It’s in the numbers: Defining a deal (Part 1)
Hello! You’re reading my first post for this website!
What better way to begin than to write about the area right up my alley - investment properties! This is my comfort zone; I shan’t be experiencing writer’s block.
You ready for a long read?
Know the roles
There are many forms of investing into real estate, and I don’t know them all at this juncture. What I do know is more often than not you’re going to meet a flipper, or rehabber (they are same thing), because that’s one of the most common ways of getting introduced into real estate investing.
Most flippers would start out with smaller projects - starter homes and condos. Some flips later they might find that they are missing opportunities because they’re seeing prime land with unfitting properties that wouldn’t make sense for a rehab. These investors might get compelled to explore new construction projects.
Then there are also investors who aren’t looking for a quick cash out, but rather keen on making long term gains. Buy and hold, be a landlord, collect passive income and retire in comfort! The buy and hold strategy is not exclusive to active investors in a stereotypical way of those being active in the field, like flippers. They also apply to regular folks who may just be interested in growing their money in a smarter way than putting it away in a savings account. They hold a diversified portfolio of investments- some stocks, some bonds, some real estate. Why not.
That’s not a deal. That’s discount!
My journey in real estate investing began with being a wholesaler. That’s a story for another day, but essentially a wholesaler flips the contract, not the property. In my early days of being one, I have asked agents to send me listings from the MLS wherever they think there’s a deal for investors. (Side note: I regret doing that, for ethical reasons.) I’ve not gotten any success from this channel. Not that there aren’t deals on the MLS (rare, but definitely there!). It’s just that most properties are priced for regular homebuyers to put money and work into it to bring it up to value. Or over value. It depends on how much they love it.
Agents may come across a property that is $80,000 lower than the average price in the neighborhood and think that an investor is going to flip it and make some money, but they’re wrong there. That’s a property on discount. It’s not a deal.
If you meet an investor and ask what type of investment properties he or she is looking out for, which areas and price point, more often than not you’ll get this standard answer:
“It depends on the numbers.”
So what’s a deal? What numbers make a deal?
A deal that qualifies for a flip
Rarely do you see flip opportunities on the MLS because as mentioned, most are priced incorrectly. Incorrectly as in for an investor’s perspective, and not a homeowner’s.
As such, most distressed homes that you see are actually good homes on a great discount, and not investment material. As a broad example, if a house would sell for $500,000 on the market (all nice and new and sparkly) after an $80,000 cost of updates, an investor would only make an offer up to $300,000.
The same house, listed by an agent on the MLS is likely to go at $409,000, with extra justification that the seller is absorbing the cost for rehab and even throwing you a bone with a $1,000 discount. Most homebuyers would be satisfied with that. Not investors.
So how then do these investors run their numbers? Why $300,000?! That’s $109,000 apart!
Figures for a flip
Estimated sale price (opinion of market value of property after the rehab work is done).
Rehab. A quote from a contractor is best, but otherwise a ballpark based on rehab estimate worksheets.
Agent’s commission on sale
Holding costs (cost of financing, utilities, insurance, taxes, closing costs)
Purchase price
Expected profit comes from 1 - 2 - 3 - 4 - 5
Holding costs are also called soft costs, because of its variability. Rehab estimates are hard costs, because that’s the quote for materials and labor, and it’s fixed after you’ve agreed with the contractor on the scope of work required.
Soft costs, on the other hand, are not quite fixed. It depends on the duration the project lasts. How long you work on the project directly impacts how much utility bills you pay, how much your insurance costs and what the cost of financing would add up to. Stay on the project for a year and pay your lender the full annual interest rate. Work on it for half a year and pay half!
If your attention is still with me at this point, you’re doing great.
Expected profit is what qualifies a deal
Expected profit is a very subjective number for investors. It is what qualifies properties as a DEAL, or not.
I’ve written DEAL in caps, not because it’s an abbreviation, but because it deserves the excitement. Yes, you should jump for joy if you land yourself a DEAL!
Expected profit, is in turn dependent on the investor’s perception of risk and exit timeline. In MA, generally, investors aim to make a 12% profit on their projects. That 12% is based on final sale price, so back to our $500,000 home, an investor would aim to walk away with at least $60,000 in profit (Why they should be making $60,000 in a single flip - almost a year’s salary for some - is a discussion for another day).
There is a layer of risk perception involved. Can the investor be contented with less than 12% profit if there’s significantly less risk? Yes, absolutely.
Give an investor a small condo apartment that would sell at $300,000 and requires only new paint and carpets? Something that could be done in a week? DEAL! Will take $15,000 in profit for practically zero risk. Would another investor do the same project for $10,000? Sure- that’s making $10,000 in a week!
Deriving the offer price for a flip
Run the numbers on a $750,000 property. A beautifully constructed, but beaten down colonial in Boxborough. What would an investor offer for it to be a deal?
Estimated sale price = $750,000
Rehab = $70,000
Realtor Commission at 5% = $37,500
Holding costs on a 6 month purchase to sale project is summation of below = $18,970
Financing at 7% from a bank on whatever the investor is borrowing. In this simple example, let’s say that’s for rehab costs only: 7% X $70,000 divided by 2 for 6 months’ duration = $2,450
Note that in practical scenarios financing takes up a huge percentage of soft costs. Investors could be borrowing everything else besides the $1,000 deposit.Utilities: $300 (as an example) X 6 = $1,800
Insurance: $300 (as an example) X 6 = $1,800
Property taxes: $11,000 per annum divided by 2 = $5,500
Tax stamps (MA taxes sellers at the sale of property, at the price of $4.56 per $1,000): $750,000 divided by $1,000 X $4.56 = $3,420
Closing costs = $4,000
Expected profit of 12% = $90,000
Offer to Seller? $533,530.
Pricing for the right audience
I would never force a seller, or lie in order to get the price low enough for a deal for an investor. No caps for “deal” here. There should be no excitement in doing shady things.
Morally sound investors whom I work with disclose the price that they could offer, and walk away politely when the homeowner rejects that price. It’s a beautiful thing to witness, and proof that things can be done right, with integrity. I have been in a property with Jay Tamasi (yes, he deserves recognition) who had openly told the homeowner that he could only offer $X, but since the homeowner needs more than $X, the homeowner should list it on the market at $Y. He walked away with no benefits except good karma, and even gave contacts to a professional cleaning crew.
Back to pricing for the right audience.
If it’s not to an investor, what should an agent list it at? Many would justify that to be $750,000 - $70,000… add $20,000 to that because my seller’s home is HOT!
I think it depends on the market and audience, and indeed, whether or not the property is HOT enough for the future homeowner to undertake the following:
Get quotations from general contractors (GCs), or be more adventurous and save a whole lot more money by dividing the project into various pieces and sub-contracting them out specialized contractors;
Deliberate whether or not money saved is justified by time spent (ha, got you!);
Go to the property at least once a week or fortnightly to make sure that things are moving along (yes, don’t assume just because you’ve got a GC that you’re all set);
Pick out materials, paint, finishes;
Arrange for logistical transportation of materials;
Deal with contractors not showing up;
Deal with contractors who showed up, did work, but… did it wrong;
I lack experience here, but I’ve just got an idea to do a future post on “The 20 funniest contracting screw-ups”.
If I’m listing this imaginary property, I’ll probably list it at $659,900 knowing the Boxborough audience. $70,000 is a lot of work, and it’s just not something I’d expect the $700,000 range homebuyer to undertake.
This is why.
Anyone who can afford to live in a $750,000 house in Boxborough is paying well above the $500,000 median price of homes in Boxborough- that 50% more. At a 30-year conventional mortgage rate of 5% with regular 20% downpayment, that person shall be paying a mortgage of about $4,500 per month. That person’s income, is therefore at least three times more- at a minimum of $13,500.
Someone with that kind of earning capacity would realistically have 101 better things to do with his or her time than manage a rehab project.
Moreover, at $659,900, there are still a large number of properties in a similar price range in Boxborough AND Acton that would compete with it. I think the smartest strategy would be to price the house lower to incentivize buyers to strongly consider it, congregate at an open house and place multiple offers. A bidding war might just push the price back up to $680,000.
Stay tuned for Part 2
Here’s the end of my first post! I hope I’ve managed to articulate my knowledge clearly. Thank you for reading, I thoroughly enjoyed this process and hope you did too.
Stay tuned for Part 2 on qualifying a deal for new construction!
Oh wait.
DEAL!