“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it”
Would you rather have one million pounds (£1,000,000.00) today or have one penny (£0.01) doubled for the next 30 days?
Ask a child that question and you can bet they will want the £1m right now. If you ask a group of adults that question, I’m sure it wouldn’t surprise many to find that some of them would also choose the “get rich quick option”.
However, I can tell that you’re different, and before you decide to give your answer, you are about to do some simple maths. Let me help you with that:
- Day 1 – £0.01
- Day 2 – £0.02
- Day 3 – £0.04
- Day 4 – £0.08
- Day 5 – £0.16
- Day 10 – £5.12
- Day 15 – £163.84
- Day 20 – £5,242.88
- Day 25 – £167,772.16
- Day 26 – £335,544.32
- Day 27 – £671,088.64
- Day 28 – £1,342,177.28
- Day 29 – £2,684,354.56
- Day 30 – £5,368,709.12
For those that have patience, are capable of simple maths and know about the wonders of compounding, will be delighted to find an extra £4,368,709.12 sitting in their pocket just by waiting an extra 29 days.
How does this relate to flipping you might ask?
Well flipping is essentially the equivalent of taking the £1m on the first day.
There is no doubt that flipping is an extremely fast way of getting money out of property. For those that have watched Homes Under the Hammer, you will be familiar when Martin Roberts asks the successful bidder “what do you plan to do with the property, rent or sell?” More often than not, we see the property “investor” opt to sell. Sometimes they make a profit and in some cases they don’t. The sadist in me always finds it funny when the investor realises that their property is worth less than what they paid for it at the start, keeping in mind refurbishment costs. You can almost always trace it back to the fact that the owner paid too much at auction, rather than a failure to refurbish it cost-effectively.
When they make the choice to sell, I always find myself screaming at the television, “NOOO, don’t sell! Think of what your missing out on” Of course each to their own.
I can understand why some investors may want to take their money out quickly. It might be because they have to pay back a financial investor, or perhaps money is stretched. The property owner may just want a big lump sum of cash to spend. My theory is that they just don’t understand the power of compounding, like the kids and adults who take the £1m rather than the prolonged but more rewarding wait for the £5.4m. If your goal is to maximise your income over the medium to longer term, then in my opinion, there are better ways to achieve that, than flipping.
Using a property as a long-term or short-term let will inevitably make you less money over a 6 month period. The reality is however, after two or three years, you may end up matching or even exceeding the profit made on a flip. All the while you still own that property and continue to receive that income long into the future.
If you base your livelihood on the money made from flips, then there is no alternative but to, once you have completed a project, move on to the next one. If you stop, the money stops. Furthermore, flips are not usually undertaken by people who have a full-time job, let alone other dependants. To get your money back out in six months will likely require you to flip properties as your main occupation.
(note: flips can take more or less than six months, depending on the work required. They can range from a simple paint job coupled with a tidy of the house in a matter of a few weeks, to a major refurbishment that can include; extensions, strengthening works, re-cladding, re-arranging the internal layout and installation of new features and fittings which could go on for up to a year).
This is not a luxury many can afford. To undertake a flip in addition to a 9 to 5 job will undoubtedly take you longer than expected, require you to work during the evenings as well as weekends, resulting in unwanted stress. Pay a professional to do the work for you and sacrifice your profit margin at the expense of time. Get the whole thing right and you could make a lot of money very quickly. Get it wrong, then be sure to have enough cash reserves to get you out of trouble.
Conversely, the great thing about retaining the property is that the income is passive (or nearly passive). This means you will be earning money while you sleep. The property can be run as a Serviced Accommodation unit or a Buy-to-Let and will generate an income on a monthly basis without much input from yourself, so long as you have a managing agent. You could get away by running a BTL on your own without spending too much time provided you have a good tenant, however, a SA unit certainly requires more attention.
Let’s take a look at a simple example and see how flipping compares to retaining the property over a certain number of years.
First of all we must make a couple of assumptions:
- Assume you buy a property for sale. It’s in reasonably good condition and will not take a lot of money to bring it up to a good liveable standard. You are also aware that if you were to do a great loft conversion and add an extension, you are likely to get a good return on the resale.
- Property Purchase Price £200,000.00
- Annual Livelihood expenses £50,000
I must stress that this example is completely fictitious and is only used to serve the purpose of explaining how compounded income can change your life.
Option 1 – Flip
- Large Refurbishment £50,000
- Price of Sale £350,000
- Profit £100,000 (£350,000 – £50,000 – £200,000)
The resale price is based on a 3:1 ratio between cost and value. Meaning that for every £1 you spend, you should aim for an increase in value of approximately £3.
Option 2 – Retain and let on a short-term basis
- Light Refurbishment (negligible in the grand scheme of things)
- Average Monthly Income £2023 (roughly 12% yield)
- Ongoing Costs £607 (roughly 30% of income)
- Mortgage £375 (3% interest @ LTV = 75%)
- Profit £1042
- Annual Profit £12,500
We can now have a look at how these two strategies might compare over the foreseeable future.
With Option 1, some of the money from the resale is used for our livelihood as flips require us to be on site pretty for much most of the day.
Assuming £25,000 from each flip is put aside to pay for the deposit of the next purchase, another £25,000 is put towards the refurbishment of the next flip and £50,000 is put towards living expenses.
Given that it takes six months to do each flip, it will take twelve months before enough funds are available to take on two flips at the same time (2 x £50,000 for a deposit and 2x£50,000 for the refurbishment). Remember, the money used to buy and refurb the first property is reinvested to buy and refurb the next. So now at the start of the second year, two flips are undertaken every six months. However, that’s all we can manage as there is not enough time in the day to do any more. That means 4 flips at most can be done in a year. That means our annual profit would be £400,000 from year two onwards.
In option 2 the money from the property is coming in passively, leaving us able to undertake a full-time job that will pay for our livelihood. If we were to save up our property income to be able to afford another property, we would have to wait four years to have enough to pay for the deposit (£50,000) for a property of the same price as before. Now, once we have two properties generating passive income, we can start to save up for a third property. This will only take us another two years and again we can repeat the process. The table below shows how this continual process will grow our property portfolio and income.
No. of Houses
As it turns out, it would take us 16 years and 1 month to have bought enough properties that would generate an annual income to match that made from flips after 2 year (£400,000). However, as we go further on, the amount generated from retaining properties (Option 2) will become almost exponentially greater than that from flips.
There are obviously some glaring omissions from these calculations. The first is tax, which is includes capital gains tax paid on the sale of a second property and income tax paid on the income from renting a property. Also, If you were earning £400,000 of passive income from a number of properties, I am sure you would have retired by now. If not then you must really love your job. This would of course slow down the rate of portfolio building but the good thing to know is that it would eventually become an option. Whereas, if you were to persist with flips, then it’s unlikely you would have been able to take much time away from the building site. It’s also very unlikely that if you were earning £400,000/year, your living expenses would stay at £100,000 a year. Very few of us are capable of spending significantly less than what we earn and would affect both strategies. We live in a materialistic society, but that’s a different story.
Now, it’s time for some magic. I have talked about both strategies working independently. I would now like to share with you, what could happen if we were to combine the two strategies together. Let’s multiply the quick returns of flipping with the passive and compounding effects of retaining properties. We will now see a hugely significant change to the rate of growth.
Let’s refer to the example aforementioned. If you remember the flipping scenario, we could hypothetically have £400,000 of disposable cash after year 2. Let’s now, instead of buying another property to flip, use the available funds to buy multiple properties in which to hold onto for cash-flow through letting. We will maintain the assumption that it takes £50,000 to get a mortgage for a £200,000 property. That way we could expect to have 8 properties being rented out immediately. If we refer back to the table which detailed the number of years it would take to build a similarly sized portfolio when using the retaining strategy only, it would take over 10 years.
To compare this to our analogy at the start, this hybrid method would be the equivalent of taking the £1m on the first day and then doubling it every following day. Congratulations, you have just saved over 8 years in building a property portfolio.
Again, just to reaffirm the assumptions made earlier. These examples are exclusively used to explain the concept of compounding and flipping. Each investment opportunity will have its own set of challenges to overcome which will dictate your exit strategy. What works for one property may not necessarily work for another. We are all people with different goals, skills and personalities which affect the decisions we take. It is up to you to determine the correct course of action; however, I do hope that by reading this post, I have opened your eyes to the options available.
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