So far, I have covered Location, Property Type, and Type of Tenant in Part 1 and Property Condition in Part 2 in my series on defining real estate investment criteria.
In this post, I will cover the fuel to wealth creation, FINANCIAL METRICS. A grasp on the financials is what separates investors from traditional home shoppers. As a fellow investor, I know that it also helps you sleep well at night after a deal. I encourage my clients to get better at crunching more numbers on paper before even viewing a house.
There are many potential ratios and estimates to calculate, but I will start at two that are critical for the determination of profit.
1. AFTER REPAIR VALUE (ARV)
It is common for seasoned investors to say that you make your money on the buy, not the sell. When you estimate the ARV, you take a view on the future value of the property when you are ready to sell or refinance. The conservative approach is to base your estimate on recent sales with similar size and rehab condition and only modest appreciation. It is hard to make up ground after making too lofty an assumption later.
Once you understand the ARV, you can begin to determine a purchase offer strategy. Many investors shoot for a 70-80% discount off the ARV in the Philadelphia area on rental properties and an even deeper rate for a flip to allow room to finance the expected value-added repairs. Similarly, a motivated seller targeting an investor buyer would be wise to consider an asking price strategy that leaves some of this value on the table.
In the end, you have to make sure that your rehab costs plus your purchase price don’t exceed the ARV. Your profit wiggle room can quickly disappear if you don’t factor in a worse case scenario in your more detailed rehab estimate that includes both labor and materials. Fortunately, the older housing stock around Philadelphia allows for many opportunities to profit with value-added repairs.
2. MARKET RENT
For rental properties, the market rent defines your income ceiling. If your income forecast is based on fantasy monthly rental rates for the area, you can run into trouble. I recommend that you factor in the rent that the middle 80% of the tenants in your area are willing to pay.
Often, there is an opportunity to increase the rents from the previous owner. I have observed that many motivated sellers have tenants in place paying below market rents. One way to justify higher rents is through making cosmetic repairs. However, there are limits to the feasible rent boost based on the geography, as discussed in the first post in the series.
I encourage you to share your thoughts on your ideal targets for ARV and rents with your agent early. Instead of just saying “send me a good deal,” you can say that you say “watch out for homes in neighborhoods with properties worth $75K per unit fully rehabbed and rental rates around $1,200 a month”.
To wrap up the discussion on financial metrics and criteria, we will review two more real estate benchmarks in the next post.