Blog #77: “Are There Any USPAP Issues with Flipping Real Estate?”

QUESTION: I like TV shows such as Fixer-Upper and Flipping Las Vegas (although the guy on Flipping Las Vegas is really obnoxious). They make the flipping process look easy. This is something I’d like to do as a side-hustle when my appraisal business slows down. How do I get started? This looks like a way to make a lot of money in a relatively short time. I want to know, though, if I as an appraiser might run into any USPAP problems with flipping.

ANSWER: Many years ago, a business professor asked students to analyze this statement: “You don’t make your money when you sell – you make your money when you buy. You just don’t receive your money till you sell.” He mentioned this in the context of the present value of future income, a concept with which an appraiser must be both familiar and comfortable. Residential real property appraisers may not understand that, when a buyer purchases a property to flip and sell it, that buyer is paying the present value of a (potential) future income. That future income, the buyer ardently hopes, includes an entrepreneurial profit or incentive commensurate with the risks of such an investment of time, money, and talent. If this wholesale-retail-profit relationship is not clear (it is part of the highest and best use hierarchy), then that appraiser needs to take university-level finance, construction, entrepreneurship, and philosophy classes now.

Part of the problem any investor faces is the difficulty of buying at wholesale to sell at retail, the very foundation of making a profit. The problem is TV programs make this process appear far too easy and quick, which it is not. Indeed, It is fraught with risks. Therefore, earning a profit from such an endeavor is not as easy as the producers of those TV shows would have you believe. Remember, it’s TV and TV likes happy, profitable endings.

To purchase a property well below its market value takes is an extremely rare situation in which the seller must sell while under duress. As a result, the sale is not an arm’s-length transaction. In other words, to buy an average house in a $100,000 neighborhood, and then spend $30,000 fixing it up, the grantee must purchase the house for approximately $60,000, assuming the grantee/flipper was satisfied with a $10,000 profit. Typically, a purchase this far below retail is not possible.

When it is possible, the grantee must be able to Invest a great deal of his or her own money up front (or have a great line of credit with a really understanding bank). This means they started out with a great deal of money. Repairs, renovations, and so forth, quickly add costs that will reduce any potential profit upon sale. To buy, renovate, and then flip a property usually requires an intimate knowledge of construction, the presence (and costs) of a general contractor, a construction crew and sub-contractors dedicated to speed and quality, and a hot market for such properties. If any of those are not present, the risk of buying the property, then losing money on the flip (i.e., not earning a profit), is greatly increased.

Simply put, the typical purchaser cannot buy a property sufficiently below market, repair/renovate it, and then flip it for a profit commensurate with the risk involved in doing so. Contractors have a greater chance of success because they can purchase the material and labor at a price sufficiently low enough that there is a profit available on sale. The typical retail purchaser buys drywall 5- to 10-sheets at a time, thus pays full retail (which includes a profit to the retailer). On the other hand, a contractor can buy 100 sheets of drywall at a time (if not more), therefore receive a discount not available to the typical purchaser. This ability to purchase at wholesale increases the contractor’s profit for potential over that of the retail purchaser.

We as appraisers have to be very careful about how we account for any profit available in such a situation. The retail purchaser who renovates a home might spend $25,000 to upgrade the kitchen. Nevertheless, it might cost a contractor only $20,000 to carry out the same renovation and repair processes. As a result, what is the cost of those repairs? Further, what, if any, of the $20,000 to $25,000 contributes to market value? It is possible that none of this money spent would flow to contribution to market value if, for example, these repairs were necessary to repair/renovate a property after a disaster such as a fire or an earthquake.

It is likely that we all have seen a homeowner put $20,000, $30,000, or even $40,000 into repairs and renovations, yet receive only a fraction of this returned at the sale of the property. In other words, we might spend $35,000 on renovations, but it might contribute to market value only $25,000. In this case, we have $10,000 of over improvements, which are likely a super-adequacy, thus an inversion of time and funds the market will never recognize.

Our challenge as appraisers is to carry out sufficient analyses to determine how much of what an investor spends on repairs and renovations actually contribute to market value. Then we must determine how much of those funds (a) were necessary in the first place just to bring the property up to neighborhood average, and (b) how much of them were personal choice, thus merely creating a functional inadequacy over- or under-improvement which may add nothing to market value (and, indeed, may detract from it).

Also, we are all aware that cost and price do not equal market value. To confuse cost with value will likely involve a value opinion well above the market value of the property. This is not a situation in which the appraiser wants to find herself. Yet it is something appraisers do every day.

Therefore, such television programs as Fixer Upper and Flipping Las Vegas are meant solely to entertain the viewer. They are not to educate, enlighten, or train that viewer. In a 30- to 60-minute TV program, it is just not possible to paint an accurate picture of all of the diabolic twists and mephistophelian turns that go into buying a property, repairing/renovating it, and then selling that property at what the flipper hopes is a profit.

The point of all this is that you don’t make your money when you sell – you make it when you buy (which is where the entrepreneurial incentive or profit is). And you have to purchase the whatever sufficiently below its market value that you can hold it, fix it up, and then sell it for its retail market value. That’s when you receive the profit.

It is essentially impossible for the novice to buy a property far enough below market value, repair it in a manner that will be attractive to the market, and then sell it for enough profit to make all the risks of doing so worthwhile. Appraisers must be aware of the fact that $25,000 expended on the purchase of the property and its repairs & renovations does not necessarily involve a $25,000 increase in the property’s market value (as these TV shoes would lead you to conclude). Price and cost are not market value. This is true no matter how loudly and enthusiastically broker, builder, contractor, lender, TV producer, and/or sellers demand it to be otherwise.

One last comment on profit: According to the hierarchy of highest and best use, a use cannot be the highest and best use of the site as if vacant unless that use provides an entrepreneurial incentive or profit greater than any other use. How many appraisers analyze that as part of the components of the Cost approach? Please, appraisers, do not plead there is no entrepreneurial incentive or profit necessary in the Cost approach! An appraiser’s opinion of the market value of the site in the Cost approach assumes that site is vacant and available to be put to its highest and best use, thus the Cost approach assumes new construction when such an incentive is imperative. Without it, no entrepreneur would take the risk to build anything!

Therefore, if the appraiser’s analysis does not include an analysis of the potential entrepreneurial profit or incentive, then the appraiser has not followed USPAP in forming a value conclusion from the Cost approach. This is a potential Ethics violation, as well as a potential violation of SR2-1 (misleading) and 2-3 (not deriving a value opinion as per USPAP). All of these omissions are likely significant USPAP violations (although, frankly, these concepts, to this depth, may be beyond the comprehension of many state appraisal boards and their investigators). That lack of comprehension could work for you or against you. When it comes to a state board, however, assume it will work against you.

And, finally, as to USPAP problems with flipping. Since everything you’d do relative to the purchase, repair/renovation, and sale of the property would be as a principal, not as an appraiser, I see no USPAP problems, at least as far as any potential purchaser of the repaired/renovated house is concerned. I would also recommend you never mention to anybody during the flipping process you are an appraiser. That way, nobody can hold you responsible for making any representations you were, thus took advantage of them via your greater knowledge of the market.

When you have any USPAP or USPAP-related questions, please feel free to contact me, Tim Andersen, The Appraiser’s Advocate, at tim@theappraisersadvocte.com. Thanks! It will be a pleasure to work with you!