Congratulation! You’ve finally found your first property and you’re excited to see if this one will be THE ONE that is going to start you on your investing career. But wait – how do you “run the numbers” and what are you looking for? That’s what more than one investor has asked when just starting out.
Important Real Estate Terms – The Basics
DEFINITION: “Run the numbers” is simply doing your due diligence and analyzing the real estate transaction as an investor does.
To start analyzing a property, you want to do a complete review of the subject property as well as run comps for other properties in your market area.
When searching for comparables, look for properties that are in the same current condition as the one you are looking at that sold within the last 6 to 12 months. Also look at properties that sold or are currently on the market that have been repaired and renovated. Both sets of data are important.
Real Estate Formulas
How to estimate ARV – As we mentioned earlier, ARV is the After Repair Value – what the home is worth after it’s renovated.
By using the comps that you found, you will be able to determine a reasonable value for the property once your scope of work is completed. If you can, it would be a good idea to personally view properties on the market as well.
How to estimate repairs – I have no idea what it costs to renovate a home! Well, that’s not an uncommon thought for someone just starting out. Finding contractors and experts is possible in your area. Talk with your lender, Home Depot or Lowe’s personnel, friends and family. In addition, there’s online resources as well.
By using these resources you’ll be able to meet and find some individuals or companies that can give you estimates for the scope of work you are considering.
What kind of a return are you looking for? 65% or 70% or 75% ARV
You will hear investors say that they are looking for something at 65%, 70% or 75% of ARV. And it’s a basic math equation. What that means is that they are looking to be “all in” at that percentage.
DEFINITION: “All in” means that all costs and expenses for the project will not exceed the percentage set. That percentage can be 65%, 70% or 75% depending upon the investor and the property. All costs and expenses include: Acquisition and sale costs, holding costs to include insurance and taxes, repairs, renovations, landscaping, transaction fees, utilities including water and sewer, bank fees and charges – literally all expenses that were incurred to acquire, complete and sell the property.
For example – a home is worth $200k … the investor wants to be all in at $130k, $140k, $150k, depending upon the percentage that they’ve chosen for the subject property.
How to calculate MAO – maximum allowable offer. So, how do we work the numbers to determine the offer we’re willing to make?
To start with, the maximum allowable offer, or MAO, is the maximum price point in a real estate deal where you can realistically expect to get a profit while minimizing your risk of losing money in the transaction. If you go over your calculated MAO then you are likely to lose money and minimize your chances of pulling in even a small profit. While the MAO formula is designed to increase your positive results while minimizing risk, it’s not very helpful if you don’t estimate the value of your property and your repair costs accurately.
We start backwards from the ARV to get to the offer price based on the return you are looking for.
When you’re rehabbing a property, the formula would work like this:
MAO=(ARV*0.7)-repair costs
Where:
ARV: After-repair value—what the property will is worth once you’ve completed the work.
0.7=70%: This is the percentage by which you reduce the ARV. As we noted above, it is your “all in” percentage. Depending on the property, pricing, your source of available funds, and area, it may vary. However, it is usually within the range of 65%-75%. (For more expensive homes and areas that are rising rapidly, the percentage can go above 75% slightly. For less expensive homes and slow growth areas, the percentage is likely to be around 65% and even a bit less.)
Repair Costs: The cost of the repairs that it will take to get the house from its current condition to its ARV.
Our example: You find a house that you can put under contract for $400,000. You know that comparable properties in the area, fixed up, are selling for $700,000. You also estimate that fixing up the property will cost $150,000.
Let’s work the formula.
($700,000 * 0.7)-$150,000
=($490,000)-$150,000
=$340,000
How to calculate the CAP rate – What is a CAP rate? It’s an abbreviation for capitalization rate.
If you prefer more of a passive income with cashflow properties, the CAP rate is the formula you would use to calculate the expected return on a real estate investment.
DEFINITION: The CAP rate, which is the abbreviation for capitalization rate, is the rate of return generated by an investment or real estate after expenses but excluding debt and interest expenses.
You can calculate the CAP rate of a property using the following formula:
CAP Rate = Annual Net Operating Income / Property Value
If you decide to look for properties that you want to buy and hold and collect the residual income from, you can use the CAP rate to compare properties to determine which options offer you the highest rate of return, all other factors being equal.
These are some of the basic financial terms you’ll hear investors and lenders use. You can find even more here. Understanding these important real estate terms as well as the real estate formulas is critical to your success. In addition, it will give you a leg up when it comes to finding the right piece of real estate for your next project.