| | Flipping Q & A
Q: Can you please explain the difference between “illegal flipping” and legally selling a property for a profit? –CB, Cincinnati
A: I’ve gotten this question a lot lately, thanks to the passage in May 2003 of the HUD “anti-flipping” rule and the subsequent attention the media has been paying to “illegal flipping.” Buying and quickly reselling a property for a profit is still perfectly legal (and a great way to build wealth!), but has, unfortunately, gotten a bad name thanks to the fraudulent activities of a small number of investors.
The “illegal flipping” to which you’ve seen reference involves deception, false appraisals, and, usually, bank fraud. Although it wears many faces, an “illegal flipping” transaction typically has some or all of the following characteristics: It is done with the intent to defraud the buyer, who is almost always an unsophisticated, low- to moderate-income first time home buyer. The property is purchased at a very low price and sold at a higher-than-retail price by a seller who has done does minimal repairs to the property, often covering up major defects without fixing them. The seller colludes with an appraiser to get a higher-than-market appraisal, and with a mortgage broker to falsify information on the buyers application, making the buyers seem more qualified than they are. The result is that the buyer overpays for a property that he can’t really afford, and which turns out to have major problems that he can’t afford to fix. He can’t sell his property, because he paid more than it’s really worth, and when he can’t hold on any more, the property is foreclosed upon. The buyer loses his home and his credit rating, the bank loses when it gets the property back–and we all lose when homes go vacant by the hundreds and property values drop as a result.
Before the word “flipping” was hijacked by these folks, it was most commonly used to describe a strategy called “retailing. In a “retailing” deal, the investor buys a property at an under-market price, then fully repairs and renovates it with the intention of making a profit by providing a qualified home buyer with a top-quality home. Unlike “illegal flipping” transactions, the home buyer is generally middle- to high-income, as the properties chosen by real retailers are not in low-income areas. The seller prices the house at–not above–true retail value; therefore, no appraiser collusion is necessary. The seller pre-qualifies all potential buyers to assure that they will be able to purchase the property quickly and with no hitches, thus assuring the seller a quick return on his investment. The buyer goes through the normal loan process with the lender of HIS choice–not one chosen by the seller for the lender’s willingness to “bend the rules”.
The “anti-flipping rule” put into place by HUD last year in an attempt to stem the tide of foreclosures resulting from illegal flips. Under the rule, FHA will not insure loans on properties where the seller has owned the home for less than 3 months, and requires additional appraisals and paperwork in order in insure loans on properties where the seller has been the owner for 3-6 months. This rule has ended up affecting almost all home sales by investors, as most conventional loans–even those not insured by FHA–now require a 6 month holding period. The unfortunate side has been that thousands of homeowners have been denied affordable loans on some of the best properties in their chosen areas, simply because the retailer hasn’t owned the property long enough. In trying to stop a few bad people from defrauding home buyers, the government has succeeded in limiting housing choice for tens of thousands of potential buyers.
Reprinted from the Real Deal, a monthly newsletter for Real Life Real Estate Investors with permission of Vena Jones-Cox. Get a free 3-month trial subscription by logging onto regoddess.com