Over the past year, I’ve mentioned a certain phrase time and time again, but never really elaborated on what that phrase means or how to do it. That phrase is “buy smart.” In my article “How to Make a Million Dollars in Real Estate: A Step by Step Path” I mention it as one of the most important aspects of building a real estate empire. In that article, I stated that on an investment property, you should always seek to pay 80% of the purchase price or less, with the ability to add 10% more by “forced appreciation” (fixing it up a little.) But how easy is this to do? Who is going to accept an offer that is 80% of the value? Today I’m going to elaborate on that concept of “buying smart” and give you some ideas for how buy smart and pay less for your properties.
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What Does it Mean to “Buy Smart?”
The simplest definition for “buy smart” is simple: Don’t Buy Dumb.
Okay, let me expand a little bit. Buying smart means to buy at a price that leaves no room for speculation, for error, mistakes, or “Murphy.” Let me give you example of how someone might “buy dumb:”
There is a fourplex listed at $120,000 that brings in $2400 per month in income. Investor John looks at the property and says “well, it looks like the water bill is $200 per month, and the mortgage (with taxes and insurance) would be around $1200 per month. Wow! This thing cashflows at $800 per month!
That’s how you buy dumb.
Why? Because Investor John forgot about maintenance, repairs, vacancy, garbage, management, and dozens of other potential costs. If Investor John paid $120,000 for this property – he may have just bought dumb. He wouldn’t know if it was a smart buy or a dumb buy until he spent more time analyzing.
Buying Smart means looking at ALL the costs associated with the property, along with all the potential costs and the “worst case” costs and including those into your calculations.
How To Buy Dumb vs. Buying Smart
Anybody can buy dumb. It’s very easy – there are ton’s of properties listed in your neighborhood that you could go out and buy right now. However – the vast majority of these purchases would be dumb to buy. The following tips wil help ensure you “buy smart” instead of “buy dumb:”
Buying Based on the Lies of the Seller
The first mistake many investors make is buying a property using the numbers provided by the seller. However, newsflash: sellers lie. It may not even be intentional, but often times the information provided about rental rates, vacancy, or repairs may be exaggerated or simply flat out wrong. If you want to “buy smart” you need to verify every number and do your due diligence carefully.
Buying on “Pro Forma”
Don’t be overwhelmed by the fancy Latin language. Buying “Pro forma” simply means you are buying based on the “future predictions” that the seller or the seller’s agent has come up with. Why would you pay for something based on the guess of what it might be worth? You wouldn’t buy anything else in life that way! Imagine asking a car dealer to pay just $1200 for that new car because someday it will be worth that? Despite the silly nature of “pro forma” numbers, agents continue to use them to “demonstrate what is possible.” If you want to buy smart – buy a property based on what it’s worth today, not what it could be worth.
Buying on Emotion
First-time homebuyers are not the only ones guilty of buying on emotion. Even seasoned investors can easily be caught up in the moment and forget the math that makes or breaks a deal. This is why I am such a huge fan of spreadsheets – because they are objective. They don’t let me simply “overlook” the fact that there is going to be vacancies.
Buying Based Only on Numbers
I love math, as everyone probably knows by now. However, one thing that math and a spreadsheet cannot account for is the unforeseen. This is when experience comes in handy – as well as the “rules” of real estate – the 50% rule (when dealing with rentals) and the 70% rule (when dealing with flips.)
The 50% rule is a general rule of thumb that helps an investor quickly analyze a property. Some argue it’s too conservative, that the cashflow is actually higher. However, the 50% rule has grown in popularity among seasoned investors because they understand that in reality, sometimes there are charges that don’t show up on a spreadsheet. Sometimes the roof leaks, sometimes a flood hits, sometimes the economy crashed. The 50% rule helps to account for the unforeseen circumstances that you will never think to factor into your math calculations.
If you are looking to flip a house, the 70% rule can help you determine the cost you should pay. You might do the numbers on a spreadsheet and assume you can pay one amount, but the 70% rule might tell you to pay significantly less. Again, the 70% rule (like the 50% rule) helps you to account for the unforeseen issues you never would have thought to include in your calculations.
When I look at a property for a investment or flip, I like to look at both the rule of thumb (50% or 70%) AND the spreadsheet math – and use whatever number is more conservative. That’s how you buy smart. As I said in the introduction – “Buying smart means to buy at a price that leaves no room for speculation, error, mistakes, or ‘Murphy.'” (Tweet This Quote!)
For a much more detailed look at the 50% rule and the 70% rule, check out Chapter 5: How to Find Investment Properties in the BiggerPockets Ultimate Beginner’s Guide to Real Estate Investing.
Tips for Buying Smart
The following are just a few tips to help you buy smarter. I’m sure there are a lot more I’m missing – so please, if you have any additional tips, feel free to include them below in the comments.
- Look at a LOT of properties – and only choose the best.
- Don’t be afraid to offer to little.
- If your offer doesn’t make you blush – you offered too much.
- When you offer – mention in the official offer that you “understand the property had ____, _____ and _____ wrong with it.
- Be likable (especially when dealing with motivated homeowners.)
- You should look at 100 properties, offer on 10, and only get one accepted. Thats a deal.
- Hire a licensed contractor to give you a price on repairs before buying the property. Don’t guess.
- Have a professional inspector go through the property to learn everything about it.
- Bring your deal to the BiggerPockets Forums and let seasoned investors help you analyze.
- Set up automatic alerts through your agent for new properties that meet your qualifications. Jump on good deals.
- Have your financing in place before making offers.
- Include as few “contingencies” as possible in your offer (but don’t get too risky if you are just starting out. You probably need the inspection and financing contingency if you are just beginning.)
- Be conservative in your math.
- Be conservative in your math. (yes, that’s twice because it’s so important.)
Can you think of any more tips for “buying smart?” Or do you have any thoughts on “Buying Smart” versus “Buying Dumb?” Add them below in the comments!