Automated Home Flipping

By: 
Al Jacobs

A newspaper headline recently attracted my attention: “Zillow Quits Automated Home-Flip Business.” A brief reading of the article described the circumstances remarkably well. The mammoth real estate firm, Zillow Group Inc., had been purchasing thousands of homes across the country each month while, as rapidly as possible thereafter, attempted to sell them at a profit.

Apparently things failed to work as they intended; during the company’s third quarter they posted a loss of more than $380 million. Following Zillow’s common stock plunging 11.5% on Nov. 3, the firm announced its intent to exit that field of operations at once.

I will confess I’ve paid little attention to Zillow over the 15 years since its founding. My only involvement with the firm I can recall was about 10 years ago, when I logged into their website to see what value they placed on my personal residence in Dana Point, California. At the time I knew my home’s value to be about $2,500,000, and was simply curious to see how accurate they might be. Within a matter of minutes I spotted their figure: $1,700,000.

Almost instantaneously I understood why they erred so badly. My residential area consists of a group of several hundred single-story custom homes, many of the parcels on curved streets, approximately 300 yards from the Pacific. There are possibly 75 to 100 homes with fine ocean views; the remainder possess none. At the time such a preferred lot site added perhaps $750,000 to its value.

My home has an excellent view of both the ocean and Santa Catalina Island. I presumed Zillow’s automated appraisal technique took no consideration of this, and they simply averaged my home in with all the others in the subdivision – view or no view. When the discerning eye is absent, and artificial intelligence substitutes for the human brain, there can be no assurance the results will be accurate.

This concluded my interest in the firm, and I paid no further attention to it. As an aside, it’s my suspicion, as Zillow increased in size and prominence, it became more automated … and by my estimation, less capable of determining real estate values satisfactorily. With a machine substituting for the human element, what is left is the ability to perform in greater volume and at increased speed – sorry, but this is not the route to profitability. Let me now provide you with instructions on home flipping.

In the flipping business, economic timing can be important. By late 1994 a real estate recession eased in many parts of the nation. However, the Chapter Nine bankruptcy filing by Orange County in December of that year made an impact. For the next 18 months newspaper articles described the area as an economic basket case, with dire predictions for recovery. As expected, both buyers and sellers lost confidence in the local real estate, and prices once again dropped.

Perception is not always realty. Despite gross malfeasance by some local public officials and a temporary budget problem for the bureaucrats, the county remained as fine as ever, with an exquisite climate, sunny beaches, prosperous businesses, low unemployment and strong infrastructure. With these factors in mind, it seemed an ideal time to acquire residences, hold them for a few years as rentals and then – with a touch of good luck – dispose of them at a handsome profit.

In collaboration with a real estate agent long active in the local condominium market, I selected half-a-dozen projects from which to cull properties – all in Santa Ana, one of the county’s major cities. Each contained several hundred units in areas described as lower middle class. In March of 1995 we began acquisition of condo units acquired by prior foreclosures, concentrating our efforts on units held by government agencies such as the VA or FHA or by commercial banks and mortgage insurance companies.

Clearly these hapless owners wanted quick and unfettered disposal. We designed our bids to meet this requirement: purchase price all cash; property condition as is; no contingencies; escrow to close in 15 days. In the sealed-bid auctions, we often won out over competing bids offering more cash to the seller.

Our program worked out as expected. During the interval extending through the end of 1997, as the media portrayed the county as slipping into the Pacific, sellers remained motivated while serious buyers all but disappeared. Over this period, we acquired nearly 50 condos at prices about 60% of current value. As the escrows closed, we quickly renovated each property and, thanks to a brisk rental market, made them income producing, with annual cash flows of 12% to 15%. Irrespective of future appreciation, these properties met all the criteria for sound investment.

As the calm invariably follows the storm, 1998 ushered in an era of recognized prosperity. With the bankruptcy now a distant memory, the media discovered a revitalized economy, and by the spring of that year, Orange County became – to paraphrase Vice President Al Gore – reinvented. Property values rose as buyers and sellers reacted, at last, to market reality. And with the advent of a healthy sales climate, we wasted no time in disposing of the condos at substantially increased prices.

And finally, what might a skeptic conclude in the aftermath, where a handful of persons profited from circumstances that saw fortunes lost, political careers destroyed, properties seized and innocent families evicted from their homes? Perhaps nothing more than a reinforcement of the ancient adage: It’s an ill wind that blows no good.

And now to you prospective flip investors, don’t go away; I have another lesson to impart. The year is 2010, and the horrendous national recession which hit two years earlier is still taking its toll on millions of distressed Americans. If any records are being set, it is in the number of persons who lost – or are still in the process of losing – their homes through foreclosure.

And what complicates the situation all the more is during those past two years, home values dropped precipitously … many to the point where not only the homeowner is without equity, but the lender’s defaulted loan is substantially higher than the property value. This may not sound like good times, but it is made to order for flipping.

Working with Janelle, an experienced real estate broker, and her husband, Tyson, a competent handyman, we began attending the twice weekly foreclosure auctions held in front of the Superior Court building in Riverside. We obviously intended to make bids, but the efforts preceding our bidding proved to be the key as to how we might fare.

The point I am stressing is countless hours of involvement is required before a suitable bid can be made. The house must be inspected as thoroughly as possible – not easily done in many cases – and, in conjunction with the probable costs of required renovation, a current market value established.

And how shall we determine our bid? Here are the criteria: What unpaid liabilities will remain after the foreclosure sale? This is vital. Will there be an occupant following the sale? If so, their removal will take time and money. Is the house among the lower valued ones in the neighborhood? I’ve determined the lower, the better. Are there any obvious impediments such as a particularly poor location or a junk residence next door? These can affect sales value.

And lastly, what does a trained eye see which adds or subtracts from marketability and sales value? Once again, this requires a real live human – not an automated device. And finally, when all is cut and dried, it is my contention the bid should not exceed 60% of anticipated market value.

During the four-year period 2010 through 2014, we worked the Inland Empire of Riverside and San Bernardino Counties – the least expensive areas of Southern California, acquiring about 75 houses. Our average purchase prices ran between $65,000 and $125,000, and these on houses we rapidly sold in the range of $115,000 to $200,000.

My estimation is we averaged a profit of between $20,000 and $30,000 on each sale … though when something went particularly sour, our return might drop to near nothing. At other times, however, we got especially lucky and pocketed a pretty penny. As for the arrangement with my two associates, I financed the operation in its entirety, and they did all the work. We split the profits 50-50.

Let me now add without Janelle’s astuteness, and Tyson’s capability, our flipping operation could well have been a dismal failure. This is not an operation to be run indifferently by robots ... which I somewhat suspect is the way Zillow chose to run theirs.

I’ve noted over the years, as businesses grow and age – and correspondingly as they become highly profitable – they conduct themselves in inappropriate ways. They dismiss their clients, abuse their employees, ignore their customers and handle their finances improperly. This must have something to do with the way we are as a species; perhaps the legislature will enact a law to prohibit human nature.

A final thought: It appears automation is becoming ubiquitous, so as I’m told, no one will be able to avoid it. This is probably true, but I am postponing it as best I can … and I welcome anyone who concurs to come along and reside with me here in 1957.

Al Jacobs, a professional investor for nearly a half-century, issues weekly financial articles in which he shares his financial knowledge and experience. Al may be contacted at al@abjacobs.com.

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