“We make our money when we buy.”
The famous mantra of seasoned investors. No matter how much you can sell your flip for or how much rent you are receiving from tenants, you won’t turn a good enough profit if you didn’t buy the house at a low enough price.
Last week, we discussed how to acquire the money to purchase an investment property (check out last week's blog if you missed it), so this week I’d like to help you figure out just how much money you should attempt to acquire.
The Golden Rule
The golden formula for investing is 80% of the ARV - Repair Costs = Your Max Allowable Offer. If you can get that percentage lower than 80, even better. So what does that mean? The ARV is the after repair value. In other words, what the house would sell for on the market after you’ve fixed it up (even if you plan to rent it and not sell it). How will you know what it will sell for after fixing it? You’ll need to run the comps (comparables) of houses that sold within a one mile radius in the last six months. Those comp houses should look similar to what you envision your home will look like once you fix it up. So don’t take the trashy or outdated houses into consideration. 😉 If you don’t have a way to run comps, hook up with a real estate agent. Once you have your ARV, multiply that number by 80%. This will give you the first part of your formula. So if your house could sell for 150k once renovated, then you’ll start with 120k. Now you have to calculate how much it will cost you to renovate the house. If this part is a struggle for you, get some people to come see the house with you and give you some estimates. Or, Facetime them while you walk through the house and see what they say. Once they give you an estimate–let’s say 30k–subtract that number from the number you get after multiplying 80% by the ARV. So in our example, our number is now at 90k. This means, in order for you to actually make a decent profit off of the sale or refinance of your house, you should offer NO MORE than $90,000 (in this example). Renovations always end up costing a little more than expected, so this formula will cover that and give you some wiggle room. If you find a house that could potentially sell or refinance for 150k but you need to put 30k worth of repairs into it to get to that number, then offer 90k or less.
Now, most people who list their homes on the market will not list it for 80% of the ARV minus repair costs. Nor will they accept an offer produced by that formula. Some woke sellers who realize that their home needs work and can’t sell for the price their neighbors received, may list their home at a lower price. However, those can be very hard to find. So, homes that are currently listed for sale may or may not be homes you should purchase. You’ll just have to do your research and see if the home fits the formula and if you can negotiate the price.
So, instead of searching the market for homes for sale, you’ll want to buy a property off market. Do you ever see those signs on the street that say, “We buy homes for cash”? The people who post those signs are looking for off market properties. People who need to sell their home off market are people who are either in some type of bind and need a quick and easy sale, or they are people who do not want to pay the money or go through the trouble of listing their homes. These are the people you’ll want to target. It can be quite difficult to find people who need/want to sell their homes off market, so I’ll give a tutorial on that in a subsequent blog. Additionally, many investors also purchase from the Landbank or at auctions.
Maybe you just aren’t up for the task of remodeling a home. It can be difficult to estimate repairs or to find someone to help you inspect the home and give an honest opinion. If you aren’t handy in the home repair department, it can be difficult to find a trustworthy contractor. So many people are steered away from purchasing homes that need serious rehab simply because they don’t have that skill set or they don’t have “a guy.” If that’s you, but you still want to get in the investment game, there’s still a place for you.
If you aren’t up for the rehab challenge, you could purchase a turnkey property to rent out. Turnkey properties aren’t homes that you can flip, but they are homes that could house a tenant. If you are going this route, you wouldn’t use the same formula listed above (you could use that formula to purchase a rental property, but it’ll need to be an undermarket value home). Instead, you would use the 1% rule. If your property could rent for 1% of your purchase price, then it’s a great deal. So, if you purchase the home at $150,000, you should be able to rent it out at $1500 a month. If the rental market in your area and for that type of home doesn’t support $1500 a month, then you’ll need to move on and find a different property or negotiate the price. Alternatively, you could definitely rent it for less than 1% of the purchase price, but that will just depend on how high your monthly mortgage payment is and how much you have to pay in property management fees. If you can produce some cash flow each month after paying all the bills associated with the home, then less than 1% is fine. Just know that the goal of purchasing rental properties is not to generate tons of monthly cash flow; it’s to generate future income. So if you break even or only produce $100-$200 a month in income, that’s okay too. This type of investment will provide you with income down the road (and tax benefits today 😎).
At the end of the day, you just need to execute a deal that is right for you and your situation. Evaluate your personal goals. If the purchase helps you meet those goals, then do it! Every investor is different and has different financial and career aspirations. So, just do what’s right for you. 🙃