There are significant differences between investing in retail real estate and distressed real estate. In order to make successful investments, it is necessary for investors to understand the basics. The following steps will help you make smart investment choices:
Buy from Eager Sellers
Investors should work solely with sellers who are in need of liquidating their property either because they are in foreclosure or their property is underwater. Most of these properties will include real estate owned homes and short sales, as well as pre-foreclosure properties, in which either the bank or the owner is looking to sell. Other circumstances may influence a homeowner to sell their property, including divorce, disability or property damage.
Generally, sellers that are looking to unload their property will not have the patience to list their home with a real estate agent, who may take a while to find a buyer. Distressed property owners usually want to take immediate action and sell their property as quickly as possible.
“A more viable option for invest in distressed homes is to contact homeowners in foreclosure and make an offer to buy the property before it goes to auction,” says Brian Davis, a real estate investor and co-founder of SparkRental.com. “The “We buy ugly houses” crowd has been using this model successfully for years. They come out, inspect the property, and make a lowball offer with the promise of a fast, cash settlement.”
Advertise to Find Sellers
Most real estate agents and investors are searching for property on multiple listing services (MLS), real estate databases that list homes. Therefore, it is important for smart investors to come up with an alternate strategy by reaching out directly to sellers who are underwater or facing foreclosure. One way of contacting motivated sellers directly is to post bandit signs in select neighborhoods, run classified ads in local newspapers, or mail letters or postcards to homeowners in foreclosure. This strategy allows investors to sidestep foreclosure auctions where the competition can be fierce.
“Buying a distressed property can be a great investment if you know what to look for,” says Mark Ferguson, founder of Invest Four More in Denver. “But just because a property is distressed does not mean it is a good deal. Banks who sell their foreclosures are trying to get as much money as they can for their properties, and do not simply want them off their books.”
Adhere to the ARV Formula
A rule of thumb to adhere to when investing in distressed real estate is the After-Repair Value Formula (ARV), which is ARV x 70% – the Repair Estimate (RE) = Maximum Offer Price (MOP). The MOP is the most that should be paid when purchasing distressed property.
Most hard money lenders use this formula to calculate loans for investors that plan on fixing and flipping properties. This formula is applied to wholesale real estate. In order to establish the ARV, investors should consult comparable property sales and take into account material and labor costs to determine a repair estimate.
According to Susan Naftulin, CEO at Rehab Financial Group, “Location, amenities, finishes, and upgrades can all have an effect on the ARV. Carefully planning what improvements you are going to make with respect to how they will impact the ARV is the smartest path to making money. Remember that flipping a house is a business and nothing will impact your profits more than understanding and maximizing the gap between your investment (purchase and rehab costs) and the ARV.”
Estimating Profit Potential
To estimate the expected profit on a fix and flip property, investors should use the following formula:
Sales Price – Commission – Purchase Price – Repair Estimate (RE) – Your Holding Costs – Maintenance and Repairs – Your Closing Costs = Your Potential Profit.
This should also include insurance, property taxes, repairs, maintenance, interest, points, fees and closing costs, as well as unexpected repairs.
“If a home’s ARV is $150,000 and it needs $25,000 in repairs, then the 70 percent rule states an investor should pay $80,000 for the home. $150,000 x 70% = 105,000 – $25,000 = $80,000. Buying a house for $80,000 that will be worth $150,000 may seem like an awesome deal, but you have to remember all the costs involved in a fix and flip,” says Kevin Davis, a realtor at Big Block Realty Inc.
Be Conservative with Estimates
Investors should be conservative with their estimates, meaning they should assume the house is worth less than estimated and that repairs will cost more than expected. Since it may also take longer to sell the property than anticipated, there may also be maintenance costs. Also, sales commission and closing costs can be up to 10% of the sales price. Overestimating the ARV and underestimating the RE is a common mistake for new investors, which can result in a minimal profit or even a loss.
“Many investors try to stretch the 70 percent rule or whatever rule they use when the market is appreciating, and it is tougher to find deals. I think this is a huge mistake, because no one knows if the markets will continue to increase, stay stable or even decrease. Most flippers got into trouble during the housing crisis, because they assumed the markets would always go up and they didn’t have to get as good of a deal. Even in an increasing market you should stick to your rules and guidelines, because it is better to have fewer deals that make money than a lot of deals that lose money,” Davis says.
Expand Real Estate Education
Real estate investment means being current on changes in the market, therefore continuing education is indispensable. As a beginner, you should understand the differences between wholesale real estate and retail real estate. This includes knowing why investors pay cash for properties and understanding why homeowners sell properties at a loss. Investors should spend considerable time reading up on the wholesale real estate and distressed real estate market. Also, networking with investors in the fix and flip industry is a source of knowledge.
One way to meet like-minded investors and learn is to attend seminars, workshops, boot camps, and real estate events. By searching online for the Real Estate Investor Association (REIA) in your area, you can find events in your area. It pays to invest in education rather than losing money on a transaction.
Have an Exit Strategy
Investors should always have an exit strategy before buying a property. This include knowing what you plan on doing with the property, how much you are willing to pay, and whether you can refinance if your sales expectations are not met. Investors should also consider their personal cash reserves, expenses, borrowing costs and long-term goals before buying a distressed property.
“Before you set foot in a house, you should know how much you can pay for it, how much you can borrow against it, what the rents will be when you freshen it up, what it will cost to add value, and what you can expect for a return on investment. Let the neighborhood market drive your choices rather than your personal preferences. In real estate, you will make money being patient and using your calculator wisely. You want to have two or three properties identified and negotiate first on your number one pick. Rookies tend to be long on optimism and short on patience. This business is not easy and not a get rich quick play,” says Richard Montgomery, author of House Money – An Insider’s Secrets to Saving Thousands When You Buy or Sell a Home.