This week, we’re going back to basics and answering some fundamental questions about getting started in real estate.
Today I want to talk about how I evaluate properties. Some people use very sophisticated, data-intensive ways to figure out whether a property is a good deal or not, and I think there is a place for that. But sometimes, when you have a complicated formula for figuring out your maximum allowable offer, that can act as a deterrent and a hurdle. You don’t want the process of coming up with an offer to be a hurdle. You need a formula that’s reliable, quick, and makes sense.
Before we get to that, let’s go over some of the terms that you use when you evaluate a property:
- After Repair Value (ARV): What will be the value of the property after you renovate it fully? The only way to know that is to compare the property to similar renovated properties in the area. You could always use Zillow or Trulia, but a realtor will be able to do a more comprehensive search for you.
- Rehab Costs: How much is it going to cost to get the property renovated? If you’ve never done this before, you’re going to need a local experienced investor to help you. If you can’t form a relationship like that, you’re going to at least need to reach out to a contractor, preferably someone who has been referred to you by someone, to help you figure out those costs. You will need a lot of guidance from other people in the beginning and that’s fine; you’re going to learn as you go. If you’re a contractor or a builder, maybe you don’t need anybody to help you with this step because you know how much everything costs and how long it’s going to take.
- Target Profit: How much profit do you want to make? Some people decide on a target as a percentage of the sale price. Others set a long-term goal for the year instead. I would say keep it simple at first: come up with a percentage of the sale price or just a flat number. Be careful that you don’t go too low, because if your profit margin is low, you’re making it hard on yourself if something were to go long. Let’s say you find a house whose ARV is $100,000. You determine that it’s going to take $20,000 to renovate it. Let’s say that you only want to make $5,000 from this flip, so you make an offer for $75,000. If you end up holding this property and paying taxes and utilities for longer than you thought, or if some issue comes up and you have to spend more money than you thought, that $5,000 profit you were hoping for will be completely eaten up. On the other hand, if you plan for a target profit that’s too high, you’ll never get a house because your offers will be too low. You have to find a happy medium. If you really don’t know where to go, a good goal is 20% of the ARV.
- Closing Costs/Realtor Costs: This is the only factor that makes things a bit more complicated. Typically, closing costs are around 4% of the sale price and realtor costs are 3% to the seller’s agent and 3% to the buyer’s agent. So you have about 10% of the sale price that you can assume you will spend on these extra costs.
- Maximum Allowable Offer: The most money you can offer on the property to make the profit you want.
Another possible factor is the cost of money. I don’t factor that in because I normally pay my private lenders a percentage of the profit, so there are no fees or fixed interests during the rehab.
So, my simple formula to evaluate a property is:
ARV−10%−Rehab Costs−Target Profit=Maximum Allowable Offer
Using this formula allows to bid on a property knowing confidently that you are going to make money. Typically, you won’t even start bidding with your maximum allowable offer so that you have a little room to negotiate.
Another way to calculate your maximum allowable offer that’s even simpler is called the 70% rule:
(ARV x 70%)−Rehab Costs=Maximum Allowable Offer
In our example above, the number comes out the same, but generally the 70% rule doesn’t take everything into consideration. It is a quick and dirty way to come up with an offer number that feels safe.
If you have any questions about different formulas for coming up with a maximum allowable offer, feel free to comment below or email at email@example.com.