Buying Foreclosures at Auction: How to Avoid Overpaying
Overpaying for property is one of the biggest risks of buying foreclosures at auction—and it’s also one of the most common mistakes made by new investors. That’s why it’s important to have a solid system for valuating potential purchases in place before making bids.
For years, my partners and I have profited on foreclosure flips with a system based on the following simple equation:
Resale Price – Cost = Max Bid
While the system itself has evolved over time, the foundation (the equation above) has not and will not change. If you’re able to accurately estimate a property’s resale price and the costs associated with getting it ready for resale, you can get some great deals at auction while avoiding most of the bad.
Below, I’ll cover the basics of what it takes to determine a property’s resale price and outline the costs you’ll need to consider in order to come up with the right figure for a max bid.
Estimating a Property’s Resale Price
Estimating resale price is a good place to start with any potential property flip. Resale price is what you believe you’ll be able to sell a home for after you’ve completed any necessary work. In other words, it’s what the property should sell for on the open market once it’s in salable condition.
That’s easy enough to understand, but estimating resale price isn’t always easy because it’s dependent on a variety of factors, some of which are ever-changing.
Location, for one, will have a considerable impact on price, as will surrounding properties and the current economy. Fortunately, in most cases, it’s possible to come close with market-value calculations fairly easily as long as similar homes in the same area have sold recently. Sales of similar homes are called comparables, and they’re the key to estimating resale figures quickly.
To find comparables, real estate data sites like Realtor.com and Zillow can be used to search for sales data. Recent sales are always best but not always available. Comparables should also be near the home you’re looking to buy (in the same neighborhood if possible) and similar in size, style, and amenities for best accuracy.
Unfortunately, finding these ideal comparables isn’t always possible, but that doesn’t mean you can’t work with what you’ve got to estimate resale price. In our upcoming book Bidding to Buy, we detail the system we use to adjust comparables to account for differences between them and the subject property.
Calculating Costs for Foreclosure Flips
Even if you’re able to calculate resale value accurately, you’ll make very little (or lose money) when the time comes to resell unless you’ve considered costs and capped your max bid accordingly. Here are the most common costs encountered on the road to resale.
If you opt to have a Realtor list your property, you’ll pay a commission. Typically, this will be between 3-4% of the sale price.
In order to finalize the deal, legal fees and closing costs will need to be paid. We generally assume these will add up to about 2% of the resale price.
Back taxes are common with foreclosures. If the previous owner owed property taxes, you’ll need to pay these after taking ownership. Fortunately, a title search will tell you how much is owed, so you won’t need to estimate.
While many liens expire after foreclosure, some will still need to be paid by the new owner. These can include mechanic’s liens, federal tax liens, and city utility liens. Again, a thorough title search should tell you what, if any, liens need to be paid and how much it’ll cost you.
In general, we prefer to buy unoccupied foreclosures to avoid additional costs and headaches. However, you’ll miss out on some great buys if you elect to overlook all occupied foreclosures. When working out our max bid on an occupied property, we add an additional 5% to account for costs associated with getting occupants out.
There are certain expenses associated with researching potential property buys. Title research and drive-by inspections, for instance, will require an investment of time (if you opt to do it yourself) or money.
Also, as with any home, you’ll need to cover expenses like insurance and security until the property sells. These expenses tend to be fairly consistent from one property purchase to the next, so you’ll be able to estimate them with better accuracy as you gain experience.
Since you never really know the true condition of properties offered at auction, you should bid with the expectation that work will be required to get the home back to salable condition. In Bidding to Buy, we cover exactly how we calculate line-item renovation costs, so check that out for an in-depth outline of what we typically pay contractors per job.
In a pinch, you can calculate these costs with the assumption that material and labor costs will be roughly equal. Simply double the price of material costs for a figure to factor into your max bid.
Formulating Your Max Bid
After calculating the costs outlined above, don’t forget to factor desired profit into your max bid. In most markets today, a figure between 10-20% is reasonable.
Now, with estimates for resale price, costs, and profit complete, you can formulate your max bid. Here’s how the equation from the beginning of the article should look after expanding on it to account for expected costs and desired profit:
Resale Price – (Realtor Commissions + Closing Costs + Past-Due Taxes + Liens + Occupancy Costs + Miscellaneous Expenses + Construction Costs + Desired Profit) = Max Bid
Your max bid, the final figure in the equation above, should serve as your stop point on auction day. As long as you’ve done your homework and don’t exceed your max bid, you should stand to make a profit from your foreclosure flip.
Have questions on estimating costs or calculating resale price? Let me know in the comment section below. Also, be sure to check out our upcoming book, Bidding to Buy, where we detail our step-by-step system for investing in real estate foreclosures.
Bidding to Buy: A Step-by-Step Guide to Investing in Real Estate Foreclosures by David Osborn and Aaron Amuchastegui is available now in the BiggerPockets Bookstore.
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