Editors Note: This topic was first discussed in my columns in early 2000. A lot has changed in the last six years, so it is time to revisit and update! In last month’s column “What is it Worth?” we started with the bottom line. That is, before we buy a foreclosure to fix and sell for profit, we first solve for our RESALE price. Now in Part 2 we will review how to estimate YOUR SOFT COSTS (buying, holding, selling and profit). Next month in Part 3 we will discuss how to determine your REHAB costs and how to pull it all together so your OFFER PRICE guarantees that your profit will be built in when you BUY THE HOUSE! Enjoy!
Over the last few years, the wealth created by real estate has been unbelievable. So many investors have made easy money. Most paid full market value for their property and simply sat back and waited for the value to go up. Everybody boasted about how rich real estate has made them.
But today’s market is not the same – there has been a change. (Please Read this months Nationwide News).
Now, you must BUY RIGHT to lock in your profit at your purchase.
To wait (and hope) for home prices to go up will, in this market, prove to be financial suicide. Many investors who don’t understand this will be washed out of the real estate market in 2006. I last saw this happen in the early 1990’s, during that price correction. I got better at buying houses cheaper, while my competition ran after their next “easy money” opportunity (e.g. the Nasdaq). And you know what happened to them after that….
But most new investors really don’t know what to pay for a foreclosure property. They think if it’s in foreclosure, I’ll just give the seller as little as I can (like just moving money) and take over their loans, right? WRONG! You must know how to structure win-win deals to give your sellers the MOST you can! That way they say YES to your offer and you get to buy more houses and make more money!
So where do you start?
My offer formula is really simple. Just like in any business, I first determine the resale value of my product. Then I deduct my soft costs (buy, hold and sell), my repairs and my profit. What is left is what I can pay for the house. Next, your price needs to meet the seller’s needs (his cash at close of escrow) so you have a win-win deal. Plus the seller needs to have enough equity (existing loans and liens must be substantially less than what you want to pay for his house), so you can do the deal.
(All of these issues (and more) are covered in detail in my new “2006: Six Steps to Mastering Foreclosures” CD home study course. Of course I will highlight the basics now in this 3 part series….)
Now at this point you have:
- Accessed your local foreclosure listings from Foreclosures.com
- Weeded your leads for those with the most potential equity (Please review: “Weeding Your Leads Has Never Been Easier!”)
- Determined your top resale value (Please review: What is it Worth?”)
Now you need to start deducting all your costs so you can determine what you should offer to pay for the property.
There are many soft costs to include when you buy, fix, and sell a house for profit. Most investors and Realtors only think of construction and sales commission expenses. But there is a lot more to this business. And I keep track of it all in an Excel budget file for each property.
Here are some of my additional “soft costs:
- Buying costs (title and escrow closing fees)
- Operating costs (utilities, insurance, property taxes, maintenance)
- Money costs (monthly interest, and hard money points when applicable)
- Selling costs (advertising, marketing, commissions, concessions, title and escrow closing fees)
In my typical deal, my “soft costs” alone can equal 8-20% of the resale value.
The reason for the large variance is due to these factors:
- What is my source of financing? (‘Subject to’ or a Hard money loan?)
- How long will I hold the property? (Am I in a hot or cold market?)
- How hard is it to sell houses in my market? (What additional expenses will I have to find a buyer for my house?)
You can see when we can buy “subject to” existing loans to finance the property (which is our cheapest source of money) and we’re in a hot market (our hold time is only 3-4 months) and when the MLS inventory is low (less than a 6 month supply of houses on the market)… our “soft costs” will be closer to 8% of the resale value. Hence, in a hot market, we can afford to pay more for a house!
On the other hand, if we have to get a Hard Money Loan to finance the purchase and repairs (100% financing, no credit approval is available) and we’re in a cold market (our hold time could be 6 months) and when the MLS Inventory is high (more than a 6 month supply of houses on the market)… our “soft costs” will be closer to 20% of the resale value. Hence, in a cold market, you will need to pay a lot less for a house!
In my 3 Day “Mastering Lab” program, I give each student a copy of my working Excel file, including all my cost formulas built in. This allows them to have a working budget in place, on every offer they make, with the confidence that the deal will be profitable. This has been a huge jump-start for my clients when they return home from the program.
Next, you must decide what repairs will get you the most “bang for your buck” and how much it will cost you (versus what will you gain in resale value), and deduct those costs. They vary greatly based on the age and condition of the home and how well it will compete with other homes on the market when it is time to sell. I will cover that, plus why I use a General Contractor and how I found him, in next month’s column.
Finally, dont forget your profit! I always make sure I get paid at least 15% of the resale value or $30,000, whichever is higher on every deal. That 15% factor is important. Sometimes things go wrong. Your costs exceed your budget. Your hold time was longer than expected. Your resale value was lower than budgeted. All of these items will come out of your 15% profit. So do not make this margin too thin! You have a risk, and you must be rewarded for it! (In all my years of investing, I have never lost money on a house. I did only make $7,000 once although I had planned on a $30,000 profit. Thank goodness for my 15% profit cushion!)
Let’s pull out our calculator and see how this all pencils out:
- Determine Resale Value
- Deduct: Soft Costs (average 15% of your Resale but range is 8-20%)
- Deduct: Repairs (next months column)
- Deduct: Profit (15% of your Resale)
- What is left = Your Offer Price to the Seller
- Deduct: Loans, Liens and cash to stop the foreclosure (bring all current)
- Net left = Cash to Seller at closing for their Equity
Now you know the basics of “Doing the Math” so your offer makes you a handsome profit and provides cash to the seller at closing. The key is finding a motivated seller who wants your cash and services more than they want to keep their property. As our Senior Consultant, Andy Anderson has said many times, “It’s an art, it’s a technique.” Too many investors try to copy from those who haven’t mastered it themselves. Be wary about whom you’ve selected as your mentor.
Stay tuned for next month’s column “Setting Your Offer Price” (making money when you BUY the house) Part 3 of 3: “Determining Your Rehab Costs” where we will pull this all together.
Here’s to making 2006 our Best Year Ever!
