Headlines of house flipping and increased novice investor participation of signs of a top in the housing market for high-end homes.

Contrarian investing is the art of selecting and timing investments by directly opposing the actions and attitudes embraced by the crowd of enthusiastic but ill-informed market participants. The central premise of contrarian investing is that the crowd is usually wrong, and the exuberance or panic of the crowd misprices assets, providing confident investors opportunities they can take advantage of.

I have some experience with contrarian investing. I wrote extensively about a crash in the housing market in 2007 and 2008 when the crowd believe house prices could only go up at 10% or more per year forever. I rented to avoid the crash (shorting real estate). Later, when most believed house prices could only go down by 10% or more per year, I went to Las Vegas and bought as many homes as I could from the crowd that was in a full panic.

One of the signs of a contrarian opportunity is the widespread participation in a market by novices who got lucky with a few speculative bets and suddenly believe they’re experts. There’s an old adage of Wall Street that when your shoeshine boy gives you a hot stock tip, the market is near a top, and it’s time to look for the exit. Similarly, in real estate, when novices start flipping homes, and stories of their success flood the newspapers, it’s time to be wary of a market top.

High-end house flipping is soaring

Diana Olick, August 23, 2014

It is dirty, financially risky and potentially dangerous work, but depending on the current direction of the housing market, it can be highly profitable. But home “flipping,” defined as buying and selling a home within a short period of time for the sole purpose of making money, is now on the slide.

Home prices rose dramatically last year and are now easing, leaving a very small margin for flippers.

“Home flipping is settling back into a more historically normal pattern after a flurry of flipping during the recent run-up in home prices in 2012 and 2013,” said Daren Blomquist, vice president at RealtyTrac. “Flippers no longer have the luxury of 20 to 30 percent annual price gains to pad their profits.

The house flipping shows get more popular when prices rise rapidly too. Everyone cooks up ideas of how they too can get rich quick. When you watch the calculation of profits on these shows, it always looks like the people add huge value with their renovations. In reality, the rising tide of rapid appreciation provides most of what they make.

As the market softens, successful flippers will need to focus on finding properties that they can buy at a discount and efficiently add value to.”

So now many are looking to high-end neighborhoods to reap big profits.

The high end of the real estate market performed particularly well since the efforts to reflate the bubble gained traction in early 2012. The high end had the fewest foreclosures and the largest remaining population of underwater borrowers in cloud inventory to aid in restricting for-sale properties. Further, only the well-heeled have both the down payment and credit scores necessary to close a deal, so more transactions occur in at these price points. However, since flippers now see this as the only opportunity in the market, it’s more likely a sign of the end of the rally and perhaps a top.

Real estate agent Christal Goetz and her contractor husband, Eric,

Novices or experts?

found a home in a sought-after northwest Washington, D.C., location in January. The four bedroom, three bath house was nothing short of a disaster inside, so they got a good deal, paying about $535,000 for it.

“We definitely look for location, it has to be a great location where we know it’s going to be in high demand,” said Christal. “We look for good bones to the structure, but also what can make it really unique and interesting.”

High demand, unique and interesting? Hmmm… That’s some serious expert analysis, right?

They put thought, design and about $250,000 into the 2,600-square-foot home and listed it for $925,000. Today it is under contract at the asking price.

I suspect the $250,000 added more value than the thought they put into it.

Based on the numbers provided, these people put $785,000 into the property, including about $350,000 of their own money (down payment plus improvements). If they sell for $925,000, they must pay a buy-side commission plus other fees and incentives. They stand to make $60,000 to $100,000, to compensate them for the risk plus the time and effort involved.

“It’s like any business really. Do you go after the small individual clients where you have to do a hundred accounts, or do you go after, as I say in the business world, the ‘white whale,’ where you’re getting five or six clients but your profit margin is higher,” reasoned Christal.

That sounds very plausible until one of those white whales turns into a white elephant and eats all your money.

Still, as home price gains are easing nationwide, overall flipping is down.

Novice flippers only appear just after a period of rapid appreciation lured by the easy money they see the experts make. By the time novices enter, the opportunity is gone, and most put in a large amount of time, effort, and money only to either lose money or break even.

Flippers represented 4.6 percent of all U.S. single-family home sales in the second quarter of this year, down from 5.9 percent in the first quarter of 2014 and down from 6.2 percent in the second quarter of 2013, according to RealtyTrac.

The average gross profit of $46,000 per flip, a 21 percent return, was down from 31 percent a year ago, which was the peak since RealtyTrac began looking at this segment of the market at the beginning of 2011.

Those gross profits sound impressive, but when you add up the renovation costs, fees, and other transaction costs, a 21% gross margin is about break even.

High-end flipping, however, is heating up. Flips with a sale price of $750,000 or more rose 21 percent from a year ago, while homes priced below $400,000 declined as a share of all flips from a year ago, according to RealtyTrac. Homes priced between $750,000 and $1 million had a 41 percent return, which explains why flippers are heading to higher-priced neighborhoods.

These are also the most dangerous flips in the market because the buyer pool at $1M is much thinner than the buyer pool at $250K. It’s common for these properties to take longer to renovate and longer to sell. Flipping is both a margin and a turnover business. Turning your money over twice per year at a 10% margin is not as profitable as turning your money over four times per year at 6%.

Markets with the best return on flips in the second quarter included Pittsburgh (106 percent), New Orleans (76 percent), Baltimore (73 percent), Virginia Beach, Virginia, (66 percent) and Daytona Beach, Florida (63 percent). Metro areas with the highest dollar amount of average gross profit on home flips included San Jose, California, Washington, D.C., San Diego, Los Angeles and Seattle, all of which had an average gross profit of more than $100,000 per flip, according to RealtyTrac.

Flipping is definitely getting harder, as there are fewer distressed properties for sale. Prices may be easing, but they’re still rising because supplies are low.

“The secret to flipping houses is getting the property to be at a great price, and there’s just very, very few properties in our area at low prices,” said David Fogg, a real estate agent in Burbank, California.

Lack of available supply is the limiting factor in Southern California. Shevy and I both know investors who would participate in flips if we could find the deals, but in a limited inventory environment, other flippers are looking over every new property on the market, and only those with the most aggressive assumptions get deals, and since they are aggressive in their bidding, there is often little or no margin in the deal.

The Goetzes say it’s all about quality—the location and the renovation. They currently have three other houses that they are in the process of flipping.

They’re going to get crushed; it’s only a matter of time. People like them are a great contrarian indicators, and with the potential exodus of Chinese hot money, high-end flippers working today may get burned.

One of the best and briefest written works on contrarian investing comes from Rich Toscano at Pigginton.com. The article below was one of my favorites from the housing bubble era, but it’s information is timeless.

The Dumb Money

RICH TOSCANO | December 20, 2006

One argument I hear a lot is that foreign demand for local real estate has grown substantially in recent years, and that such foreign demand will be supportive of prices in the future.

Unfortunately, this argument puts the cart squarely in front of the horse. Investors from other countries are well known to be the very last participants to arrive at the scene of a financial bubble. They are the last to hear about all the riches to be made, the last to buy in, and the last to realize that the party is over.

The chart to the right provides an example from the history of bubbles past. The blue line represents the price of the Nasdaq Composite Index during its late-1990s flight to the heavens, along with the very beginning of its eventual journey back to earth. The red line denotes the dollar amount of U.S. stock purchases made by foreign investors.

It can easily be seen that foreign buyers chased the U.S. tech stock bubble all the way to the tippy top, and that they lagged prices the entire way. The final onslaught of foreign cash did not even hit our shores until after the Nasdaq had begun to decline from its final peak.

Far from being a positive fundamental, a sudden excess of foreign participation in an asset market is indicative of ill-informed speculative money at work. When the foreigners really start piling on, it’s always a good sign that the end of the bubble is nigh.

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