PROPERTY PROFIT POTENTIAL #PPP
Don’t let your investment property go under water with three
dollars and six dimes… Yeah you may laugh, because you did not do your math…
When making decisions on an income producing property, investors often
exaggerate property profit potential by not fully calculating all of the
components surrounding the cash investment. Read along as I go through 10 numbers novice to advanced
level investors can use to help them make informed decisions about a ‘Property’s
Profit Potential’.
Purchase price + closing cost (2) + repairs
The purchase price is
obviously an important number in real estate investing however there are 2
other numbers that coincide with this number, closing cost & rehab cost.
Underestimating these 2 additional cost associated with the purchase price
could quickly begin to eat into your return. Also, often times investors fail
to realize that there are 2 sets of closing cost. You pay them when buy the
property and when you sell. In most cases when the investor loses, it’s because
they did not properly calculate the rehab or repair cost and the closing costs
for both acquisition and disposition of the property. This is the short version
but unknown closing cost like additional liens that have to be settled is also
a return on investment killer… Your closing attorney should uncover all of this
in a title search, but I’ve seen several cases where a lien was missed and had
to be negotiated & settled just days before closing.
#Fact The HUD-1 Settlement Statement has recently been
replaced by T.R.I.D. (Tila Respa Integrated Disclosure) The implementation of
these new rules may delay closing or cause other unforeseen issues. Talk to
your broker & lender and be sure to ask questions about how the new
disclosure rules may affect your closing.
2. Area recent sales (market values) - This
number will help to determine if you are paying a fair price for the property.
What are the comparable sales? à How
much are homes currently selling for that closely resemble the subject
property? Using this method in the valuation process is called “The sales
comparison approach”. You find 3 or more recently sold homes that closely
resemble the subject property. If the house that sold had additional rooms or
amenities beyond what the subject property has, you subtract from the price
based on the value of the items the subject property does not have. If the subject property has more features
beyond what the home that sold had, you add to the price of the one that sold
to get the value of the subject property.
This information can be found on tax websites and other real estate
listing sites. This number also determines what you could possibly re-sale the
property for. The best way to obtain the most recent and accurate comparable
sales data is to 1. Order a professional BPO (Broker Price Opinion) or 2. Have
a real estate broker with MLS access to the area you are purchasing in, do a
simple CMA- Comparative Market Analysis.
#Fact A BPO is simply the paid version of the
CMA, a CMA on steroids basically…
What to look for when buying a home: Bank Rate
Find comparable sales & home values: Zillow
Eppraisal
3. After Repair Value
(ARV) - The after repair value of a property is simply the value of the
property once all of the repairs have been made. This is a very important
number because you need to buy the property within a certain percentage of
ARV…Some investors like to purchase properties at 50% of ARV, some at 70% of
ARV; it all depends on the size of the return they’re hoping to capture. If I
can buy a property valued at $300,000, needing $20,000 in repairs for just
$210,000, which is 70% of the After Repair Value, the potential profit is
$70,000 minus closing cost, etc…. #Facts Distressed properties are often
discounted up to 35%, sometimes more.How To Find Foreclosures:
4. Average Days on
Market: If you don’t have some idea of how long it’s going to take the home
to sell, you won’t be able to accurately calculate your holding cost. Once you
become the owner of the property, the clock starts ticking! You’re now
responsible for the taxes, insurances, utilities, maintenance and all other
cost associated with the property…These items need to be calculated per diem as
well as monthly, that way if you know those bills total say $300 per month/ $10
per day and average days on market is 45, your potential holding cost could
total $450… This is also one of those numbers that needs to be padded. You can
do all of the research in the world and still run in to situations, natural
disasters, government controls etc., that could slow down your selling
time.
#Facts Certain restrictions on short sale or foreclosed properties can
require you to hold them for at least 100 days. When buying distressed
properties be sure to inquire about selling restrictions.
5. List to sell price
ratio: (how much are sellers getting versus what they are asking for) This
number is important because buyers ultimately determine the sale price. The
house may be listed for $275K but when the property closes, you see that it
actually sold for $266,750. In this case, the list to sale price ratio is .97% which
means they accepted the offer that came within 3% of the asking price…The offer
that was discounted by just 3% ($8,250 off in this case) This number should
help you make offers as well as make decisions on the types of offers you
should accept on your property. Keep in mind that there are different sales
concessions that discount what the seller actually received… The seller could
have provided a home warranty, paid a percentage of the buyer’s closing cost or
some other financial concession that would have ultimately reduced the amount
the seller actually received. When using a broker with MLS access, you can
usually find out exactly what the sales concessions were for comparable sales.
6. Listing Agent
sales commission: Simply put, this is what you’re paying your listing
broker in the employment contract, better known as the ‘listing agreement’.
This will be added to your overall investment cost. This number will ultimately
reduce your cash on cash return if it is not thought out early on, so be sure
you know it’s negotiable. Yes I said it… NEGOTIABLE!
#Facts Antitrust
laws prohibit real estate commissions from being one set price.
7. Cash-on-cash
return/ROI Return on Investment: The calculated annual before tax cash flow
divided by the total cost invested in the deal. If the total cost of the deal
is $230K and you sell the property for $300,000, the cash on cash return on
investment (ROI) is 13%. This number should be padded to allow for those
unforeseen events that can eat into the return. I like to see the return
doubled in my pre- investment analysis. In my opinion, it is better to estimate
less and make more, than to estimate more and actually make less. Having a good estimate of ROI will help you
to decide if the deal is worth doing. Normally if you can make a return of at
least 8% on multiple properties, you are earning more than the interest most
other investment vehicles are currently paying. Interest is almost free these
days which means the money is practically free…Why not let the money work
somewhere else where it can earn more? Why leave the money in a low paying
interest earning vehicle where it’s barely increasing its value?
The Ultimate Analysis: Cash on Cash Return vs. Overall
Return/Bigger Pockets
8. Cap rate (NOI-Net operating income divided
by property value) This number is used to valuate income producing
properties like residential rentals and commercial spaces. This is also known as
the ‘Income Capitalization Approach’ in appraising. You divide NOI (gross
income minus operating expenses) by the sales price to determine this
percentage. To find out the cap rate in
a particular area, your broker will need to locate recently sold comparable
properties and get the sales price and the property’s annual net operating
income. This calculation allows you to compare investments and indirectly
measure how fast an investment will pay for itself.
More details about cap rate from Wikipedia:
Here is where you need the financial professional with the fancy
degree….
9. Time value of
money/ NPV-Net Present Value: This number has to do with the point in time
in which you receive the money. Money today is worth more than money later. In
more in depth analyzation of the investment, investors can look at the time
value of the money to see if a project makes sense. If money now is taken for
the purchase of an investment with the hopes that it will make money later,
that money loses the value that it could make today if it was able to earn
interest today.
Video on NPV By: David Pio, CCIM-Certified Commercial
Investment Member, LEED- Leadership in Energy & Environmental Design
10. Discounted cash
flows- By discounting future cash flows to a present day’s rate, investors
will be able to properly calculate NPV (Net present value) As mentioned above,
the investor must understand the time value of money. If the money were used
today, it could be invested at a specific rate of return, earning for the
investor. If that money is used to make money in the future, the investor can
estimate the future cash flows for a certain amount of years and then discount
those cash flows to determine what they are worth today. Investors can use this
calculation to determine the offer price on an income producing property by
discounting those future cash flows into a present value to offer today.
