If the Numbers Make Sense
The price you pay for a property and the amount of work you put in it don't always tell you if it's a good investment. Properties you plan to fix up and sell are evaluated differently than properties you plan to fix up and rent. No matter how you plan to use the real estate, crunch the numbers to find out if the purchase makes sense.
What's the anticipated market value of a property you intend to resell? You have to know that figure before you can decide if you want to purchase it. Start by estimating what the property's fair market value will be after all of your work is complete, then deduct your expenses:
Write down the amount you would agree to pay for the property.
Add up the costs to acquire the property, such as loan-related fees, title work, and inspections.
Estimate the total amount it will cost to fix up the property.
Figure the amount of interest you'll pay during the time you expect to own the property.
Add in property association dues, property taxes, and other similar fees for the period you expect to own it.
Calculate the amount of commission you will pay if you use a real-estate agency to sell the refurbished property.
Estimate your closing costs for the second sale.
Total your expenses and initial investment, and deduct that figure from the property's anticipated fair market value. What's left over is your potential profit before tax deductions are considered. Is it enough of a profit for the time and effort you plan to invest in the property? Is there a large enough gap between the amount spent and the market value to buffer expenses that exceed your estimates, because expenses have a habit of doing that?
You can juggle the numbers around, looking at them from different perspectives. Take away the fix-up expenses and look at your profit. Can you cut those costs to yield a better return? Can you negotiate a better price for the property? Evaluate the variables to come up with the best scenario.
Income Producing Properties
You can use the gross rent multiplier (GRM) method, described in Chapter 7, to help determine property values based on their sales price and the amount of rents you can charge for them. The GRM is helpful, but it is only one part of the picture you must look at to determine if a property is a worthwhile investment.
Income capitalization is another way to look at the deal, using this formula:
VALUE = NET OPERATING INCOME (NOI) ÷ RATE OF RETURN
Estimate value by using the GRM formula.
Calculate the NOI by adding up all potential rents for a year, then deducting the total of all projected yearly expenses.
Estimate the rate of return by doing a comparative market analysis of similar, but not rehab, properties that have sold recently. A commercial real-estate agent can help you find the comps. If you know the sales price of those properties and their NOIs, you can plug the numbers into the formula to calculate the rate of return.
Calculate the average rates of return for the comparables, and divide your own projected NOI by that percentage to estimate the property's value.
The rate of return, or capitalization rate, helps you determine how much future rents are worth by today's standards, which helps you determine current market value.