I wanted to use this blog post to answer a question that I've been asked several times over the past few weeks.
It's actually one of the most important questions you'll have to answer as a real estate investor, and maybe you've already had the chance to wrestle with it first-hand. The question I'm talking about is:
“HOW MUCH SHOULD I OFFER FOR THIS PROPERTY?”
It's a very important question, because your offer price has everything to do with your ability (or inability) to make money on a real estate deal.
Offer too much, and you won't have enough of a profit margin.
Offer too little, and the seller won't do the deal.
With this in mind, I'd like to provide a bit of explanation on the basic math that I use to come up with an offer price for any given property.
The Importance Of Price
No matter how you slice it, your offer price is going to play a major role in the overall scope of any transaction. With the right number, you'll have a grand slam deal on your hands. With the wrong number, you can lose yourself a lot of money in an instant.
There are a couple of sayings that a lot of real estate investors like to throw around:
“Begin with the end in mind.”
“In real estate, the money is made when you buy.”
Well, guess what, both are true. If you make the right assumptions about a property's market value and have an accurate idea of what your closing costs, holding costs and improvement costs (if any) will be along the way, you can essentially write yourself an enormous paycheck, simply by choosing an offer price that allows enough room for your profit margin… however big or small you'd like it to be.
How Most Investors Think
Most of the people who flip houses and buy investment properties use something called the 70% Rule – perhaps you've heard of it.
It's a simple mathematical equation where you take the anticipated value of a property (ARV or After Repair Value), multiply it by seventy percent (0.70), and subtract ALL costs along the way, which will give you your “maximum offer price” that you should consider for your subject property.
As an example, if you think a property will eventually sell for $100,000, and you estimate that you'll have to pay $10,000 in various costs along the way, your equation would look like this:
$100,000 ARV x 0.70 = $70,000 – $10,000 Costs = $60,000 Offer Price
Since you'll be paying $60,000 for the property and another $10,000 for various closing and improvement costs, your total investment will be approximately $70,000. However, since you're planning to sell it for $100,000 in the end, this means you'll have a net profit of $30,000.
Want to give it a shot for yourself? Give it a shot with this calculator:
Of course, if you make any errors in your assumptions along the way, this $30,000 net profit is also your margin of error.
If you end up selling the property at a lower price than planned, or if you fail to account for some huge costs along the way, those errors will eat into your profit margin, and could even cause you to lose money if your assumptions are wrong enough.
The equation makes sense on paper. It's not a bad framework for making offers IF the market is trending upwards, IF your assumptions are perfect, and IF you really are able to sell the property immediately, it could work… but personally, I don't think it offers nearly enough certainty.
How I'm Different
When I was living through the Great Recession, which sabotaged real estate values in the United States from around 2008 – 2013, I saw too many people lose their shirts using this “tried and true” 70% rule.
There is always an element of uncertainty with any real estate deal, and with all the wild cards that can come up in a real estate deal, 30% just isn't a big enough profit margin to make me comfortable. I want more.
You see… a lot of the properties I buy are vacant lots, raw land and housing in C-class neighborhoods. When a real estate recession hits, these types of properties don't tend to sell quite as fast when they're listed at “full market value” (which by the way, is an incredibly subjective number to begin with).
Unless I'm offering some kind of crazy incentive in the form of:
- A ridiculously low price
- Seller Financing
- The #1 most desirable property in the neighborhood
- All the above
…I just don't think it's wise to rely on the 70% rule, because there's not enough profit and protection built in.
To put it another way… I don't want to leave ANY possibility of getting hurt, regardless of whether the market changes or I've made some kind of judgment error on the property's fair market value.
In my mind, the only way to get around this is to make offers that are way, WAY below market value. I'm talking 30%, 20%, even 10% of market value.
You might think this kind of offer is crazy, but it's not a pipe dream – trust me. I make offers like this all the time and when you're reaching out to the right demographic of property owners, many are happy to accept them.
It's just a matter of knowing how to find motivated sellers (which is a topic for another blog post).
If you want to see my take on how I run these numbers, this video explains my approach.
<<VIDEO COMING SOON>>
Want to try it yourself? I've included the calculator right here!
As you can see, it follows a different logic than the 70% Rule calculator I showed earlier.
Rather than giving me a wide range of percentages to base my offer on, it forces me to stay FAR below 70% (and frankly, I think 40% is too high for most of the vacant land properties I purchase – I generally keep my offers within the 10% – 20% range, depending on the market value).
It's important to note that the Market Value you determine for this property is very, very important. If you get this number wrong (particularly, if you set it too high), it will completely screw up your numbers and make the results unreliable. As with any calculator, the quality of your outputs are only as good as the quality of your inputs, so make sure you have at least an accurate ballpark idea of what the property is worth. This is NOT the time to simply “wing it” and guess without doing some research.
The beauty of it is, if I know my goal is to make an ROI of at least 100%, or if I have a specific number I need to hit as my Net Profit, it's very easy to adjust the numbers (whichever ones have the most flexibility) until those numbers fall where they're supposed to… and if I can't get the numbers to work, I walk from the deal. It's that simple.
Base Your Offers On Math, Not Emotion
What I love about this calculator is that it tells me in very plain terms what the consequences of my numbers will be – for better or worse.
If I'm going to stick to my business model and keep my emotions out of the equation, I need to make sure my Net Profit and ROI fall in line, and this all starts with finding a reasonably accurate market value for the property, and keeping the offer price in the acceptable range.
This approach help keep my emotions in check, so I can make my decision based on what the data says.
Am I going to miss out on some opportunities because my offer prices are too low? Absolutely.
Am I willing to compromise my business model just because I'm worried a seller might not accept my offer? Absolutely not.
Am I going to break my own rules and bump up my offer price just because I “fell in love” with a particular property? Um… are you kidding me?
YES – I have to play the numbers game and send out a lot of offers. Do I hear the word “No” a lot more than I hear “Yes”? Of course!
But what do I get in return? I get peace of mind.
When someone does accept my offer – I get to be 1,000% SURE I'm holding the deal of a lifetime in my hands. And it's worth the effort! When we stick to our guns and make data-driven decisions, we can reap some huge benefits. If there's anything I've learned about real estate investing, it's that data-driven decisions beat emotion-driven decisions every time.