Knowing what to pay for a home is critical in the rehabbing game. I’ve come up with my own method for determining my purchase price for a property. While I don’t think my method will work for everybody, maybe it will give you a good place to start or perhaps, some new ideas.
There are a lot of different variables that you’ll have to take into account on any specific deal; I’m interested to know from other rehabbers how their math looks.
How to Analyze a Real Estate Deal
Deal analysis is one of the best ways to learn real estate investing and it comes down to fundamental comfort in estimating expenses, rents, and cash flow. This guide will give you the knowledge you need to begin analyzing properties with confidence.
Calculating the Purchase Price for a Rehab Property
Step 1: Know the value of the property. – That is the resale, after repairs value of the home. Make sure you view actual recent comparable sales. Once I feel confident I know what a property is worth I deduct 26% from that price. 20% is what I like to shoot for in a profit. With the market firming up here lately I’ve been cutting that margin to 16% on real good deals. On bigger deals or on deals that feel a little more risky I stay firm with the 20%. I wouldn’t go much lower than 16%.
Historically homes sell on average for something around 8% less than asking price. If you’re only pricing in a 10% profit then you might end up just doing a practice flip. A practice flip is a deal where you don’t make any money. Essentially you donate all of your time and effort for free to the end home buyer. The other 6% is the number I put in for closing costs when I sell the home. I’m a licensed Realtor so I list the home myself, which will save me a little. So in my case, 4% goes to Realtor fees and the other 2% is what I budget for other closing costs. You can choose to try to sell the home yourself and save the Realtor commission. If you are not a Realtor and you plan on hiring a Realtor then you probably will need to budget 6% for the Realtor fees plus another 2-3% for closing costs. I always anticipate having to pay some of my buyers closing costs.
Step 2: Deduct the costs of any and all repairs needed to get the home ready for resale. – Make sure you’re realistic about this number. I know so many rehabbers who grossly under estimate the repairs. I highly recommend getting actual bids from licensed and insured contractors.
Step 3: Deduct your holding costs. – Your holding costs include your mortgage interest, utilities, taxes and insurance.
Finance: I estimate that the average flip will take me 6 months to complete. So if I’m borrowing $100,000 from a hard money lender at 12% then I multiply 100,000 by .12 which will equal $12,000 for the year. Now since that’s a year’s interest cost you can divide that by 2 to get a good ballpark estimate on your finance costs for half a year or six month which in this case would be $6,000.
Taxes: For taxes you can just call the county or look on the county website in many cases. If you’re working with a Realtor then the taxes will usually be listed in the MLS. They’ll list the costs for an entire year, usually. Make sure you are looking at the most current year. Then just divide that number by 2 to get a cost for six months.
Insurance: call an insurance agent for an estimate. Make sure you get a suitable policy. If the home needs major structural rehabilitation then inform the insurance agent of this fact. Homes undergoing major construction have more potential hazards and risks than your basic turn key rental property.
Utilities: I just usually estimate $100 to $200 per month on this. Don’t kill yourself trying to get down to the penny.
Step 4: Deduct the closing cost you’ll pay when you buy the home. – In my case I normally end up paying 4 points to my private lender on the money I borrow for the deal and then I usually estimate about 1% of the purchase price for closing costs. So if I’m buying a house for $100,000 and borrowing $80,000 then I’ll expect to pay $3,200 in points ($80,000×0.04=$3,200). Then in this case I would expect to pay about $1,000 in closing costs or 1% of $100,000. I know some of you are saying hey Justin how do I do step 4 if I don’t yet know what I’m going to pay for the property. We’ll just put in your best guess at this point. You should be pretty close by the time you get to step 4.
Step 5: Deduct any other expenses such as finder’s fees to wholesalers or Realtors.
Using a Real World Example
EXAMPLE: let’s say I come across a home that I decide will be worth $200,000 after a little spit and polish and a good marketing plan. So, now what am I willing to pay for this property?
Step 1: I deduct 26%. I do this by multiplying $200,000 by 0.74. That is 100% minus 26% equals 74%. You can also multiply $200,000 by .26 which would tell you what 26% of $200,000 is and then deduct that number from the $200,000. But it’s much easier to do it the first way. So…
$200,000 x 0.74 =$148,000
Step 2: Deduct the cost of repairs. Let’s say this deal only needs carpet paint and some light repairs and strategic updating. Our contractor submitted a bid to us for $20,000 for this work.
$148,000 – $20,000 = $128,000
Step 3: Deduct holding costs.
Let’s say I guess I’ll have to borrow about $100,000 from my private lender to get this deal going. And, I know she charges 12% interest.
The math: 100,000×0.12= $12,000/2=$6,000.
The counties website shows that this year’s taxes on the house will be $2,400. Divide that by 2 to get $1,200 which should be your costs for 6 months.
Our faithful insurance agent tells us a 6 month policy on a vacant home will cost us $500.
We guess $100 per month for six months which is $600 total.
Total Holding Costs = $9,500.
$128,000 – $9,500 = $118,500.
Step 4: Deduct your closing cost incurred when you buy the home.
Points: We are guessing that we’ll be borrowing about $100,000 dollars on this deal. We know our lender charges us 4 points. So that is $100,000 times 0.04 which equals $4,000.
Closing costs: We’ll guess to be 1% of the purchase price which will be around $100,000 so $100,000 times 0.01 = $1,000.
Our total closing costs then will be about $5,000.
$118,500 – $5,000 = $113,500
We now know our purchase price is $113,500.
On this particular deal we should be willing to pay approximately $113,500. Now we did our numbers above estimating a $100,000 purchase price. So if you want to get your numbers tighter you would go back to steps 3 and 4 and plug $113,500 to get an even more accurate number.
Remember, this process isn’t going to get you down to the penny. This is down and dirty. The process I used for estimating interest costs is a very simple and crude method. But it should get you close enough to be profitable in the end.
Share a little about how you calculate your purchase price.