How Flippers Are Increasing Value-Add

LADERA RANCH, CA—There will be more heavy rehab transactions in the market as investors try to create more value to generate attractive property margins, Brad Rust and Joe Gigliello, co-presidents of Pivotal Capital Group, tell GlobeSt.com exclusively. We spoke with the principals, who are hard-money lenders on fix-and-flip properties, about the trends they are seeing in this arena as well as the opportunities they are seeing in ground-up construction financing.

GlobeSt.com: We've heard that many real estate investors are beginning to prefer flipping residential properties to holding and renting them. What trends are you seeing in the current fix-and-flip market?

Rust and Gigliello: For today's investors, the choice to flip or hold and rent is based on a wide variety of factors. Among them: location, capital availability, profit margins, rates of return on investment, home inventory availability and rent vs. buy dynamics. In Southern California, for investor house-flipping activity, starting in early 2014 we saw a gradual decrease in the number of homes being purchased from banks as short sales. During the second half of 2014, investors started buying off-market transactions directly from owners. The shift away from short sales/bank REO acquisitions was quite evident by the end of 2014 in that there wasn't a surge of transactions that need to close by ear-end, unlike the previous four years. We believe this has also had a material impact in reducing the volume of hold-and-rent opportunities. Quite simply, there are fewer homes available to buy in the market.

The increase in home values that was experienced in the last year-and-a-half has caused some investors to be more cautious on acquisition prices, which negatively impacts profit margins if prices don't continue to rise. Although asking prices have increased substantially since 2013, actual sales prices of renovated homes began to flatten in 2014. However, because sellers are typically slow to adjust prices downward, many investors currently remain on the sidelines or are purchasing more conservatively.

GlobeSt.com: What do you expect to see in this sector in the current year?

Rust and Gigliello: For 2015, we generally expect to see the same environment as the last half of 2014, including reduced numbers of hold-and-rent, as well as fewer basic rehab transactions. In addition, there will be more heavy rehab projects and/or ground-up construction projects as today's real estate investors are being pushed to create more value in their projects in order to generate attractive profit margins. Of course, the real estate market is very dynamic and can change quickly. The number of bank REOs and foreclosures could increase, prices can shift more substantially and house flipping and/or hold-and-rent by investors could change significantly depending on the environment.

What we do know is that throughout the last few decades, in both rising markets and decreasing markets, house flipping and new construction activity has always occurred. The key to long-term success in real estate is for investors to anticipate where the demand and profit margins will be strongest, be flexible and willing to try new things and react accordingly to capture quality deals. On the financing side, the same can be said for lenders; they need to see where capital needs are the greatest and provide attractive solutions to investors.

GlobeSt.com: How are investors taking advantage of rising housing prices in Southern California? Are you seeing fix-and-flippers targeting specific high-end markets in this region?

Rust and Gigliello: Rising prices are like a double-edged sword. Although profits increase, increased pricing also makes the next acquisition more expensive, pushing prices even higher, potentially above what the market will bear. Slow and steady, modest price increases are usually the best for a long-term sustained housing market.

With the peak foreclosure/short-sale wave generally behind us, there are fewer quick rehabs being done. Gone are the days of paint-and-carpet rehabs. The majority of rehabs these days require a more-significant rehab budget due to either the poor condition of a home or a higher level of rehab planned. This dynamic has led to an increase in flipping higher-priced homes. In higher price-per-square-foot locations, large rehabs can generate a higher profit margin than the same rehab in a lower price-per-square-foot area. 

For example, in Los Angeles, more deals are being done that involve heavy renovations and/or room additions. These have seen significant activity throughout the county in every price point, even locations commanding price points above $1 million. In Orange County, there has been a fair amount of new ground-up construction projects on infill lots. In addition, we have seen many homes being torn down to the studs and undergoing major renovations. In San Diego neighborhoods close to downtown or the coast, there has been an increase in infill residential teardown/rebuilds and heavy renovations. According to our clients, profit margins in San Diego may currently be thinner than other parts of Southern California, resulting in a reduced number of overall transactions across the market area.

GlobeSt.com: What opportunities are you seeing in the ground-up construction financing sector of the market?

Rust and Gigliello: As noted above, heavy renovation rehabs, as well as new ground-up construction, is a factor of the changing market conditions. Throughout Southern California, we are seeing increased demand for our construction loans from investors buying vacant lots or existing houses that they plan to demolish and build from scratch. There are conventional bank loans available for construction, but they do not offer the speed, ease of use, leverage, fewer requirements and less red tape that we are able to offer. This is because, as a private lending company, we are not saddled with the same regulatory environment as a conventional bank. This allows us to operate much more entrepreneurially. Our capital is more expensive than a bank, but we provide a service to the real estate investor for which they are willing to pay a premium.

GlobeSt.com: Why is hard-money lending different and more attractive to today's investor than other types of conventional/bank financing?

Rust and Gigliello: First and most importantly is the speed—hard money is generally much quicker than other types of financing, both in terms of approval to proceed with a loan, as well as the time it takes to actually fund the loan. another important factor that sets hard-money lenders apart from bank financing, especially in this current economic climate, is that banks generally do not lend on distressed real estate (homes needing major repairs), and hard-money lenders generally do. In addition, hard-money lenders also typically do not rely on credit; instead, their lending is asset based, which provides more opportunity for investors to get their deal done. Hard-money loans typically advance higher leverage with fewer requirements and less documentation than other types of financing. Sometimes no appraisal is needed, and often there is no personal recourse with hard-money loans.

GlobeSt.com: Why is hard-money lending becoming increasingly popular in today's market?

Rust and Gigliello: There continues to be a large number of lenders readily financing fix-and-flip projects throughout Southern California. The number of lenders and fewer transactions being done has resulted in downward pricing pressure as lenders compete for available transactions. To attract deals, some lenders have become more aggressive on loan sizes offered (higher leverage). This downward pressure on rates and increase in loan sizes benefits investors since it reduces their overall cost of capital and increases their potential returns.