How to STILL Make Money in Real Estate

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shapeimage_2.jpgAs a real estate investor, I’ve done it, seen it, or heard it all. The news is filled with doomsday predictions daily, and Real Estate investors are bailing left and right. The good news is, there is still money to be made in real estate, and with less and less real estate investors in the market, there’s even better deals to be had, and more money to be made than before. 

It’s not nearly as easy as it was in the past decade, where any random person could basically luck themselves into profits. Gone are the days in which a coat of paint and some new carpet can increase the price of the home by tens of thousands. But with smart up-front planning, and intelligent renovation choices, all the “negative” aspects of the current real estate market can be carefully mitigated and “flipping” real estate can be very profitable. There are two constants which are discussed daily in the news these days, and those are home prices and inventories. Home prices are not an issue. A downturn in home prices is irrelevant to renovating properties. Unless a renovation takes longer than six months (which it never should), the depressed real estate price is already built in to the price you pay for the property. So pay no mind to the state of home prices. They are what they are, and what they are is just another piece of the investment decision equation, which I will discuss below.

The only concerning issue is the bloated inventories. There are more homes for sale right now than ever in our history. It’s a staggering number. It’s concerning because it means there is a lot more competition for a similar number of buyers. What hides behind this statistic, however, is that there is still a strong number of buyers. One constant in this nation is that there will always be home buyers. Home ownership is the “American Dream”. People upgrade, downgrade, get married, change jobs, etc. Built into our system is a constant churning of home buyers. No matter the market, no matter the economy, people will be buying, switching and changing homes. Additionally, interest rates are still at near historic lows, which allows for more people to afford more house. Therefore, the good news is that demand is relatively stable. Basic economics explain that static demand and increasing supply puts a downward pressure on price. This is not a concern though; we’ve already addressed that. The lower price is already built into the price you pay for the property when you but it, so it is not a factor in the end result. The only concern that high levels of inventory brings is the increased time it takes to sell a property (called the “days on market”). During the real estate bubble, homes sold in record time. They sold within days, even hours. That is obviously no longer the case. Homes take much, much longer to sell. This merely has the effect of increased carrying costs (the monthly cost to own the property -- mortgage, property taxes, utilities, etc.). This is just yet another thing to be built in to the investment decision equation. Pinning down this number is difficult, however, and here is where an intelligent, numbers focused real estate agent becomes invaluable. They will have access to, and the ability to interpret, the historical local, city-wide, regional and state-wide numbers on average days on market, not only for homes in general, but homes in a certain price range, and style (ranch, two story, split, etc.).


Personally, I’m thrilled about this market. The media driven frenzy over the “dire” state of real estate has not only created some of the best deals in history, but it has, as I said earlier, driven a very large majority of real estate investors out of the market. This means there are better deals, with less competition. Those, like me, and now like you, that truly understand this market, are left to sop up all the deals, and laugh all the way to the bank. The great part about real estate, like so many staple American industries, is that it is cyclical. You can absolutely count on that. Therefore, the smart intermediate strategy in this market is two fold: 1) build a cash base from renovations, and 2) use that to acquire and amass a vast base of income generating properties (see How to Buy Rental Properties). When the market swings back, and a seller can sell just about any property, for any price, liquidate all of this amassed property, and move into commercial and/or residential developments. Immediate, intermediate, and long term -- the strategy revolves around a single core term: leverage. More on that in a planned future article.


Ok, so you’ve heard my spiel on why now is the best time to be a real estate investor, and why this market shouldn’t concern you, unlike everyone else and their neighbor, who seems to be just looking for bad news. Now on to the how-to.


To buy or not to buy, that is the question

I’m big on equations. For some reason, I find them comforting. It allows me to process information better. I typically try to find a way to put everything into equations. It’s good for two reasons -- one, when you can visualize the components of a decision, the variables seem to stick out like sore thumbs. From there it’s easy to isolate those variables and focus on them, because they represent to the true root of the decision. And two, equations take the emotion out of things. That allows for more clear, strategic decisions.


Before I get into the equation itself, let me spend a second discussing what is absolutely necessary. I completely rely upon my real estate agent in order to find me the numbers which comprise the various factors in the equation. I can’t stress enough how important a good real estate agent is. I’ve had and worked with countless of them, and have only recently found one I really value. You must find one that is very data oriented, and intelligent on top of that. They have to be able to not only access, but explain to you, information such as absorption rates, days on market calculations focused on various housing types in various areas, historical price trends, and etc. Once you find one that gets and explains to you that information, and fast, you’re ready to move on.


The Equation 

Here’s the equation. Take a look at it and the following legend and supporting calculations, and then we’ll take it apart and discuss each piece separately.


(Y * .98) - (Z * 1.15) - (CC * X) - ZY - RF - DP = NPP

Legend

Y = Estimated Sales Price

Z = Renovation Costs

X = Days on Market + Renovation Timeline

CC = Carrying Costs

ZY = Closing Costs

RF = Realtor Fees

DP = Desired Profit

NPP = Negotiated Purchase Price


Supporting Calculations

CC = [Monthly Debt Service (your mortgage) + utility bills + property taxes] * X

RF = Y * [commission % (typically 5-7%)]


Let’s use an example to walk through this equation. Say you’re scouting properties, and you run across this one: 3 bedroom, 2 bath, 1,900 square feet. We’ll ignore the list price for now, because it’s irrelevant. Regarding that amount, all that matters is what you can negotiate it down to, not what it starts at. So we’ll get to that in a bit. Ok, so you’re interested in it. You like the area, it has good curb appeal, etc. The first thing to do is get inside and check out what’s between what it is and what it needs in order to be a dynamite property. It should go unsaid, but I’ll say it for clarity sake -- the way to make money flipping properties involves finding ugly properties with several different problems, many or all of which you can fix in order to make the desired profit. I reference it in closing, but again, I describe this process more in detail here.


Back to our example. So through further research into the property, you determine that by finishing the basement you can add another bedroom, another bathroom, and 1,000 more square feet. Additionally, maybe you realize that the bedroom and the office share an entrance (most, if not all, states require a bedroom to have 3 things to be considered an “official” bedroom: 1) a private entrance, 2) a closet, and 3) an appropriately sized window (typically referred to as “egress”). Therefore, by some creative reworking of the entrances, maybe you can close one off and add one so that each room has it’s own entrance, and therefore you’ve added another bedroom (read here for some guidelines into what types of renovations to do). To summarize, your research has shown that you can turn the 3 bedroom, 2 bath, 1,900 square foot home into a 5 bedroom, 3 bath, 2,900 square foot property. Not bad. The next step is to submit this information to your real estate agent. The question is simple: after converting it to the end result, what will it be worth? 


For our example, let’s say the realtor comes back and says the market value of a 5 bedroom, 3 bath, 2,900 square foot house is $400,000 in that area (I’ll use round numbers for ease of calculation, and I make no attempt for these numbers to be accurate to whatever region you live in, so bear with me). $400,000 is Y, our first variable.


The next step is estimating how much it will cost to make the improvements you previously determined where possible/necessary. This is a combination of gathering bids and perusing your local home improvement center for materials costs (if you plan to save some money by doing some of the work yourself). Let’s say your renovation cost estimate is $50,000. That becomes Z, our second variable.


Next, inquire with your realtor regarding “average days on market” numbers for your area. Find out how long, on average, it takes for a similar home to sell in your area. Let’s say it’s 180 days, which, in this market, is becoming more and more the norm. Next get an estimate from your mortgage professional regarding monthly mortgage payments. Finally, work up a timeline for the renovation itself. Take the time you estimate the renovation to take, plus the time it will take for it to sell once it’s on the market, and multiply that by the monthly expenses you estimate. That becomes your carrying costs. That’s CC, our third variable. This is a very important one. Many many real estate investors overlook this variable, or they calculate it out only to a certain extent (say, through the end of their renovation timeline) and then leave no room for sales time. The days of selling it on “open house day” are long gone. Even with competitive pricing, which we’ll get to later, the hope to sell it quick is not something upon which you can base your budget. Let’s estimate that the renovation will take three months, plus the average days on market estimate from earlier (180 days). That equals 9 months from purchase to sale. Let’s estimate mortgage costs, taxes, and utilities are $2,000 a month. Therefore, carrying costs for our example are $18,000.  


Alright, we’re in the home stretch. The remaining variables are relatively straight forward. Get an estimate of closing costs from your mortgage professional. Plan for a worst case scenario in which you will be responsible for both the closing costs on your impending purchase and closing costs when you sell it (if nothing else, pay the closing costs as an incentive for the buyer). That’s the ZY variable. Let’s estimate it at $10,000 ($4,000 on your purchase, $6,000 on the sale of the property) for our example. Moving on, the RF variable is simply the estimated future sales price (Y) multiplied by your realtor’s commission (let’s estimate 6% for our example). So that’s $400,000 times 6%, or $24,000. DP is desired profit -- that’s a personal consideration, completely up to you. Larger scale investors that I know base their decisions upon return on investment. It’s just like evaluating a mutual fund or an online bank account. Your desired profit should be a percentage range, with the range depending upon the perceived risk in the property. For example, let’s say your desired profit range is 5-7%. You can also arbitrarily pick a dollar figure as well. Either way, build into the equation a profit for your effort -- don’t leave that part to chance. For ease of calculation, let’s say your desired profit on this project is $20,000. It’s important to build this in the equation on the front end, because it’s in addition to things like carrying costs, closing costs, and realtor fees. These are things that are usually forgotten, and end up eroding profit after the hard work is done and your property is sold. 


Finally, NPP. NPP (negotiated purchase price) is where the rubber hits the road. Run all the foregoing numbers through your equation and you will know what your NPP (which is essentially your bottom line) is. This is the number upon which you negotiate with the seller of your future investment property. Any amount under this price you can get is all gravy on the profit end, but this amount represents the absolute maximum amount you will pay for the property. Take that to the negotiating table, and get started.


Now that we’ve walked through the equation piece by piece, let’s finish it up with the numbers I estimated earlier. I’ll repost the equation first, and then fill it in.


(Y * .98) - (Z * 1.15) - (CC * X) - ZY - RF - DP = NPP

($400,000 * .98) - ($50,000 * 1.15) - ($2,000 * 9 months) - $10,000 - $24,000 - $20,000 = NPP


Before we finish the calculations, two final comments. As you can see in the equation, there are two fixed numbers within the equation, .98 and 1.15. The .98 represents a 2% discount on estimated sales price. Listing your property for sale at 1-2% below market value is your best opportunity to get rid of the property as soon as possible. It’s a statistical fact that buyer interest in a property spikes right upon listing and then diminishes rapidly in the days and weeks following, before leveling off. The 1.15 represents a 15% “cushion” on your estimated renovation costs. This comes from personal experience on my part and those of the thousands of investors preceding you. There is no way to accurately estimate renovation costs when you have no idea what is behind the walls before you start. Additionally, relying upon inspectors, contractors, and even the weather can make for some very unpredictable budget turns. Building a 15% cushion ahead of time can ease some of these issues, and do wonders for your stress levels during the project as well.


Alright, now for the final result. In our example, the NPP would be $262,500. Because of all that’s built in to the equation, the final number makes things easy. Head into negotiations with this number in mind, and get whatever you can get up to, or equal to, it. If it turns out that you can’t purchase the property for this amount, then move on to the next property. Even though you may have invested a lot of time and energy at this point into evaluating the property, don’t let it cloud your judgment. Focus on the built in profit potential, for example. If all the numbers work out, you are well on your way to that amount, at a minimum. Additionally, things could turn out even better. The property could sell well below your estimated days on market, you could come in at or under budget, and so on.


Conclusion

Ok, so by now you might be asking, how do I find a property like this? Do they even exist? The answer is a resounding yes. There are several ways, like through foreclosures for example, however there is a way to find properties that meet this equation in any area, at any time, in any market -- which I have described in more detail in another article entitled How to scout potential “flip” properties.


And that’s it. This is my tried and true blueprint for real estate investing, in any market. You can make money with this formula. I’m proof. Stick to the formula, populate it with valuable and reliable information by talented real estate and mortgage professionals, put as much time and energy as you can into the research on the renovation opportunities and estimates, and watch the money roll in. GOOD LUCK! 

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This page contains a single entry by the boozwatt team published on January 6, 2008 8:29 PM.

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