary Response Pt 2

In my last post, I discussed why house flipping seems like a guaranteed way to lose money most of the time - how it violate both common sense as well as standard real estate rules of thumb. However, it's unmistakable that many people became flippers. Why?

The solution that I propose is this: the flipping business model was an evolutionary response to a unique set of conditions or environment. In this environment, the model flourished and multiplied. But like a specialized organism adapted to a single niche, it has not been able to survive in other environments and now faces extinction. Think of the deep sea worms that live among the volcanic vents at the ocean's floor - they are well suited to that environment, but take them out of that ecosystem, and they die.

What was the environment where they flourished? Firstly, they grew from 2001 to 2005 when prices were appreciating in CA, FL, etc. at rates of 20%+.



And because the classic flip has a cycle of 3 to 6 months, the profits from success allowed the flippers to "breed" incredibly quickly. Let's say a flipper started off in 2001 with one house. Six months later, he would be able to take his winnings and finance 2 or more new deals. Thus, one would expect to see rapid growth of this profitable business model.

The second environmental feature required was loose financing - particularly of the zero down, interest only, negative amortization variety. This was the high growth "food" that the model lived on, allowing the flippers to carry the properties for a fraction of the out of pocket costs that would have prevailed in a normal environment. Indeed, with no money down and the negative amortization feature, a flipper could carry the home with essentially no out of pocket expense during the holding period. With this, the flips could grow and multiply even faster.

But the environment has changed and is no longer hospitable to the flipping model. Now, prices are dropping and exotic loans are rare. This has caused the extinction of the model. Those, like Casey Serin, who tried to use the model too late in the game have found that it no longer works in the current environment - that it is poorly adapted to current condition.

This evolutionary approach is not unique to the flipping model. Think of the late '90's where companies such as pets.com and eToys, companies with no profit and no viable business model could launch IPO's raising billions. Those same models were supremely adapted to the internet bubble but faced extinction in the 2001-2002 climate. Expect the same for the flippers.

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.

Purpose of this Blog

While there are many excellent resources out there discussing the speculative US housing bubble and crash, I would like to take a slightly different approach. Much of this information is contradictory (perhaps intentionally) and can be confusing, even to a well educated, well informed readers. This is true even of people who "should know better".

My goal is to take a non-shrill, common sense approach to the issue and discuss the phenomena from a non-judgmental basis. Too often, I feel like the discussion of what is an important economic event becomes a shouting match between those (in the mortgage or real estate industries) who claim that there is no bubble and those who (like I have been in the past) who claim there is a bubble but focus on fraud, stupidity and greed of those involved. I'm not sure that this is all that productive.

With that in mind, I'd like to focus this blog on the following foundation: There has been a speculative bubble in housing, especially in places like Florida, California, Boston, Arizona and Nevada. This is really a common, well-documented affliction of capitalism that has happened again and again throughout history (stocks in the 1920's, internet bubble, Florida land in the 20's etc.). Like all speculative bubbles, the housing bubble involves a "mania" where people, by definition, do foolish, irrational things. And like all bubbles people (both good and bad, smart and dumb) get caught up in that madness and ultimately get hurt. Not to excuse them, but as in all get rich schemes, bubble also attract more than their fair share of swindlers, fraudsters and the like. That's why they are bubbles and that's why they are a danger.

To put this all in historical context, writing in 1841 about the Tulip bubble of 1600, Charles Mackay noted:

Many individuals grew suddenly rich. A golden bait hung temptingly out before the people, and one after the other, they rushed to the tulip-marts, like flies around a honey pot. Every one imagined that the passion for tulips would last for ever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them.

Cross out tulips and use California real estate and you could use the same paragraph to describe the period of 2000-2005.

I believe that economics is about a search for the truth, about objective understanding of our world and not "proving" someone is right or wrong. I believe it is akin to going to a doctor. The doctor takes a look at the symptoms (say temperature, skin, etc.) and then based on experience, what he learned in med school and what his textbooks say, provides an objective diagnosis. I do not believe economics should be about wishful thinking and making people feel comfortable by dispensing comforting sounding phrases such as "soft landing".

In Business Las Vegas reports from Nevada. “In his latest take on the Las Vegas housing market in light of new home sales remaining weak, new home prices dropping and inventory of existing homes increasing, local housing analyst Dennis Smith said he appears to have underestimated what was happening when he predicted at the end of 2006 that the market was bottoming out.”

“Smith said any suggestions that the market was going to improve by the end of 2007 appears to have been just wishful thinking.

That is, I'd rather go into a doctor who, after looking at my symptoms said something like "You have chicken pox, it will probably last for x days and your tempature will probably be x degrees during that time. You will experience pox on your face and back but they should go away after x days." than "You're OK, don't worry."

One further point, and it involves both critical reasoning and economics. The National Association of Realtors (NAR) is an industry group who's members benefit when more homes are sold at higher prices. Therefore, using basic economic theory (that people will do what they are incentivized to do) and common sense, I can predict that any message being sent out from this organization will support buying more houses being sold at higher prices.

There is nothing "wrong" with this. I have the same expectation when I was listening to OJ's lawyer in the OJ Simpson case - his lawyer is paid to get him off and thus all of his arguments and evidence will support this point. I have the same expectation when I listen to a PR release from Wallmart's PR firm - that the message will be that Wallmart is great. If you look at the success of past predictions from NAR, you'll see that they have pretty much all supported "buying right now" and that these predictions have been poor at best. But again, that is to be expected because these statements are NOT about educating or informing the public. They are about getting them to buy houses now so that their members will profit. And, taken with that understanding, the NAR predictions are doing exactly what I would want them to do if I was a Realtor.

I plan to write one or two well thought out posts per week. Each will be in depth and well supported and will be based on a larger historical and economic perspective. The following posts are planned: Flipping as a business model, Sub-prime lending as a business model, bailouts from a historic perspective, best internet bubble resources, likely price declines. Stay tuned...