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.