Real Estate… Answered

No term in the real estate investing field is more misunderstood than flipping. Realtors and attorneys will tell you that flipping a house is illegal. Is it? The answer is yes… and no. "Flipping" has two separate definitions. The one attorneys and realtors talk about is illegal. Investors use the second and completely different definition, which is not illegal. In case you get into a debate on the subject, let’s go through each of them step by step.

1) Understanding Illegal Flipping

According to the Department of Housing and Urban Development, flipping occurs when:

A recently acquired property is resold for a considerable profit with an artificially inflated value.

The keywords here are "artificially inflated." An unscrupulous developer or investor pays off appraisers and lenders to convince an unwitting seller that a property is worth more than its real value. The seller innocently buys the property, believing that they’ve made a great investment. When they try to sell, other realtors or buyers will discover the artificial value, causing the owner to lose a considerable amount of money and possibly face foreclosure.

Here’s an example. A developer will build one or more houses that have a real-world value of $100,000. Instead of selling them for the real value, they pay an appraiser to say each property is worth $200,000. Typically, the developer will also bribe an underwriter to give a naïve buyer a loan for $200,000 based on the fake appraisal. The buyer closes on the property for $200,000, giving the developer $100,000 of additional, illegal profit. Then, when they try to sell a year later, they discover the property is only worth $100,000, even though they owe the bank $200,000.

2) Understanding Legitimate Flipping

Investors do not engage in illegal flipping. When they talk about flipping a house, they are referring to a completely different process that is entirely legitimate. The key difference is they buy and resell the house without artificially inflating its value. It’s like a consignment shop owner that buys knickknacks at garage sales for a steep discount and then resells them at their storefront for a price closer to retail. The consignment shop owner isn’t artificially inflating the value; they are simply buying low and selling high.

For example, a real estate investor might find a motivated seller facing foreclosure and buy their house for $70,000, when it’s actually worth $100,000. In other words, the investor is buying the house $30,000 below its true value. A few days later the investor will typically sell the property for $80,000 to a homebuyer or colleague that is looking for a good deal. The investor makes a quick $10,000 and the buyer closes on a house with $20,000 of equity. Not only is the process completely legal and ethical, but everyone wins.

Some investors have started calling the process "wholesaling" in order to reduce the confusion between the two separate definitions of the term, but for now, "flipping" is still the industry standard. So, we have to live with the confusion. Your best defense against someone calling you a criminal is explaining which process you are using and the common misconception about the term. Whenever you talk to a lender, realtor, or attorney, tell them that you’ve found and undervalued property and a buyer willing to pay its true retail value. You’re just the middleman in the transaction that gets paid for finding a great deal.