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Posted almost 3 years ago

Analyzing a Property with Forced Appreciation

Is it a good deal? Have you ever asked yourself that question when you’re looking at a property?

There are four ways to make money from real estate: Cash Flow, Appreciation, Principal Paydown, and Tax Benefits. Understanding these will help you figure out if a property is a good investment or not.

Appreciation in real estate can take two forms: Long Term Appreciation and Forced Appreciation.

Long Term Appreciation can be generally defined as the increase in value over time. Over the long term, that value grows at the rate of inflation, or even a little bit better. It is unpredictable over a short period of time, but in the long term, you can generalize the growth. Similarly to how the stock market growth is generalized at 10% annually, real estate appreciation can be generalized at about 3% to 5% annually.

On the other hand, Forced Appreciation occurs when you do repairs or updates to a piece of real estate and manually bring up the value in a short amount of time. It is a very predictable form of growth, and it is actually how house flippers make their money.

As a matter of fact, I use the same principle whenever analyzing a rental property. You can also use it if you decide to flip a home. We will discuss each of the terms below to get a better understanding of how we can make Forced Appreciation work for us.

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After Repair Value (ARV)

What is the house going to be worth once it’s fixed up? What about with a new kitchen, bath, floors, paint, or maybe just about everything? The value of your home after it is fixed up is called your After Repair Value. A realtor can help you figure out the ARV of your home.

Total Purchase Closing Costs

The Total Purchase Closing Costs refer to the expenses incurred during the purchase of a property. This includes, but is not limited to, the Title Insurance, Transfer Tax, Loan Origination Costs, and some other miscellaneous expenses.

You can ask either your title company or your real estate agent to determine the value of each of those items. From the example above, the Total Purchase Closing Costs is about $8300.00, which is a normal amount for a property in that price range.

Total Holding Costs

The Total Holding Costs are the amounts incurred while holding the property before you sell or rent it. To calculate this, you will need to identify the monthly expenses for the Real Estate Taxes, Insurance, Condo Fees, Utilities, and the Interest on the loan. You will then multiply it by the number of months you expect to hold the property.

In the example above, I expect to hold 7 months after buying the property to rehab it to be rent-ready. A 7-month project is a pretty big rehab and for me, it would entail the house needing a full gut job. Therefore, the Total Holding Costs for this property is about $4,855.00.

However, if I have only lighter cosmetic work to do on a property, I allocate 2 to 3 months. This means the house only needs either a new bathroom, floors, paint, or some light repairs.

Sale Costs

Sale Costs refer to the costs incurred to get the property sold. You will need to determine what the commission is going to be to pay an agent to sell it, the transfer tax, and other miscellaneous fees involved in the transaction. From our example, I’ve allocated $15,000.00.

Furthermore, if you decide to take the route of refinancing the property instead of selling, then Refinance Costs can be substituted for the Sale Costs.

Repair Costs

In order to determine how much you need to allocate for the Repair Costs, you need to figure out the repairs or updates required to bring the property to a condition that is similar to the other properties you are using as comparable sales for the ARV.

If you are not comfortable with repair costs, you could get a contractor to walk through the house to give you an idea as to what these numbers will look like. If you are still uncomfortable with your repair figures, you can always pad your number by increasing the amount by a certain percent. How much you pad it is up to you. This “padding” is commonly known as a contingency factor.

Profit Margin

Finally, decide on your Profit Margin. Yes, you actually define how much you want to make, or how much forced appreciation you want to have. Determine what is acceptable to you.

Once you have identified the Total Purchase Closing Costs, Total Holding Costs, Sales Costs or Refinance Costs, Repair Costs, and the Profit Margin, subtract them from your ARV, and you will get the Maximum Purchase Price, which is $116,765.00 in our example.

The Maximum Purchase Price is the maximum amount you can pay for the house and still have the Forced Appreciation or Profit you desire. Obviously, this is assuming, your other numbers are correct.

Notice that Asking Price is nowhere to be found on the spreadsheet. This is because it really doesn’t matter what the asking price is. Regardless of what it is, you have to figure out what you can pay for the property to make it a good deal for you.

So, when you're analyzing deals and making offers on properties, you can use this simple formula to make sure that you get a good deal!



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