Three Calculations All Newbie Real Estate Investors Should Know

Note: This is my next installment in my series ABCs of Buying, Selling and Investing in Real Estate.  Each post, I write a fictional story centered on a letter (C this month) and give some advice around the story.  The story is fiction, but the advice is real(ty).  

This post continues the story found in Three Calls All Newbie Real Estate Investors Should Make.

Leroy had called me several months ago about getting into real estate investing (REI).   He had been saving his funds for years from his salary as a Software Engineer.  He felt that he had a good grasp on the business via his own research.  He had called me to find out what else he needed to do in order to get into the game and do it quickly.   Today, Leroy called me again.  He had found a mentor and had been working with the mentor for several months and felt like he could go out on his own now.  His mentor had been very close lipped about how he was evaluating each real estate deal.  His mentor did not want to give anything away about how he analyzes a property for its potential from a financial standpoint.  Leroy had learned how to do the rehab on properties, but never really got into the financials.   He asked me if there was anything he could use when it comes to analyzing the financial aspects of a deal.   What calculations did my investors use to evaluate deals?

Here is what I told Leroy….

First, I told Leroy that he needed to find a different mentor.  Mentors were supposed to take their students in and teach them everything about the business. Unfortunately, you do hear about mentors who take advantage and only “teach” the student aspects of the business that ends up saving the Mentor some funds (like doing free labor on rehab projects).   After I got this advice out of the way, I told Leroy that the calculations he uses to analyze a property is dependent on his own unique situation including his goals and objectives.   For example, I told him that some of my investors only care about the cash flow a rental could bring to the table on a monthly basis.  They don’t really care about any of the other numbers as long as they are realizing a certain level of cash every month.    For flippers, many of them will analyze the numbers based on the bottom line or Return on Investment of the deal.  If the property will not give them a good return, they will not pursue the property, or at least not above a certain offer price.    I have other investors who dig a little more deeply into their spreadsheets (several good ones can be found at biggerpockets.com) and will work with several calculations to determine if a property matches their own goals.   Since Leroy wants to flip properties for a living, I recommended he look at three of the most common calculations most of my real estate investors will use when flipping a property.   

1.  Rehab Costs– When it comes to flips, my real estate investors always look very closely at this calculation.  Many of them can walk through a property and mentally compile a list of repairs and their associated costs.   If you are new to flips, you need to start asking around for good honest and reliable contractors, who can help you with this calculation.   The horror stories you hear about crooked contractors are probably true, which is why you want to find at least three contractors to try before choosing one.   Contractors like to work with flippers because of the volume of work they get when trust is created between them and the investor.   Investors like finding one good contractor because most contractors will start to reduce the rehab costs once they realize the investor plans to use them multiple times for flips.   It makes better financial sense for real estate investors to use a trusted contractor over and over again.   Some contractors will work with you on repairs before a property is yours, while others will not even look at a property until you own it.   As a newbie, you will need to find contractors who can help you compile the rehab costs.    

2. After Repair Value – After Repair Value (ARV) is the other important number that most of my real estate investors request of me when evaluating a flip.   This number is something I can provide to my clients but with a caveat.   We technically are not allowed to give appraisals of properties after repairs because we have licensed individuals called appraisers to do this for us.    However, appraisers have to make a living and will charge hundreds of dollars for each of their appraisers.  I can get around this restriction by putting in a disclaimer that I am not an appraiser and the value I give is where I would recommend listing the property if it was move in ready.   This recommendation comes in the form of a range so the final determination falls to my client to make concerning what the ARV will be.    How does one get the ARV?  There are two common ways for this number to be determined.   The most common approach is the sales comparison approach which looks at past sales of nearby comparable properties to determine where a property will sell when it is move in ready.   Most agents are taught to include properties that have sold, or pending.  We also include properties that are currently active on the market.  When looking at these properties, we have to evaluate the size of the property via the square footage, how many beds/baths and the condition the property was in when it sold.   I always like to look at the target property as well before giving a final range of possible list prices.   The second common approach to value is the income based approach where one looks at the current rental value versus the overall value to determine a sales price.   This one is mostly used for rental properties.   

3. Return on Investment.  The final number most of my flipper clients will evaluate is the return on investment.  What will this property bring back for the investment made into it?  The formula most people use for ROI is the net profit/Cost of Investement X 100.   Of course, most people I work with simplify this down to what their gross profit is versus their net profit.  To get this number, you need to know how much you will spend on a property (cost of purchase plus rehab costs plus misc fees) and how much the property will sell (ARV).   These investors want to know what the bottom line will be.  How do you know how much to offer on a home?   Once again, many of my investors look to the end ROI results to determine their offer price.   They all have their own formulas when it comes to what they want to see in return, but many investors look at a common formula of (70% ARV – repairs) as a baseline indication of what to offer on a property.  In this tight seller’s market, this number will often be way too low to be competitive so many investors will try to find a number they can live with (80% ARV – repairs) in order to have a chance to acquire a property.  I have other investors who just sit on the sidelines and wait for the market to turn more buyer friendly before investing any more funds.   

Leroy seemed happy with what I told him.  He was pretty sure he knew some contractors that could help him determine rehab costs.   As far as ARV, his mentor had an agent that provides these numbers.  Finally, Leroy was going to look closely at what he wanted to get in his return on investment so he can better understand what to offer for properties.