You’ve heard the adage: Profit is made when you buy the property.
Simple, yet powerful. Unfortunately investors often forget that lesson and wind up paying too much for properties.
If I am going to rehab a property and commit funds to that project, it is critical that I know the right price to pay (and then buy below that number).
The formula I use and have been using since Day 1 is:
ARV – Rehab – BSH– Profit = MPO
ARV = After Repair Value
BSH = Buy, Sell & Hold Costs
MPO = (Maximum Profitable Offer)
Determining the ARV is an art more than a science. Of course, I start by looking up sold comps and focus in on the properties that are the closest to my subject property and most similar in bed/bath configuration; square footage; age; location, and overall design. Although appraisers may go as much as a mile away and up to a year in sales, I prefer the houses 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 for the online listings of the sold comps. You’ll often find an abundance of pictures of those houses to determine what they looked like on the interior. I specifically look to see if the other houses used granite or some other solid surface countertop versus laminate in the kitchen; are there upgraded appliances; did they use carpet, laminate flooring, or hardwoods; did they use manufactured shower/tub surrounds or tile; are the bathroom floors tile or laminate. I also check the exterior to see if the comps have garages, carports, or just driveways; are they brick, clapboard, or vinyl siding.
At this point, I now have a pretty good picture of the level of rehab required to hit the same price points as the comparable properties. I then review my subject property for anything that may make my house less favorable to buyers than the comps. Some examples might be the house is close to railroad tracks or a noisy road; it sits on a busy road; it is adjacent to something less favorable than a neighboring house (cemetery; parking lot; retail store). If any of these I may have to vastly reduce the ARV.
How much you adjust the ARV is largely a judgment call. I try to think like a potential buyer who is looking at two very similar homes. One is sitting on a quiet lot with neighbors on each side. The other house is sitting on a busy road. How much of a discount would it take to incent buyers to purchase on the busy road? Certainly more than a $5-10,000 discount. I might also consider if there are any extra amenities that I can offer in my house that are not available in the comps. This will also help to tip the scales, but will also cost additional rehab dollars.
One last test I perform before I lock in on an ARV is to review currently listed properties. By the way, I am not a real estate agent and do not have access to MLS – I do all of this research online using the same tools to which you have access. Listed properties tell me two things: (1) that the prices are holing and Sellers are not dropping their price; (2) what the houses look like with which I will be directly competing.
Determining 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 greater than the comps may not yield much in additional price, but increase rehab costs greatly. On the flip side, not upgrading enough may make the house less favorable to buyers than the competing houses.
BSH can be easily calculated as a percentage of the ARV. I have seen it run as little as 12% to as much as 20% of the ARV. Most come in at around 15%-18%. The big drivers are whether an agent is used or not and the cost of money. It is a good idea to do a more detailed analysis of your actual BSH costs until you see where your percentage usually falls. Here is a list of the most common expenses which make up this category.
- Closing Cost – Buy
- Loan Origination Fees (Points)
- Loan Interest
- Hazard Insurance
- Property Taxes
- Utilities
- Marketing Costs
- Home Warranty
- Closing Costs – Sell (paid on behalf of the buyer)
- RE Agent Commission
My profit is the minimum amount I would want to make on this project for it to be worthwhile. Why don’t I use a higher profit? Because it may cut me out of potential deals. I am calculating the most that I would be willing to pay before I walk away from the deal. Placing too much profit in the calculation will drive that number to low to have offers accepted. Having said that, I negotiate as far below the MPO as possible knowing that every dollar I shave off is additional profit. I just also need to know the number where I need to walk away.
A quick acid test for profit is to add your purchase price plus your rehab expense. Your profit should equal at least 15% of that sum.
Example:
MPO $ 90,000
Rehab $ 30,000
Total $120,000
x 15%
Profit $ 18,000
So in this example, I would want to make at least $18,000 in profit (I’d round up to $20,000). If not, it just may not be worth it to purchase this property.
Once I’ve determined all of these numbers, the final step is to perform the math to determine the MPO or MAXIMUM Profitable Offer. In other words – the absolute most I would pay for the property. It is not my desired price – it is the highest price to pay. My goal in negotiations is to buy the property as far below the MPO as possible. Remember, every dollar purchase below the MPO is additional profit in the deal.
The point that I hope you walk away with is that there is more to consider in determining the right price to pay than just crunching a few numbers. You need to be smart and study the market and the competition. If you do the upfront work, you’ll buy properly, sell your rehab quickly, and realize a great profit.
I require that each of my private mentoring students do this research and analysis before I sign off on any offer. I don’t do it to give them extra work or to make a point. I do it so ensure every deal is profitable. I want the same for you so please follow my tips.
Expect abundance,
Lou Castillo
