FIELD NOTES: Eyes of The Investor
After more than two years in the business of buying investment grade real estate, I have come to realize that there are few agents who understand what makes a property ‘investment grade.’ I find that many new agents also struggle with pricing their investment grade listings, failing to properly account for the repairs & updates that need to be performed by an investor in order to push the appreciation on that house to maximum value. Properly pricing any home is challenging; only moreso when dealing with a property that probably won’t pass FHA financing, reducing the pool of buyers to all-cash investors, but not all ‘cash’ investors are created equal, and this is the rub.
I have been asked by the many realtors and licensed real estate agents how to see properties with the eyes of the investor. It’s a broad topic, as there are many different types of properties, exit strategies and thus breeds of investors. But because I’m asked this a lot, I thought I’d take a stab at it.
So you’ve just landed an Exclusive Listing Agreement on a soddy brick 2/1 in Ormewood Park and the offers are stampeding in like a herd of wild buffalo, but your client is overwhelmed and is looking to you for guidance. “This one’s highest, but is it truly best?” Nice. That’s a good problem to have.
But just because you have scaled Mount Contracts doesn’t mean you’re standing on firm ground, and you have a duty to your client to close this deal under the best terms possible. How do you determine which juicy contract to choose? Investment grade properties represent opportunity, but opportunity is according to the eye of the beholder. One investor might view the property as a potential rental, and another a flip of one kind or another. One may have better contracting costs than another, or better networking. The differing exit strategies and competitive advantages out there present unique mathematical goals and criteria, and knowing which is the best option informs pricing. Location is heavily weighted, naturally.
Let’s take that 2/1 mentioned above for example. If it’s more than 1200 square feet of bricks sitting on a quarter acre in East Atlanta, it could be worth close to $200,000, but the exact same house west by the quarry park shouldn’t crest $50,000. That East Atlanta buyer is more than likely going to turn that 2/1 into a nearly-new 3/2, spend $120,000 doing it, and sell well into the $400s. The quarry park buyer only cares if it’s rented or rentable with minimum additional investment and market rent is twice asking price.
Investors view any property according to how they can monetize the investments. This ‘how’ is called the Exit Strategy, and it can be simple or complex, and often has more to do with the property than the investor. There are basically three exit strategies: Wholesaling, Renovation, and Rental.
• A Wholesale exit strategy sees the investor buying the property from your seller, and then ‘flipping’ it to a renovation company for a cut of the equity. For example: You sell that 2/1 above to a wholesaler in East Atlanta for $130,000. That wholesaler doesn’t touch the property, he or she simply marks it up and immediately sells it for $165,000 to a renovation company like Light Box Homes. In general, wholesalers need to get that property for as little as possible in order to create the margin necessary to flip it for a profit without making any improvements. These buyers tend to offer the least for a property, as they need the margin in order to sell it downline.
• A Renovation exit strategy involves buying the property from your seller and then sinking money into renovating it. The idea is to push the appreciation to full market value for the neighborhood. For example, a renovator might take that 1200sf 2/1 and change the layout to make it a three-bedroom, two-bathroom home with an open floor plan. This is the highest-risk exit strategy, as it takes the average renovation company six to nine months to complete the project before they bring it back to market. Depending on their vision for the property, the cost of money used to complete the project, and contracting costs, the price a renovator can pay varies wildly, but is mostly dependent upon the spread. More on that later, but in general, these buyers will offer you the fairest price for your property.
• A Rental or Passive Income exit strategy is just that: Buying the property to rent it. These investors are referred to in the industry as ‘passive income’ investors, and they need to maximize their cash flow on a property while minimizing risk. In some cases, a passive income investor may need to repair or improve a property in order to get the most rent possible, and you must factor those repairs in when you’re pricing an investment property. A good rule of thumb is the 1% rule: For a passive income property to make money, rent must be no less than 1% of the sales price. So if you buy a rental property for $100,000, you need to get at least $1000 a month in rent. Market rent rates and repairs greatly affect the offer price delivered by these buyers.
Nothing is more infuriating than an 800-square-foot investment grade property listed for the same price as a 1400sf comp. Doesn’t that agent know how much time and money it’s going to cost to add 600 square feet to that house to bring it up to full market value? In many cases, no. They have no idea the additional cost in time and money that expansion is going to eat.
Once you’ve got your investment grade property under contract, you need to know how much it’s going to cost to bring it to full rental or retail value; so you need two pieces of information: Repair costs and After Repair Value (aka full market value).
The cost to repair a house depends on the condition of the systems and the level of finishes needed to reach the top pricing tier of a given market. Are you just doing the bare minimum in order to make the house ‘rent ready,’ or are you adding square footage, replacing all systems, opening the layout and updating all finishes to bring it to full market value?
Here’s a quick look at both strategies: Let’s take that 2/1 again, and let’s say market rent is $1200 a month, but ARV for a fully-renovated 3/2 is $400,000. If you’re listing the property as a rental and it needs $30,000 in repairs to make it rent-ready, you shouldn’t list it for more than $90,000. But if it takes $120,000 to bring it to the top of the market, you can list for much more.
PRO TIP: The easiest way to determine repair costs is to bring a seasoned real estate investor to the property pre-listing. A good real estate investor with a long track record of successfully flipping properties will be familiar with the neighborhood, rental rates, and the construction expenses to within fifteen percent. He or she should be in and out of the house in less than twenty minutes and have an exit strategy ‘vision’ for the property that matches the comps plus a rough estimate for completing the job.
Sometimes it’s easier to use price-per-square foot for a rough estimate of repair costs. On a property big enough to be an interior-only renovation (more than 1200sf in our formula), we use $80-per-square-foot. So that 1200sf 2/1 should take about $96,000 to bring to full market value if all an investor has to do is an interior renovation. If a property is in need of an addition, each new square foot of house is going to cost an average of $100-per-square-foot. So that 800sf 2/1 in need of 600 more square feet is going to need a $124,000 in renovations ($80 x 800 + $100 x 600).
That’s a big difference, which is why you should pay close attention to the comparable houses that have sold for top dollar in the neighborhood.
The After Repair Value is what that ugly investment grade listing should sell for once an investor has turned it into a shiny new home, and the difference between this price and your list price is the spread. The wider the spread, the more profit potential for the investor, so it’s important that you research this number carefully so that everyone makes money. When the investor who buys your investment property wins, the neighborhood is improved, with high-quality renovations pushing values higher on retail listings and thus maintaining pricing momentum that benefits the whole real estate ecosystem.
The first ingredient in calculating ARV is picking a reasonable exit strategy for your investment grade property. Is it reasonable to assume that a renovator can add 1200 square feet to that 800 square foot house? Or does it make more sense to just add 600 square feet?
Well, what do the sold comps say? Is a 2000 square foot home selling for appreciably more than a 1400 square foot home in that particular neighborhood? Are there new-construction homes that compete at the higher square footage?
Once again, let’s revisit that 800 square foot 2/1 above. When you search the retail comps, you find nicely renovated 4/3’s with 2000 square feet selling around $410,000, and renovated 3/2’s selling for around $380,000. That’s not much difference, so it probably isn’t worth the renovator’s time and expense to spend $184,000 adding 1200 square feet when they can get basically the same money for an investment of only $124,000. Other things to pay attention to when reviewing the full market value comps:
• Did they replace the electrical & plumbing systems, HVAC and roof?
• Did they change the layout dramatically (e.g. add beds/baths, open-concept living area, etc.)?
• What level of finishes did they use (e.g. granite, hardwood floors, appliances)?
• How extensively did they landscape and what is the quality of the lot?
• Are the comps isolated to one pocket of the neighborhood or spread out over a large area?
Pay attention to all of this, because if a renovation company is your target client, they’re going to have to do the same exact things in order to match those comps.
So now you have a rough idea of what repairs and improvements a house needs plus what it should sell for in today’s market once it’s fully renovated. You now have two of the main ingredients in the Spread: The difference between what an investor will pay for an investment grade property, and what it should sell for on the retail market once fully renovated.
Above is a pie graph demonstrating the spread for an average renovation exit strategy property in East Atlanta (an area of real estate Light Box Homes specializes in). For the purposes of the diagram, I have averaged buying and holding costs, and interest is 12%. As you can see from the diagram, the spread is from $150k to $380k. Someone with better contracting prices, better borrowing or selling costs, could pay your seller more for that property, but you get the idea.
“Wow, but the investor is walking away with $50,000,” you might say. But what is reasonable? What would YOU want to walk away with after six grueling months running a major residential renovation? That $50k is more than just a profit margin, too. Remember: That investor is about to sink $330,000 into a nine-month project; and a lot can happen in the space of nine months, like a housing crisis a la 2008. Thus, that $50k is that investor’s margin of error should the market turn south.
(NOTE: Flipping houses is uniquely risky in that the investor must finish the project, even if he or she knows their going to make zero money, because the alternative is bankruptcy and even higher losses.)
So ARV and the purchase price are the bookends in the investment spread. The market controls the ARV, but you Mr. or Ms. listing agent, have the power over the other end of the spread: The purchase price. You can list higher or lower depending on your seller’s time constraints and selling strategy, but realize that there are limits, and it is unwise to list too high and risk scaring away all potential buyers, or list too low and start a bidding war that just wastes yours and your seller’s time and patience.
So you’ve got your list price figured out. Now it’s time for YOU to go shopping…For buyers, that is! Because in a growing market with strong fundamentals such as Atlanta, there are a TON of new investors entering the market, with a wide variety of skill and experience levels. And with inventory levels at record lows, the glut of new investors has created an unnaturally high demand for investment grade properties.
Within an hour of listing that 800 square foot 2/1 on the MLS expect your phone to be ringing around the clock with interested buyers. Not all buyers are created equal in the investment world, and knowing which one to pick could mean the difference between closing quickly or pulling your hair out. Buyers and their contracts can be qualified according to Offer Price, Financing, and Terms.
With so much demand out there, it is so tempting for sellers and their agents to ask for ‘highest and best,’ but beware: Highest is not always best. In fact, the highest offers often represent the neophytes, the desperate, and the hustlers who will try and loosen up the price once they’re under contract.
“So what?” You say. “Who cares if they’re offering too high? If they can come to closing, what does it matter?”
Yes. If they can come to closing. Emphasis on the word ‘if.’
So let’s say your call for ‘highest and best’ brought in some bright-eyed and bushy-tailed new investor offering $50k over your $150k asking price for that 800 square foot 2/1 in need of $125,000 in renovations. Gosh, good for you and your seller, right? But don’t break out the champagne just yet: Why would that investor, supposedly knowing what I just laid out in the diagram above, stupidly erase that $50k profit margin? Could it be that they don’t know what they’re doing?
Don’t let greed try and rationalize this annoying thought away. Be real: If someone doesn’t know how to properly assess a deal, there is a good chance they’re not going to close. Between accepting their offer and the closing table, someone will get to them; a contractor will sober them up with an estimate, or another agent will hit them with the realities of the marketplace, or more likely, their hard-money lender will kill the deal and send you back to the market for another round of “Who Wants To Blow Up My Phone?”
“Wait a second there Stephen, what’s a hard money lender? Aren’t all investors cash buyers?”
Good question. That brings us to the next criteria for analyzing buyers: Financing.
Most investors know that in order to compete for investment grade properties, their offers need to be cash. But not all ‘cash’ is created the same. The source of the funds speaks loudly to the quality of the buyer, and you can glean this information by asking for proof of funds to be delivered with every bone fide offer. The POF will come in three types:
• Investor’s Own Recent Bank Account Statement. These are the highest-quality POFs to receive. The buyer has the money ready and within his or her control, no strings attached. This can be a checking, savings or self-directed retirement account, but the bottom line is the buyer doesn’t need anyone else’s approval to wire the money for the purchase. Interest rates vary depending on whether the investor is loaning to his or her own company or using company funds on hand.
• Private Lender’s Bank Account Statement. Many investors borrow money from friends, family and other individuals to close their deals. Though not as strong a source of funds as a wholly-owned checking account, you’re only adding one person to the decision-making process, a person who usually has a close relationship with the buyer. These Private Investor loans are typically 100% Loan-to-Value (LTV) and between 8-12% interest.
• Hard Money Lender POF Letter. Also known as portfolio lenders due to the fact that they do not write loans to Fannie Mae underwriting standards and must hold on to, or ‘portfolio,’ their loans; hard money lenders offer investors the ability to borrow money quickly, at near-cash speeds, but at much higher borrowing costs than loans from a private lender. A typical hard money loan can close in 15 days, but at 75% LTV, three points and 14% interest! Thus, these buyers ar at a distinct disadvantage to cash or private money-backed investors. Worse still, most hard money lenders require a desktop appraisal of the property before they’ll release funds to close, and it is not unusual for a hard money lender to pull the plug on a deal the day before closing because the lender doesn’t share the buyer’s rosy exit strategy for the property.
• FHA 203b Bank Loan Pre-Approval Letter. These loans lend retail buyers money for both the purchase and renovation of a home, and then everything is refinanced into a traditional conforming 15 or 30 year amortized mortgage. Although borrowing costs are typically lower than a hard money loan, closing can take as long or longer than a traditional mortgage while the bank gets its T’s crossed and I’s dotted on what is a very complicated and fee-laden loan. Appraisals and construction estimates can drag out the closing process and sour a bank to a deal. Three weeks lost.
At Light Box Homes, we use private money lenders for purchasing our investment grade homes and our own in-house money to complete the renovation. This lowers our borrowing costs, allowing us to offer more to sellers for their homes, beating out buyers using hard money or 203b loans. That’s the power of experience in the marketplace. With our cash reserves high, we can also offer better terms in our contracts, which brings us to the next qualifier for buyers of investment grade homes.
When looking at a contract, the offer price is just one of many terms that define the deal. There is also the seller’s contribution to closing costs, the earnest money deposit, inspection period, appraisal contingency, special stipulations and days to close. Phew! That’s a lot! When it comes to terms, the short answer is simple: The shorter the better. Who has as a stronger offer? Investor A who doesn’t need any contingencies and can write a check for the property tomorrow or Investor B with a 10-day inspection period and a 45-day close on only a $500 deposit? I’ll let you stew on that for a minute while I lay out the terms and what they say about a buyer.
• Offer Price. This is more than just what someone thinks a property is worth. It’s directly related to their exit strategy. Lower priced offers are probably wholesalers who need margin. High offers can mean the buyer is naive or desperate, plans to try and negotiate under contract, or has better cost control. Offers in the middle of the range from proven renovators like Light Box Homes typically represent the most solid buyers who know the true value of the property.
• Closing Costs. This one is sort of a no-brainer. Anyone asking your seller to contribute anything towards closing is more than likely NOT a serious investor. More likely you’re dealing with a retail buyer or ‘fixer upper’ who doesn’t mind living in a work zone. You can also expect a POF from a FHA 203b loan broker.
• Earnest Money Deposit. This little jewel can speak volumes. That wholesaler who’s going to re-market your property to their buyer list while under contract with you knows that there is a good chance they won’t find a buyer in time, and may have to forfeit the earnest money. For the professional wholesaler, lost earnest money is not the end of the world, just a cost of doing business, and they try to keep that cost low. Thus, a good sign that you have a wholesaler on the line is any earnest money deposit under 1% of the purchase price.
• Inspection Period. Also called Due Diligence, the inspection period provides a buyer with time to inspect the property and better determine what repairs and upgrades it needs. Typically, the longer the DD, the less experienced the investor, or the more complicated the deal. Here at Light Box Homes, we rarely put inspection contingencies on our contracts because we have enough experience to accurately estimate repairs and upgrades after just 15 minutes of walking a property. But if you take a look at that high-priced offer from a new investor using hard money loan, you’ll probably notice a healthy five or seven day DD as they play catch-up.
• Appraisal Contingency. If anyone fills this part of the form out, they’re not a true cash buyer and you can expect a long time to close. A true cash buyer only has one appraiser: His or Herself, and they know both ends of the spread in less time than it takes a mortgage broker to make a cup of coffee. (AGENT NOTE: Beware the ‘All Cash’ GAR form. If it is submitted with an offer, read it carefully: The form can give a buyer the unilateral option to switch from cash to bank financing, appraisal and all.)
• Special Stipulations. Always read through these to make sure there are no hidden ‘gotchas,’ such as repair requests or additional contingencies. Also, if the buyer is an agent, that agent must disclose their position in the deal plus their broker’s agency relationship. Some brokers allow their investor agents to buy without taking a commission, but such arrangements should be in writing to protect everyone involved.
• Days To Close. How long is it going to take that buyer to come to the closing table? At Light Box Homes, we typically close as soon as title clears, or about a week. We don’t wholesale our deals, so we don’t need a month to find another buyer. Thus, the smaller this number, the more committed the buyer.
The last and vest piece of advice I can give to agents representing sellers of investment grade property is this: Make friends with a reputable investor. A great real estate investor is worth his or her weight in gold, as they can help you correctly price and move investment grade real estate so you can focus on growing your business. Half an hour in a house with an investor like myself can teach you a lot about how your target client views the product you have to sell. Better yet: If you partner with a well-established investor like Light Box Homes, you won’t have to go through the headache of listing that property. Just sell to that investor!
However, in many cases a seller may not accept a pre-market offer. The market being ‘on fire,’ many sellers are very curious to see what the market brings, and that’s fine. Just remember the tips above and be prepared for the onslaught of offers, and if you need any help wading through it all, don’t hesitate to call us here at Light Box Homes.
Maybe you’re out of state and listing for a seller who has property in the Atlanta area, or maybe you’re a retail agent with a client who needs to clear an old rental from their balance sheets and you don’t have experience selling investment grade property. Don’t delay: Pick up the phone and call Light Box Homes! We’re always happy to help our agent family!