How do I decide the right price to buy a house?
You’ve heard the adage: profits are made when you buy the property.
Simple, but powerful. Unfortunately, investors often forget that 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 right 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 = Costs of buying, selling and holding
MPO = (Maximum Profitable Offer)
Determining ARV is more of an art than a science. Of course, I start by looking at sold comps and target the properties that are closest to my subject property and most similar in bedroom/bath configuration; square feet; age; location and general design. Although appraisers can go up to a mile away and up to a year in sales, I prefer houses that are less than a quarter mile away and have sold in the last 6 months.
The next step for me is to search for online listings of compositions sold. You will often find a lot of pictures of those houses to determine what they looked like on the inside. I’m specifically looking to see if the other homes used granite or some other solid surface versus laminate counter in the kitchen; Are there updated appliances? Did they use carpet, laminate flooring, or hardwood? Did they use manufactured shower/tub liners or tile? The bathroom floors are stoneware or laminate. I also check the exterior to see if the compositions have garages, carports, or just driveways; they are brick, clapboard, or vinyl.
At this point I now have a pretty good idea of the level of rehab required to achieve 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 could be that the house is near the train tracks or a noisy street; is located on a busy street; is adjacent to something less favorable than a neighboring house (cemetery, parking lot, retail store). If any of these you may have to greatly reduce the ARV.
How much to 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 is located on a busy street. How much of a discount would it take to incentivize shoppers to shop on the busy street? Certainly more than a $5-10,000 discount. I might also consider if there are additional services that I can offer in my home that are not available in gifts. This will also help tip the scales, but it will also cost additional rehab dollars.
One last test I run before blocking an ARV is to review the currently listed properties. By the way, I’m not a real estate agent and I don’t have access to MLS. I do all of this research online using the same tools that you have access to. Listed properties tell me two things: (1) that prices are holding up and sellers are not lowering their price; (2) what the houses I will compete with directly look like.
Determination of the amount of rehabilitation is based on what is needed to renovate the subject property to resemble compositions. Be careful here. Remodeling to a level much higher than compositions may not generate much in additional price, but it does increase rehab costs greatly. On the other hand, not improving enough can make the home less favorable to buyers than competing homes.
BSH can be easily calculated as a percentage of the ARV. I’ve seen him run anywhere from 12% to 20% of the ARV. Most come in around 15%-18%. The big drivers are whether or not to use an agent and the cost of money. It’s a good idea to take a closer look at 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 – Buy
- Loan origination fees (points)
- interest on the loan
- risk insurance
- property taxes
- marketing costs
- home warranty
- Closing Costs – Sale (paid on behalf of the buyer)
- Realtor Commission
My profit is the minimum amount I would like to earn on this project to make it worthwhile. Why don’t I use a higher gain? Because it can lock me out of potential deals. I’m calculating the most I’d be willing to pay before I back out of the deal. Placing too much profit in the calculation will make that number too low for bids to be accepted. Having said that, I trade as far below the MPO as possible knowing that every dollar I save is additional profit. I also need to know the number to which I should leave.
A quick litmus test for profit is to add the purchase price plus rehabilitation expenses. Your profit must equal at least 15% of that sum.
So in this example I would like to make at least $18,000 in profit (I would round it up to $20,000). If not, it may not be worth buying this property.
Once I have determined all of these numbers, the final step is to perform the calculations to determine the MPO or MAX Profitable Offer. In other words, the most you would pay for the property. It is not my desired price, it is the highest price to pay. My goal in negotiations is to purchase the property as below the MPO as possible. Remember, every dollar purchase below the MPO is an additional win on the deal.
The point I hope you walk away with is that there is more to consider in determining the right price to pay than just crunching some numbers. You have to be smart and study the market and the competition. If you do the work up front, 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’m not doing it to give you extra work or to make a point. I do it to make sure every deal is profitable. I want the same for you, so follow my advice.