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You must have heard the saying: there is profit when you buy property.
Simple, yet powerful. Unfortunately investors often forget that lesson and end up paying way too much for properties.
If I’m going to rehab a property and put together money for that project, it’s important that I know the exact price to pay (and then buy below that number).
The formula I use and have been doing since day one is:
ARV – Rehab – BSH – Profit = MPO
ARV = after repair value
BSH = buy, sell and hold cost
MPO = (Maximum Profitable Offer)
Determining ARV is more of an art than a science. Of course, I start by looking at sold comps and focus on the properties that are closest to my subject property and most similar in bed/bath configuration; square footage; age; location, and overall design. Although appraisers can be a mile away and a sale a year away, I prefer homes that are less than a quarter mile away and that have sold in the last 6 months.
The next step for me is to look at online listings of sold comps. You’ll often find an abundance of photos of those homes to determine how they look on the interior. I specifically look to see if other homes use granite or another solid surface countertop versus laminate in the kitchen; whether there are advanced equipment; whether they used carpet, laminate flooring, or hardwood; did they use a built-in shower/tub surround or tile; Bathroom floors are tile or laminate. I also check the exterior to see if the comp has a garage, carport, or just a driveway; Are they brick, clapboard or vinyl siding.
At this point, I now have a pretty good picture of the level of rehab needed to hit the same price points as comparable properties. I then review my subject property for anything that might make my home less favorable to buyers than the comps. Some examples might be that the house is close to train tracks or a noisy road; It sits on a busy road; It is less favorable than the neighboring house (cemetery; parking lot; retail store). If either of these happen, I may have to reduce the ARV substantially.
How much you adjust the ARV is largely a judgment call. I try to think like a potential buyer who is looking at two similar homes. Sitting in a quiet place with neighbors on either side. The other house is sited on a busy road. How much discounting will it take to encourage shoppers on a busy road? Certainly more than a $5-10,000 discount. I might also consider whether there are any extra amenities I can offer in my home that aren’t available in the Compass. This would also help tip the scales, but it would also cost additional rehab dollars.
One last test I do before locking down on an ARV is to review the properties currently listed. By the way, I am not a real estate agent and do not have access to the MLS – I do all this research online using the same tools you have access to. Listed properties tell me two things: (1) prices are falling and sellers are not dropping their prices; (2) How do the houses look that I will be in direct competition with?
The determination of the amount of rehab is based on what it takes to renovate the subject property to look like the comps. Be careful here. Remodeling to a level much higher than the comps may not make much of an addition in price, but rehab costs increase greatly. On the other hand, not making enough upgrades may make the home less favorable to buyers than competing homes.
BSH can be easily calculated as a percentage of ARV. I’ve seen it range from 12% to 20% of the ARV. Most come in at around 15%-18%. The big drivers are whether or not an agent is used and the cost of money. It’s a good idea to do a more detailed analysis of your actual BSH costs until you see where your percentages generally fall. Here is a list of the most common expenses that fall into this category.
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Closing Cost – Buy
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Loan Origination Fee (pts)
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loan interest
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hazard insurance
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property taxes
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utilities
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marketing cost
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home warranty
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Closing Costs – Sale (paid by buyer)
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RE agent commission
My profit is the minimum amount I would like to make for this project to be worthwhile. Why don’t I use more leverage? Because it could cut me off from potential deals. I’m calculating the most I’m willing to pay before walking away from the deal. Having too high a profit in the calculation will make that number too low to accept the offer. Having said that, I negotiate as far below the MPO as possible knowing that every dollar I shave is extra profit. I just need to know the number where I need to walk.
A quick acid test for profit is to add up your purchase price and your rehab expenses. Your profit must equal at least 15% of that amount.
Example:
MPO $90,000
rehabilitation $30,000
total $120,000
x 15%
profit $18,000
So in this example, I want to make a profit of at least $18,000 (I’ll round up to $20,000). If not, it might not be worth buying this property.
Once I’ve determined all these numbers, the final step is to perform the math to determine the MPO, or Maximum Profitable Offer. In other words – the more I paid for the property. This is not my desired price – this is the highest price to pay. My goal in negotiating is to buy the property as below the MPO as possible. Remember, every dollar bought below the MPO is an additional profit in the deal.
I hope the point you walk away with is that there is more to consider than just crunching some numbers in determining the right price to pay. You need to be smart and study the market and competition. If you act in advance, you’ll buy right, sell your rehab quickly, and make a big profit.
I require that each of my personal advisor students do this research and analysis before signing any offers. I don’t do this to give them extra work or to make an issue out of it. I make sure that every deal is profitable. I wish the same for you so please follow my tips.
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