One of the first lessons I teach new investors or distressed niche agents in our mastermind group lessons are the different financial models for purchasing investment property.  There are several types of real estate investors, and they use different criteria to estimate profits depending on the value add to any transaction.

For example, a dealer or wholesaler’s value add is finding a property with profit potential.  The work of marketing to motivated sellers, negotiating price and signing a contract with the sellers is a business in and of itself.  A rehabber’s value add is making repairs to a property.  And a landlord’s value add is operating a property for the long term.

Most purchase formula evaluations are based on the industry term “After Repaired Value” (ARV).  This is a final sale value of the property either to an owner occupant based on comparable sales, or to a landlord investor based on income generated.

Dealer Margin

Dealers and wholesalers look to purchase the property at a price that will have enough margin to sell to a rehabber or landlord and leave profit on the table for them. Here are two common formulas:

• ARV x 65% minus cost of repairs = purchase price (buyers market)
• ARV minus cost of repairs x 65% = purchase price (sellers market)

If you run the calculations above based on a $100,000 ARV and $20,000 repair cost you will notice the difference between the two models, one for buyers market and one for sellers market ($45,000 and $52,000 respectively).  A wholesaler who purchases properties at these values will be able to sell to a rehabber and earn a profit on the deal.  CAUTION: When determining ARV, be sure to use all the available comparables, not just the “good ones.”  In a market of falling prices, it is also wise to check the active properties currently available as well as those under contract so you can predict a lower ARV by the time the property is ready for sale.  Time of year is also important when determining ARV.  Experienced rehabbers always want to bring their inventory to market during the prime selling season and will reduce their acquisition price during certain times of the year to account for holding costs.

Fix and Flip Profit Margin

The next formula is common for rehabbers or fix and flip investors to use:

• ARV x 90% minus repair costs minus profit margin = purchase price.
  (profit margin is subjective to each investor, but is often the amount of repairs or 15% of the ARV, whichever is higher)

This formula considers 10% of the ARV as cost of sale (agent fees, title), cost of funds and holding costs (utilities, insurance).  NOTE: Novice rehabbers would be wise to use 15% instead of ten to build a larger contingency for construction overruns and time overruns.  Using the same house as above, the final “retail” sale price would be $100,000 with a net proceeds of $90,000 after soft costs.  The hard cost of repairs is $20,000 and the desired profit margin is $20,000.  The rehabber would need to purchase the property for $50,000 in order to make a profit of $20,000. Going back to the wholesaler, who in this example would have purchased the property for $45,000 and sold it to the rehabber for $50,000 and made a $5,000 profit.  (the sellers market number of $52,000 would mean a higher demand for fix and flip properties and a higher sale price to the rehabber).

Income Property Valuation

For the Landlord model, lets use the same house and prices above, but assume the sale will be valued on an income basis rather than a comparable sales basis.  The simplest method of determining whether or not to consider a property for rental is the “1% Rent Rule:” if the example property sale price is $100,000, than it should rent for $1000 per month to make it a good investment for the landlord.  That is obviously a rudimentary method, and does not consider many factors, but is a good starting point and suitable for this introductory article.  The more sophisticated formulas are as follows (in order of sophistication and accuracy of the formula), and will be addressed in a future posting.  Be sure to subscribe to our Weblog using RSS or or your email to receive the updates.

• Gross Rent Multiplier (GRM):  Value = Gross Income X GRM  (usually 7 to 10 depending on quality)
• Cash on Cash Return (CoCR):  Calculation of % return on downpayment including tax benefits
• Capitalization Rate (Cap Rate):  Value = Net Operating Income (NOI)/Cap Rate (6 to 10 depending on quality)
• Internal Rate of Return (IRR) -this is an advanced model and calculation not suitable for this article

There are many subtle nuances that come into play with regard to these types of investment property income, profit calculations and evaluations of income property.  This article is only intended to provide an introductory overview.  If you are interested in studying these models in depth and learning the business of real estate investments, please inquire about our Investment Property Master Mind mentoring and business building meetings.  The hands-on “experiential” learning environment will enable you to work on real estate deals in a supervised environment.

Lucky Sign

I found this quote in an old business file from years ago.  The author is unknown to me and I could not find anything by Google search.  He is speaking about investing in the stock market, but I found the advice very appropriate for real estate investors.  If any one knows where this came from, please leave a comment here. 

“A man often thinks because he is pretty good in his own business and reads the financial news and talks with the other commuters in the train about business conditions, that qualifies him as a pretty shrewd fellow, who isn’t going to get burned in the market. But he is just as vulnerable as anyone else. Unless the amateur speculator is fortunate enough to have the friendly guidance of a talented financial man, and unless he is of a temperament not to be physically ruined by tension and worry, he is looking for trouble if he tries to play the market without knowing a lot of things which most so-called investors never even know they ought to know. And you not only have to master a difficult field of knowledge. In addition, you need the qualities of character not to overextend a speculative position, to ride out a falling market if need be, and to be able to take a profit or cut a loss in time. Then you have a pretty good chance of coming out on top. Otherwise you are just a sucker.”

I meet many so-called real estate investors who do not set goals for their investments, which is a first mistake.  But another mistake is not seeking proper guidance, advice and professional help.  In my business and life experience, a qualified and experienced mentor or advisor in almost any profession will pay for themselves.  Sometimes many times over.   This includes attorneys, accountants, financial advisors and so many more.  And, yes, realtors and real estate professionals pay for themselves too!  As long as they are not “suckers” themselves.  -PB