As you move forward into the business of buying and selling houses, you’ll need to start looking at how successful investors make offers. Let’s say you already have your marketing in place. You’re getting leads, and you know how to pre-screen those leads by asking three questions:
1. Is the house pristine or neglected (pretty or ugly)?
2. Can you buy the house with immediate equity built in the day you buy it, or can you create equity?
3. What is the degree of the seller’s motivation? The way you can answer that is by looking at the WWOW:
W: What is the property WORTH (value)?
W: How much do they WANT (asking price)?
O: How much do they OWE (the loan balance, if any)?
W: WHY are they selling (their motivation)?
Let’s say a lead comes in on a property estimated to be worth $100,000 (after the house is fixed-up) by a certified appraiser, but the seller is asking for $75,000. They owe nothing on the house, and the reason they’re selling it is because it was inherited.
You’ve now got clues to answer all three of the questions above. To the seller, that house is little more than a free pile of money gifted to them from a relative. Not only are they not emotionally attached to it, but they are telling you by their asking price that they are willing to give up $25,000 worth of equity. That immediately answers questions two and three. You know you’ve got them leaning in the right direction. Their motivations are in your favor.
By looking at the average house price in the market of the lead, you can tell whether it’s a pretty house or an ugly house. In this case, let’s say the market average in that area is $200,000. With this house being below market average (because it’s only worth 100k) we would lean toward this probably being an ugly house, most likely needing some degree of repairs. Now there are really only two buying strategies when it comes to buying ugly houses-either All-Cash or Split-Fund!
The other four buying strategies are for pretty houses only because your exit strategy for getting rid of a property that you get a deed on, for example, is to owner finance or lease option that property when you sell it. You’re taking over someone else’s mortgage and then you’re going to create financing with your buyer that wraps around the mortgage that you took over. You are only going to do that with pretty houses because you’ll be selling to a higher-end buyer-they’re usually more responsible and can pay bigger down payments.
Even if you can get a super deal on a house buying all-cash, you never do it on a pretty house because there are only two ways to lose money in real estate-writing a big check to buy a house or signing your name to a big bank loan in the process of buying. Even if you could get an $800,000 house for $500,000 all-cash, you don’t violate those rules. Not that it’s out of the question that this can turn out to your benefit, but it’s rare-it’ll happen maybe once or twice in your entire career as a real estate investor, if at all. As a rule, it’s a safer bet to take an option on a pretty house rather than risk your cash.
So we’re going to focus on the all-cash strategy in this example.Since we’ve determined that it’s an ugly house, we have to consider that it will need repairs. You don’t have to be absolutely accurate about what that estimate will be. In fact, you can underestimate and still not get hurt badly because when you’re using the all-cash formula, you’ll be guaranteed to turn a profit. Based on what the owner says the house needs-new paint, carpets, minor upgrades as such-we can make a ballpark estimate that repairs will cost about $10,000. So what can you offer based on this scenario?
The maximum offer for an all cash purchase is 65% of the ARV (After-Repair Value) of the house.
That leaves a 35% profit, hedge factor, cushion, whatever you want to call it. For this example, let’s say the ARV, based on legitimate comps, confirms that the house is indeed worth $100,000. Multiply that by .65, then subtract the$10,000 in repairs, and your maximum offer would be $55,000.
The reason why we buy at 65% is because we leave open one of our selling strategies-wholesaling. When you wholesale the house to someone, you’re typically selling it to an investor who is going to buy it in cash from you, then rehab it and sell it again. When you buy at 65%, you can typically sell it fairly quickly to an investor at 70%, turning a 5% wholesale profit.
This formula only changes when you write a check and pay cash for a house when you current real estate market conditions declining in value. In such cases, you may want to lower your buying all-cash formula factor down from .65 to .50. Before you make the offer, make sure you have reliable comps on the house and include a repair estimate, a ballpark number that’s reasonably considered. Also, when making an offer, you don’t want to come out of the gate making your MAO (maximum allowable offer). You might want to start out around $48,000 in this case, or wherever you’d like, but you know that the most you will offer is your MAO of $55,000.
If we’re writing a check for anything, we’re either getting it at a great discount or we’re not doing it. As long as the ARV is correct and you factor in repairs somewhat accurately, you will never get hurt using this formula.