The Exchange

Why House Flippers Might Get Hosed

They’re baa-aaack.

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Reuters

House flippers helped generate the real-estate frenzy from 2003 to 2006, buying and selling homes within six months or less to turn a quick profit as home values rapidly rose. Some flippers made a killing, but in general they added to the froth that eventually pushed the housing market over the edge. As prices began to plummet, some flippers became reluctant “underwater” homeowners suddenly stuck with a white elephant.

With home prices now rising by double-digits once again, flippers are making a comeback. Research firm Realty Trac recently published a report claiming that “flipping homes will likely become more favorable for investors in 2013 as home prices are expected to continue climbing.” The top five markets for flipping, according to RealtyTrac, are Orlando, Las Vegas, Phoenix, Tampa and Memphis.

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The Wall Street Journal recently reported that the number of homes flipped in California has hit the highest level since 2005, leading a national trend. Some flippers are professional investors, but others are individuals who just happen to have the funds for an all-cash purchase. House-flipping seminars have returned in some areas, along with warnings by consumer advocates to be wary of them.

House flipping, like many forms of speculation, has a legitimate place in a capitalist economy, as long as flippers risk their own money and pose no unusual risks to the broader system. Speculators often put up capital others don’t have, which can help keep markets fluid.

Risk of getting swamped

But some real-estate experts think flippers could quickly get swamped in a market that is still prone to shocks. "They’re a real concern to me," says Stan Humphries, chief economist at real-estate research firm Zillow (Z). "They create volatility and make prices go up more than they should. And it's usually the less sophisticated participants who get hurt the most."

The majority of economists think the recent rise in home prices — which soared by a nationwide average of 10.2% per year in the latest Case-Shiller report — is good news for the economy because it repairs some of the damage from a housing bust that slashed home values by 30% or more. But some feel new bubbles are forming. And a full housing recovery is still years away, with price gains likely to be jagged and unpredictable.

The biggest risk is what will happen as interest rates rise, which they have started to do recently. Homes that drew a queue of buyers with mortgage rates at 3.5% might not be nearly as appealing if rates rise to 5%, 6% or 7%, because the monthly payments would be considerably higher and renting might seem like a better option. “If the price of money goes up, you’ll price more people out of the home market,” Emile Haddad, CEO of real-estate management firm FivePoint Communities, said at the recent Milken Institute Global Conference. “And if you create more-expensive mortgages, you’ll put underwater homeowners more underwater.”

The Federal Reserve has deliberately pushed rates to record lows, and flippers seem to be betting that they’ll stay there. The Fed, for its part, has said it will continue its loose-money policies as long as the job market remains weak. But it has also been vague about exactly what conditions might trigger tighter policy and bring on higher rates. Some investors think it could happen as early as this summer, with anticipation alone pushing mortgage rates up by half a percentage point just over the past 30 days.

Big shock to buyers

Mortgage rates of 7% or so — nearly double current levels — would be closer to historical norms. Yet that could be a big shock to buyers still skittish about the economy and unwilling to go out on a limb to buy a house. The biggest factor may be whether rates rise abruptly or slowly. Lawrence Yun, chief economist at the National Association of Realtors, thinks the recent uptick in rates is permanent, with another half-point increase likely by the end of 2013.

Meanwhile, the housing market is distorted by several other oddities. The supply of homes is unusually low because many local builders can’t get loans needed to finance new construction. That limits supply and pushes up prices. At the same time, banks still won’t give loans to many buyers, which limits demand. If one of those pressures eases before the other, prices could swing up or down.

The most successful flippers will probably be those who recognize the formation of new bubbles and get out before they burst. “Flipping is like a Ponzi scheme,” says Humphries. “It’s not a bad idea for those who get into it first, it’s a bad idea for those who get into it late.” If there’s a fourth secret to real-estate investing these days — after location, location, location — it’s timing.

Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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