Are you gambling with your residential investment?

 

With questions abound in the stock market these days about whether the stock market is in a boom or bubble more and more investors are turning to residential real estate as an investment vehicle. Because everyone who gets into real estate as an investment lives under a roof somewhere, residential investment is usually the introductory class of investment the investor gravitates towards since it is almost always the most understandable and comfortable..

 
Often investors are swayed by meaningless buying metrics and make buying decisions based on “gut instinct” or some other subjective measure. The decision whether or not a particular residential real estate deal is a good deal or not is always based on a few hard, incontrovertible sets of calculation.
 

When purchased properly there are few investments as reliable and consistent as real estate, however, all too often novice investors are swayed by meaningless buying metrics and make buying decisions based on “gut instinct” or some other subjective measure. The decision whether or not a particular residential real estate deal is a good deal or not is always – 100% of the time – based on a few hard, incontrovertible sets of calculation and when investors don’t follow industry-proven guidelines the failure to monetize the investment is almost always guaranteed.

These formulas exist in some form or another all over the place. However, recently I came across a talk by Attorney William Bronchick on his podcast “The Legalwiz” in which he summarizes in a concise manner the myriad ways of valuing a residential real estate investment. He drew a bull's eye on the methods of formulation an investor should consider when determining whether or not a residential investment is a good deal or not. Bronchick says that figuring out whether or not a deal is a deal takes 30 seconds, and while investment in the hundreds of thousands of dollars or more likely bears a little more scrutiny than that, the formulas below at least let you know if you should pass go or not.

When buying a single family home to flip for a profit the primary question is “Can I steal it?”

As an investment vehicle, it is usually the case that the highest and best use of a single family home investment is to buy and flip. Because this type of investment almost always includes further capital investment to justify the upside sales price, and because when selling an improved single-family home the buyer wants a turn-key transaction, an investor’s goal is ALWAYS to “steal” the property to ensure an acceptable level of profit.

If you can grab a single family property at the right price, in other words, if you can steal it, you can do almost any deal imaginable. Residential lending institutions are sitting on piles of cash they need to put in play and are clamoring for positive net equity residential properties. If you don’t want to go to a bank, there’s always another investor partner looking for a deal or someone else to lend against it. If a bank won’t touch it and you can’t find an investment partner who’s interested, then that’s a signal that the price of the property isn’t low enough or the property isn’t worth while for the market.

In the single family realm for a buy-and-flip the formula to determine if you can steal it is:

ARV (after repairs value) x 70% – Cost of repairs = Maximum Offer Price.

This formula is strict. It has no wiggle room. None. Zero. Zilch. Go off target with this, and you’re ensuring a money losing investment.

Let's put these numbers in practice. Let's say you find a short-sale distressed property at a listing price of $250,000. Your inspections reveal that significant cosmetic repairs and some plumbing and electrical work are needed to bring the property up to par with the market, and this will cost $25,000. You’ve also done extensive market comparable valuation which shows that comparable improved property in your market would sell for $425,000, then your valuation becomes:

$425,000 x .70 = $297,500 – $25,000 = $272,500.

Therefore, $272,500 becomes the maximum amount you can offer for this property, and since the asking price is $250,000, the investor has $22,500 of upside potential profit walking into the investment. Or in other words, this property is a steal at $250,000.

As mentioned, the 70% of the ARV minus cost of repairs is a rigid, incontrovertible formula. However, the investor can look at the ARV estimation as a flexible number based on the “hotness” of the market and can increase the comparable value in anticipation of market growth provided that the increase is within normal market trends. However, if the market is growing at 3% annually according to market comps, it is quite foolish to adjust the ARV up to 10%. You can fudge the ARV by a few points, but it needs to be justified by market performance.

By sticking to that formula an investor puts their position in line for a net-positive, and quick, return on investment. Stray from it and don’t expect to take that vacation to Aruba this year.