Property Evaluation

During the last couple of weeks, I have been reading and re-reading Summey & Dawson's The Weekend Millionaire's Secrets to Investing in Real Estate. I've said previously here and elsewhere how beneficial the book is in the area of negotiation and the buy-n-hold strategy. They actaully take the concept of buying from a mindset of a wholesaler to more of one regarding finances. IOW, their whole philosophy is centered around the Net Operating Income (NOI) and the Return on Investment (ROI) and not so heavily the price/value of the property itself. In most books you read on real estate investing, they'll teach you the "rules" of how to find properties well below value (i.e., wholesale). The common rule is to find properties where ...

Offer Price = 70% ARV - Repairs

Of course this gets adjusted for properties that fall below around $50k or above $300k or so, but the concept is to find properties to where you have enough space to make a decent profit. Usually, 15% of the remaining 30% is for buying, selling, and holding costs. The remaining 15% is your profit. For a $100k house, that amounts to $15k, and so on.

Summey & Dawson's approach is slightly different. While they still look at price & value, and they still focus on discounted properties, their main concentration is on the NOI of the property. They use financial calculations in order to arrive at an offer price that in many instances can be higher than what the seller wants. Imagine how much more properties they are able to add to their portfolio by asking for more than what the seller wants? They do this by adjusting the terms of the offer to satisfy their bottom-line NOI.

As an example, I'll use the Sub2 deal I passed-up in June. This deal was slightly different, because the original loan terms called for a prepayment penalty if the homeowner refinanced within the first two years. But, for the sake of argument, let's suppose the homeowner wanted to sell it to me (instead of just deeding me the property), and they were asking $80,000 with a $50,000 existing loan balance. Here are the numbers:

Tax Assessed Value ....... $88,000
Property Tax Rate ........ 2.837238%
Asking Price ............. $80,000
Existing Loan Balance .... $50,000

At the time, I figured that I could rent the place out for $850/month. This was a high-end estimate, and I would probably figure more like $750-$795 in order to get it occupied quicker. Therefore, using Summey & Dawson's valuation technique, we must first determine the NOI for the property with a monthly lease of $750:

Income                           Monthly
-----------------------------   ---------
Gross Potential Rent (GPR):     $ 750.00
Vacancy Factor:                 $  62.50-  (8.33% GPR)
-----------------------------   ---------
Gross Operating Income (GOO):   $ 687.50

Expenses
-----------------------------   ---------
Management Fee:                 $  67.50-   (9% GPR)
Maintenance Reserves:           $  37.50-   (5% GPR)
Utilities:                      $   0.00-
Taxes:                          $ 208.27-   (2.84% of tax value)
Insurance:                      $  36.67-   (0.5% of tax value)
HOA Fees:                       $   0.00-
Other Expenses:                 $   7.50-   (1% GPR)
-----------------------------   ---------
Total Operating Expenses:       $ 357.44-

Net Operating Income (NOI):     $ 330.06

Armed with this figure, you can now decide what terms you can offer the homeowner. This is important, because your terms - not so much the value of the property - will determine whether the deal is good or not. We can then structure several different solutions. Keep in mind, depending on which solution will work will more often than not depend on the homeowner's situation.

Solution #1: Traditional Financing

Let's suppose you can get an 80% loan for 30 years at 8% through a local lender, and finance the rest with a downpayment. With your downpayment, you want to earn a 4% annual return. Your all-cash deal of $50,000 can then be structured as follows:

Monthly Bank Payment
   ($40,000, 30yr, 8%) ......... $ 293.51
$10,000 downpayment
   (4.386% annual yield) ....... $  36.55

Total monthly cash ............. $ 330.06

Solution #2: Owner-carry Back ALL Financing

A second approach would be to pay the homeowner $330.06/month for 30 years. This would equate to a purchase price of $118,821.60:

$330.06/mo x 30yrs x 12/mo/yr = $118,821.60

Both of the preceding two scenarios show a 180 degree extreme. If the homeowner is highly motivated and has equity, they could very well opt for the first solution. If the homeowner isn't as motivated, but doesn't have much (or any) equity in their home, they may choose the second solution. Of course, these are only two of an almost infinite range of possible solutions that exist in-between you could offer them. It all depends on the homeowner's situation, your situation, and, perhaps most importantly, the property's NOI.

In my particular case, the homeowner still owed about $86,000. Disregarding the existing loan's prepayment penalty, I would still need to find an impossible rate loan in order to pay all cash (and even then I would be plopping down $17,200 of my own money with a 0% annual yield):

Monthly Bank Payment
   (80% loan, $68,800, 30yr, 4%) ......... $ 330.06
$17,200 downpayment
   (0% annual yield) ..................... $   0.00

Total monthly cash ....................... $ 330.06

Not sure of many lenders who offer 4% motgage loans these days. Therefore, this deal would have fell through anyhow. Not to mention the homeowners existing loan payments were well above the $330/mo payment, making a straight Sub2 produce negative cashflow.

The main point I am trying to stress is that often times investors look at the purchase price and work down to the NOI, whereas, it could actually be beneficial to go the opposite direction - find the NOI, which can lead to a plethora of offering prices. It's the availability of having options that give investors leverage when dealing with homeowners and their unique situations.