KNOWING WHAT A HOUSE IS WORTH BEFORE YOU MAKE AN OFFER
When you are buying a high-dollar item, such as a house, you need to know what it is worth to you before you make an offer. You cannot predict what the seller will take for the property. The amount that a property will sell for can change every day. It is the price that a real buyer and the seller can agree on that particular day. Since both the seller’s and buyer’s situations can change in a heartbeat, the price that a property will sell for is unpredictable.
The property’s value to you can be established. If you are trying to buy a property that produces a certain amount of cash flow or that has a good chance of appreciation in value because of its location, then you can put a price on the property that you would be willing to pay.
By researching recent sales of other properties in the immediate neighborhood that are comparable in quality and condition, you can learn what the property would sell for at a retail price. The retail price is the price that the property will sell for, given enough time (which is a long time in many markets) and exposure to the market by someone who is able to negotiate a sale. It is generally the price a competent Realtor will get for a seller given enough time.
At a wholesale price, real estate is liquid. I will buy a house and close on it in one or two days, giving the sellers cash for their equity, at a wholesale price. This is about the same amount of time it would take the seller to sell a stock and get cash.
What is the difference between retail and wholesale? It is different with different types of real estate, so let’s focus on houses. If you are buying land or commercial property, it is much more difficult to determine what a property is really worth, and the difference between retail and wholesale can be much greater.
Even with houses, the difference between retail and wholesale is different in different price ranges. The lowest-priced housing in a community generally will be in poor repair and in neighborhoods with little potential for appreciation. Lenders are not fond of making loans on such properties, and, because of this, buyers are unable to obtain financing to buy these houses. This makes the lower price range less liquid. Although you can buy these houses at what looks like a bargain price, when you sell them, you may have to sell at a significant discount or finance the purchase for a buyer with poor credit.
Some investors buy these low-priced houses because they can rent them for a high rent compared with the price they paid for the house, but these houses will require a lot of management, and the owners will not benefit from the appreciation they might receive with higher-priced houses.
On the other end of the price range are the most expensive houses in your town. These are more illiquid and might sell for a 20, 30, or 40 percent discount because relatively few buyers want these houses.
Anyone who can afford to buy a very expensive house has other alternatives. These buyers can choose to buy less expensive houses, so the most expensive houses in your market also sell at a larger than normal discount if the seller is forced to sell in a hurry. This is a real opportunity for a buyer, but you must be able to afford to own the house until you can sell it at a retail price, and that could be a long time.
Houses in the middle ranges sell for closest to retail. This makes them more of a challenge to buy at wholesale prices, but it makes them safer investments in the long run. Since these houses frequently sell at retail prices, it is easier to determine their value. You can research recent sales through your public records (which can often be found online) or through the multiplelisting service records that any Realtor can provide for you.
Because these houses are more liquid, you can safely pay closer to a retail price, knowing that if you need to sell, you can get your money back in a reasonable period of time.
What is a wholesale price for an average house in a moderately priced neighborhood in your town? It depends on your market conditions. If there are a lot of willing buyers in your market, and lenders are willing to finance them, then a discount of 10 to 20 percent off the retail price is wholesale. It allows you to buy the house, hold it for a while, and then resell it for a profit.
There are holding costs to owning a house. An investor will rent a house as soon as possible to generate income to pay the cost of holding the house and will wait to resell until the house has appreciated. A speculator may buy a house and try to resell it immediately for a much smaller profit. Until she sells it, she must pay the holding costs, which are depleting her profits daily. Obviously, investing for the long run is a much more predictable way to make much more money with less risk.
If you are new to a market. How do you know how much to offer when you are buying a house? You can pay for an appraisal before you make an offer, but that is expensive, time consuming, and appraisers do get it wrong occasionally.
You can simply make a very low offer and see how the seller responds. One downside to this, if the property is listed, is that some brokers will refuse to present your offer or will present it in such a way that you don’t even get a counteroffer. If another buyer is in the wings, the low offer may give them the contrast they need to get their higher offer accepted.
An alternative is learning to place a value on the property yourself. This is easier in a stable market but possible in any market. I teach students in my seminars to estimate a price that is within 10 percent (plus or minus) of the value. I recently bought a house that was worth about $145,000. My estimation of the value was a range of $125,000 to $150,000. An appraisal would have been in that range.
My first offer was $110,000 (a little under 10 percent below my lower figure) and we closed at $115,000 with favorable owner financing. An important part of the value of this deal was the owner financing, which allowed me to buy with a small down payment and have several hundred dollars a month in cash flow. I would not have paid $115,000 cash for the house. (See Normal Returns on Investment (ROI) on the next page.)
Part of the answer to the question “how much to pay?” depends on the direction of the market in your town. Your paper may report that prices are going up or down, but every town has many markets. Every street has a market. Some streets have many foreclosures or short sales, while others have none.
Different neighborhoods are different markets. While some streets have a lot of houses for sale or rent, others (in the same price range) may have none.
Which streets have the more stable prices? Another factor (rarely considered by appraisers or prognosticators) that influences value is the number of free and clear properties in a neighborhood. Find a street that is loaded with long-term residents and you will find many free-and-clear and high-equity properties. In addition to more stable prices you will find more owner financing opportunities on these streets.
Obviously a street loaded with free-and-clear properties will have few, if any, foreclosures, although a long-term owner in a hurry occasionally needs to discount the price to attract a buyer. This lack of distressed sales helps keep the prices up in these neighborhoods.
When credit is tight for potential homebuyers, many people who would like to buy a house can’t qualify for a loan. As credit becomes more available, more buyers will return to the market to compete for the existing housing inventory. The National Association of Realtors reports the amount of inventory and the average time on the market in different markets. Get this information for your town from a local Realtor or look on the National Association of Realtors website (www.realtor.org).
A distressed sale, a foreclosure or short sale, is not sold at a market price. Often the house being sold is not in good condition. It may need significant repairs just to make it livable.
When a street has only distressed sales, then the perception is that all houses have dropped in value. When the distressed inventory is gone, the prices of houses in good condition will return to “normal.” What is “normal”? In a normal market a buyer can choose from existing houses in good repair or new inventory. The new inventory sells for the builder’s cost plus his profit and buyers are willing to pay a premium for a new house that is available immediately. A comparable used house will sell for less. However, a well-maintained used home may be in a better location and that location may command a premium.
In a normal market, a buyer of an investment house might expect a net return from rents in the 4 to 6 percent range. In a distressed market, houses sell for less and the net return from rentals is higher. In a distressed market, you might make 8 to 12 percent net return based on distressed prices.
This is higher than normal and is only possible because of the bargain prices, not high rents. The rental market is often less volatile than the sales market. Rents will drop in a recession, but not as much as prices in hard-hit markets.
Know the trends in the job market and the rental market in your town. When jobs and tenants are disappearing, you might make your best deals, but it is a risky time to buy.
When the job and rental markets show signs of improvement, you may have missed the bottom of the market, but there will still be plenty of good deals. It’s much safer to buy when you know that you can find a good tenant than when you are uncertain about your ability to rent.
You don’t want to lower your standards and rent to a marginal tenant. In a soft market, drop your rents to attract (or maybe steal) a good tenant.
Fair market value is the price that a willing buyer will pay a willing seller in an arm’s length transaction. Of course, the credit market has a lot to do with how much a buyer will pay. When the credit is freely available, prices will be higher than in a tight credit market.
Current sales are the primary source of “comps” or comparable sales used by appraisers to establish value in a residential appraisal in a normal market. If the market is heavily loaded with distressed sales, then you actually have two markets. There is a market for distressed sales and another for sales of non-distressed (in good condition both physically and financially) houses.
In a typical market, a distressed sale would not be considered as a comparable for a well-maintained house sold in an arm’s length transaction. During a recession, distressed sales can be the majority of the sales, making it difficult for an appraiser to establish values.
Bruce Norris, a successful California investor overcomes this when selling by hiring an appraiser to research and find a number of comparable sales of rehabbed or other houses in good condition. They then share these comparable sales with the lender’s appraiser. This helps the lender’s appraiser and helps the buyer and the seller close the transaction.
When looking for trends in neighborhood house prices, the challenge is finding houses that are “equal.” Every house has a unique lot, design, features, neighbors, and has been cared for differently. The best way I know to compare values in a neighborhood is to compare sales of the same house, accounting for renovations, if any, and changes in the neighborhood. Look for sales ten to twenty years apart to lap a market cycle. This takes local knowledge, and appraisers do not have the time to make this level of comparison.
Appraisers have to produce an appraisal report in a few hours, so they rely heavily on sales figures from the public records. Although they try to find comparable properties, they can’t take the time to drive every street and research every property to see if it is indeed a lot like the house that they are trying to appraise.
Look for streets where others are fixing up houses to rent or to sell. The average sale price will climb dramatically on these streets in a short time. Should you acquire a distressed property, the next step is to fix it up. I have purchased and renovated a number of houses. Here are some typical numbers: purchase price $100,000; repairs $40,000; sale price $180,000. You can see the effect on the neighborhood and on comparable sales when a distressed property is turned into a retail property.
In a hot market some builders and rehabbers build or remodel houses and make them too expensive for the neighborhood. They buy cheaper lots and build houses that are too big or too fancy for the market. These over-improved houses often sell for less than what it cost to build them. This will depress prices of the over-improved properties on these streets. Other streets have smaller (typically older) houses built on good lots. These houses are likely to be expanded or simply razed as the lot value becomes more than the value of the improvements.
Are there a lot of Realtor signs advertising short sales (or just a lot of signs)? Short sales and foreclosures are an indication of the amount of debt (too much) on the properties. These properties will sell below the market, depressing the process for a while. If you are buying on a street with many foreclosures or short sales, calculate your best offer, and then reduce it by another 20 percent.
One fun part about walking through neighborhoods and talking to the owners is finding someone who has lived in the same house for fifty years and knows the history and all about the current residents. They notice owners coming and going, know who has a growing family and know who is close to moving out.
A lot of long-term residents speaks well of a neighborhood. Neighborhoods can go downhill, even with long-term owners, but I prefer to own in a neighborhood where people want to stay, not in one where they want to get out. Talking to people will give you the inside track on what is happening on a street.
Another approach used to establish a property’s value is the income approach. Although with residential real estate this approach is typically given less weight, but it can help you establish what to pay for a house.
Houses are unique among income-producing real estate. Some property has only an investment value. The only reason you would buy a commercial or industrial building is to generate an income, so their value is primarily based on the income that they produce. A lower income results in a lower value.
A house has value separate from its income. A house is valuable to a user, and often this value is higher than the value it has as a producer of income.
In a “normal” market, a median-priced house will rent for enough to give an investor a 4 to 6 percent return. This is the return after expenses, but before income taxes. This also disregards the effect of leverage. When you finance part of your purchase, your rate of return will be amplified.
In order to compare apples with apples, compare incomes as if the houses were free and clear. When you can buy a house that will give you a much higher return than 4 to 6 percent, you have reinforcement that you are buying at a bargain price. Of course, less expensive houses often produce more gross cash flow, but they may also attract higher-maintenance tenants, which leads to higher maintenance costs. Be careful to compare houses in the same general price range when comparing net incomes.
A third way to determine value is to calculate what it would cost to reproduce a property. Of course, a reproduced house would be a new one, so an adjustment for the age and condition of the house would be used to adjust the value.
In the price range that most of us buy houses for investment, the cost of construction would be in a fairly tight range. Different construction materials, block or brick instead of frame might have an impact on both cost and marketability. Some builders have good reputations for building a quality house while others build as cheaply as possible. These factors affect the long-term maintenance cost of a house and its value today.
The part of the cost that is less consistent is the cost of not just the land but also the site preparation. If a lot is low, it may require tens of thousands of dollars in fill, compacting, and grading before you can build. Likewise, if drainage is an issue, you can spend an extraordinary amount installing a septic system. Additionally, if you don’t have access to a central water system, a well can be a big expense.
These items can be expensive but add little value to the house, since every house needs working plumbing and a building pad. Landscaping is not a big factor when buying a rental, but it can be expensive. Don’t put a lot of value on landscaping and site improvements.
In a rising market, the market approach has advantages over the income and reproduction approaches. Rents sometimes lag behind price increases, so the income approach can be low. And move-in-ready houses, with mature landscaping in an established neighborhood, will sell for a premium over a house to be built, so your existing houses may be worth more than reproduction costs.
In a falling market, the income approach is a good gauge. If you can buy a house and get an 8 to 10 percent return on your money when banks are paying a fraction of that on savings accounts, it’s a good deal. Combine that with the opportunity to buy with a low interest rate loan and you have a license to steal.
Because your perception of your market will influence how much you offer, the seller’s perception of the future will influence how he responds to your offer. Find a seller who thinks the market is still going down, and your chances of making a good deal go up. The public is always a day late when it comes to recognizing the top or bottom of a market.