To most of us the term “arbitrage” sounds vaguely familiar. Arbitrage, as a noun, is the buying and selling of things (usually securities) at a low price, and then almost immediately selling them at a higher price.
In real estate arbitrage, used as a verb “arbitraging,” means to buy one property and then sell that same property for a profit. There are three types of this: wholesaling real estate, flipping houses, and master leasing. This post focuses on wholesaling.
The difference between wholesaling and flipping
Flipping a house or a condo typically means to buy at a low rate, make repairs very economically, and then put the property back on the market in an improved condition.
Wholesaling arbitrage in residential real estate means that you do not make repairs to the property. In fact, you probably would not even fulfill the purchase agreement.
Instead you would look for properties that people need to unload (generally called “distressed” properties).
An example of wholesale residential arbitrage
Relying on a keen sense of market comparables, you see that a house is going on the market for $280,000. You know that the house needs some work and the seller lives out of state. You also know the home is in an area where other houses are selling for $350,000- $400,000.
So you extend a cash offer to the seller for $250,000, contingent upon inspection. You fully intend to buy the property because you know it is worth more in that area and in the current market. You also know the seller is motivated because it would be expensive and time-consuming for them to do any work on the house.
The seller now has a bird in the hand and has the advantage of avoiding paying any real estate agent fees. The seller agrees. But before you send the money to the seller, you talk to a local investor who is very interested in that property. So, you make a deal: you sell your contract rights to the investor for $20,000. The investor buys the contract from you for $20,000 and then the home from the seller for $250,000 cash. You have just made $20,000 in one transaction without any outlay of cash. The seller has the cash (after the inspection) and the investor paid $270,000 for a home that is potentially worth $350,000 or more.
Is real estate arbitrage legal?
Yes. In fact, many economists hail arbitrage as the grease that keeps the wheel turning. Investment advisor Zaw Thiha Tun talks about how arbitrage positively affects the market in this October 13, 2018 Investopedia article. Tun states that arbitrageurs “serve a useful purpose by acting as intermediaries, providing liquidity in different markets.” Other investment groups also support arbitrage as a means of market fluidity.