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How I Decide The Right Price For House Purchases
You’ve heard the adage: the profit is made when you buy the property.
Simple, but powerful. Unfortunately, investors often forget this lesson and end up paying too much for properties.
If I’m going to rehab a property and commit funds to that project, it’s critical that I know the correct price to pay (and then buy below that number).
The formula I use and have been using since day 1 is:
ARV – Rehabilitation – BSH- Benefit = MPO
ARV = Value after repair
BSH = Purchase, sale and retention costs
MPO = (Maximum Profitable Bid)
Determining ARV is an art rather than a science. Of course, I start by looking for sold comps and focus on the properties that are closest to my subject property and most similar in bed/bath configuration; square meters; age; location and general design. Although appraisers can be up to a mile away and up to a year into sales, I prefer homes that are less than a quarter mile away and have sold within the last 6 months.
The next step for me is to look for online listings of sold comps. You will often find plenty of pictures of these homes to determine what they looked like inside. Specifically, I look at whether the other homes used granite or some other solid surface counter top versus laminate in the kitchen; there are updated appliances; they used carpets, laminate floors or hardwoods; did they use manufactured shower or tub wheels or tiles? they are tiled or laminated bathroom floors. I also check the exterior to see if the comps have garages, carports, or just driveways; they are brick, plank or vinyl siding.
At this point, I now have a pretty good picture of the level of rehab needed to achieve the same prices as comparable properties. I then review my subject property for anything that might make my home less favorable to buyers than comps. Some examples might be that the house is near train tracks or a noisy road; it is on a busy road; it is next to something less favorable than a neighboring house (cemetery; parking lot; store). If any of these are present, I may have to reduce the ARV greatly.
How much you adjust the ARV is largely a judgment call. I try to think like a potential buyer looking at two very similar houses. One is sitting on a quiet lot with neighbors on either side. The other house sits on a busy road. How much of a discount would it take to incentivize shoppers to shop on the busy road? Definitely more than a $5-10k discount. I might also consider if there are additional services I can provide in my home that are not available in the comps. This will also help tip the scales, but will also cost additional rehab dollars.
One last test I do before locking in an ARV is to review the properties currently listed. By the way, I’m not a realtor and I don’t have access to MLS – I do all this research online using the same tools you have access to. The listed properties tell me two things: (1) prices are coming down and sellers aren’t bringing them down; (2) what are the houses I will be directly competing with.
The determination of the amount of rehabilitation is based on what is needed to renovate the property in question to look like the compositions. Be careful here. Remodeling to a much higher level than the compositions may not give much additional price, but greatly increase the costs of rehabilitation. On the other hand, not updating enough can make the home less favorable to buyers than competing homes.
BSH can be easily calculated as a percentage of ARV. I have seen 12% to 20% of the ARV work. Most come in around 15%-18%. The big factors are whether to use an agent or not 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 percentage typically falls. Here is a list of the most common expenses that make up this category.
Closing Cost – Purchase
Loan origination fees (points)
Interest on the loan
Closing Costs – Sale (paid on behalf of buyer)
Commission of RE agents
My profit is the minimum amount I would want to earn on this project to make it worthwhile. Why don’t I use a higher benefit? Because it can leave me out of possible offers. I’m calculating the most I’d be willing to pay before getting out of the deal. Placing too much profit in the calculation will make this number low enough to have accepted bids. That said, I trade as below MPO as possible, knowing that every dollar I shave off is extra profit. I also need to know the number where I have to leave.
A quick acid test for profit is to add the purchase price plus the rehab expense. Your profit should be at least 15% of this sum.
Profit of $18,000
So in this example, you would want to make at least $18,000 in profit (I would round up to $20,000). If not, this property may not be worth buying.
Once you have determined all these numbers, the final step is to do the calculations to determine the MPO or MAXIMUM profitable bid. In other words, the most you would pay for the property. It’s not my desired price, it’s the highest price to pay. My goal in negotiations is to buy the property as below MPO as possible. Remember that every dollar purchase below the MPO is an additional benefit to the deal.
The point I hope you’ll get away with is that there’s more to determining the right price to pay than just typing in a few numbers. You have to be smart and study the market and the competition. If you do the groundwork, you’ll buy right, sell your rehab quickly, and make a big profit.
I require each of my private tutoring students to do this research and analysis before signing any offer. I don’t do it to give them extra work or to make a point. I do this to make sure every deal is profitable. I want the same for you, so follow my advice.
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