DC Home Prices & Increased Competition Make House Flipping Risky

From the perspective of a real estate investor, I continue to grow ever more concerned about the long-term viability of the Washington-area housing market.

How much higher can housing prices go?

SmartAsset  recently did a study on the 100 largest housing markets in the United States. It compared the median household income to the median home value in each city. Washington came in No. 13 on its list with the average home price equal to 7.63 times the median household income.

That means the median home price is equal to more than seven and a half years of income for the median household. Experts used to recommend that you spend no more than two and a half times your annual income on your home purchase.

Arlington, Va., also made the list, coming in at No. 21 with a multiple of 6.14. These numbers are consistent with what I’ve been seeing.

Now, there are a lot of potential problems with comparing median income to median price to describe the health of a local housing market. There are a lot of factors that could skew the results. Granted, it may not be the perfect measure, but how many times have you asked or have you heard someone else ask: “Who can afford these houses?” It sure feels like homes are becoming unaffordable, especially for that critical middle-market buyer.

The problem with housing prices, or really any kind of overvalued asset, is that the run always seems to last longer than mathematically justifiable. They persist until people are fooled into thinking there’s a new market dynamic. During the past cycle, houses were overvalued by 2004. But the prices plowed upward for at least two more years — just long enough to get the most stubborn holdout to relent and jump into the market before the crash.

There’s an additional problem for us investors: contractors. Many retail home buyers don’t have to worry about this, but my business is development and home improvement. I live on cashing in on adding value to homes and/or land. I have got to have good, reliable and affordable contractor partners to add that value.

Just like what happened during the run-up in the past cycle, contractors are getting very busy again. They’re managing more jobs at a time. It takes more time to get a project done. The quality of the work is going down, and their prices are going up.

I just parted ways with a contractor with whom I’ve worked for the past four years. The last three projects he did for me all took far longer than they should have, and the final inspections came back with major deficiencies. The deficiencies were so bad that they worried the buyers to the point of considering walking away from the deal.

Sure, the contractor fixed those items, and for that I’m grateful, but the damage was already done. My buyers were looking at me like I was a shady operator. From that point forward, the negotiations become much less amicable. The buyers began wondering what I was trying to get over on them at every turn. I lost all my leverage.

Contractors and materials are getting far more expensive. Work is taking longer, and each project is getting less attention. You’re paying more for less and waiting longer for it.

Another red flag for this market: Private money is flowing freely again. The lenders are coming out again in force. It’s still hard to get a bank loan. The banks send me a dozen personal credit card offers a week with interest rates under 10 percent, but not so many offers for financing for my business.

No, I still greatly rely on private capital to finance my projects. And those private lenders have once again opened the funding spigot to almost anything or anyone. They get more comfortable and more lax with each deal that pays out.

I remember back in the fall of 2008. I specifically noted that the average home prices in many of our areas had dropped to ridiculously low levels as compared with the published median household incomes.

I specifically remember calling private lenders and telling them that the average home price in Woodbridge, Va., had dropped to less than two times the average household income. Woodbridge had just been hit by a double whammy. The financial markets had just collapsed right at the time that the county had passed several laws intended to dissuade illegal immigration. Many believe that move exacerbated the impact on housing prices in the county as a lot of people walked away from their homes.

Home prices in Woodbridge dropped something like 15 percent in October 2008 alone. Many flippers walked away from their projects, leaving private lenders holding the bag. Private lenders had just been burned to a crisp in that area and they cut way back on their lending.

I shared this insight with a lender and told him we needed to raise a bunch of money and start buying up houses. “No way,” he told me. “Woodbridge is a war zone.”

I was able to eventually raise a little money, and I bought a couple of houses but nothing on the scale I wanted. And the investors wanted their money back right away, so I couldn’t hold on to the properties to maximize the benefit.

Right after the crash, private lenders were reminded that the operator is the most important part of the home-flipping equation. I had several private lenders tell me they weren’t lending to new people anymore. They promised they were only going to lend to me and a handful of other proven real estate investors. They had learned that they don’t want to be in business with people who walk away from deals when things get bumpy.

Memories are short in the private lending world. I was recently speaking with that same lender to negotiate funding. The rates he was quoting me had gone up. He explained that there is so much competition for his money now that he’s raising his interest rates. People are jumping into this market with little experience and little cash, and the private lenders are funding them again. I’m not so special anymore.

When the market ultimately turns — and it will — you had better be aligned with good, reliable people. The people you want are those who will finish a job even if there’s no profit left in it.

That leads me right into the other danger sign. Every bubble market I’ve witnessed comes with a sense that anyone can make money in the market. Remember the stock market of the late 1990s? Remember how everyone was a trader?

New flippers and landlords are joining the market at an incredible rate. Attom Data just reported that returns on home flipping continue to shrink. But the real worry is that they show a consistent number of flipped homes quarter after quarter spread out over a larger number of flippers. There are a lot of new flippers in the mix. They’re operating on thinner, riskier margins with less experience or ability to predict and navigate problems.

Even more concerning in this report is the fact that the District had the highest rate of flipped homes as a share of the market. Most flipping activity nationwide has moved out of the primary hot markets and into secondary markets. That’s not the case here in Washington.

I don’t know what’s going to happen, and if I had to guess, I’d say this market will probably continue to be strong for another couple of years. I don’t know if the market will just level off or if prices will come down. Most of this is not much more than a gut feeling, but I’m taking measures to protect myself.

I just began purchasing houses in markets outside the D.C. area. It’s the same tactic I used back in 2004 when I started buying houses in North Carolina and Utah. It worked out pretty well then. I just purchased two rentals in North Carolina. I’ll detail those in my next column.