Real Estate Investing - Buy Low

The key to any investment, real estate or otherwise, is to buy low (and I would also argue that this same principle should be applied to the purchase of your primary dwelling, whether you consider it an investment or not). With real estate, there are innumerable ways of doing this, but few are easy. My philosophy is to find properties that no one else wants, such as those with mold in the basement, a cracked foundation, a roof that is caving in, or other serious structural problem. Not interested in such a home? Good! These flaws scare away many potential buyers and investors, resulting in much less demand which gives me more leverage to negotiate a favorable price.

When I'm evaluating a property, I get a good look inside the home. I look for cracks in the drywall between the wall and ceiling, water stains on the ceiling and on walls, tiny black spots on drywall, signs of rot on the eaves & facia, and cracks in the flooring/foundation. As I identify problems, I note them and begin a mental tally of what each item will cost to repair. Estimate high. If you're not sure how much something will cost, make friends with a contractor and take them with you to view a potential investment.

With the house I'm currently working on, I made an offer immediately after seeing the property. I knew the fair market value (FMV) of the home if it were in "normal" condition. How? I know the market. I've researched and studied my micro-market and know the selling price of nearby homes. Online sites such as HomeRadar and the Atlanta-specific AJC homefinder provide a list of somewhat-recent home sales. Two great sites that show comps on a map are ShackPrices (only for Seattle) and HomePriceMaps. One site that may some day provide the ultimate solution is Zillow.com, which can give you a "Zestimate", but today it's only available in certain markets as the site is in "beta" now (so be patient!). And remember that a Zestimate is just a start--the key to knowing the fair market value of a home is to know the details of the comparable recent sales used to derive the Zestimate. If their data is bad, your Zestimate is wrong. Finally, if you're unable to determine recent sales in a market, it's time to make friends with a local realtor and take them out for lunch. Realtors have access to a database of recent home sales through their local MLS. When you do finally determine the FMV, be conservative.

At this point, you now have two numbers:

  1. Fair Market Value (FMV) of the improved home
  2. Repair cost (now abbreviated as RC)
I need to calculate yet another number before determining my offer price, and I call it the PITA factor. PITA is my acronym for Pain In The Ass. If the house only needs new carpet and a coat of paint, my PITA factor is a low $ amount. If I need to tear down and haul away 1/3 of the house, gut it, and install a new roof, the PITA factor is high. It's different for each house and each investor, but it's real, and I include it in my calculations.

Lastly, there has to be some profit (which actually results in equity) in the deal, or it's not worth your time. And if you've errored in calculating any of the other three numbers, you're going to eat into your profit. Again, this number is different with every investor, but if there is less than $20k profit in the deal, I don't pursue it.

Finally it's time to calculate the offer price. I derive this by using the following formula:
FMV - RC - PITA - Profit = Offer price

So if the Fair Market Value = $195k, the repair costs are $20k, the PITA factor is $5k, and the desired profit is $20k, the formula to determine an offer price would look like this:
195,000 - 20,000 - 5,000 - 20,000 = $150,000

One last point: this calculation helps determine what you're willing to offer. This should go without saying, but if the house is listed for $140k, don't be a fool and offer $150k.

Likewise, if the home is listed for sale at $150k, I wouldn't immediately submit an offer with a seller's asking price. If the house has been on the market longer than a couple of weeks, I'd make a low-ball offer, knowing the seller is already cognizant of the fact they're selling a defective house and are probably afraid no one is interested. If the house is newly listed, I'd probably make an offer around $140k, as there may be something I didn't factor into the repair costs. And regardless of what is on the Seller's Disclosure Statement, once the house has closed, it's yours--problems and all.