International Investor Beware: US Distressed Real Estate
There is a lot to be said about knowing how much you should pay before you buy a house in the USA.
Recently, John Schaub, who writes a newsletter on Strategies and Solutions wrote about this very topic and some of the information in this article came from there. First, a few things about John. I first met him in 1981 when he was teaching a seminar on “Making it Big on Little Deals” with the late great Jack Miller. These two active investors corrected my thinking, changed my life, and I am forever grateful. Their seminar was all about the single family house business and the impact they made on my life has defined in many ways who I am today. Seminars can be phenomenal learning experiences and can provide the springboard and direction of your business activities and investments – especially when given by someone who lives and breathes what they teach and has earned the wisdom by working in their field of knowledge – NOT just teaching it.
If you know what to pay for a house to make a good investment, than all you need to do is take action. And by the way, taking action is the hardest step for most investors. We are not talking about a leap of faith here. When you have the courage of your convictions it is simply a matter of writing a check. Here is some great information that will help even the beginner investor to make a decision.
Is your market still latent with foreclosures and short sales? If so, it can be hard to tell which way house prices are headed. In a confused market how do you know how much to offer when you are buying a house?
You can pay for an appraisal before you make an offer, but that is expensive, time consuming and appraisers do not always get it right. That’s right, they get it wrong sometimes. You can make a very low offer and see how the seller responds. One downside to this, if the property is listed, some brokers will refuse to present your offer or will present it in such a way that you don’t get a counter offer. Often what happens is they can use your low ball offer to get another client’s accepted and thus earn both the listing and sales commission.
The best thing you can do is to place a value on the property yourself. This is easier in a stable market but possible in any market. John teaches students to estimate a price that is within 10% percent (plus or minus) of the value. Once you determine the value range, offer a percentage that is lower than your bottom range figure. If you are paying cash, you want a discount that is even greater. You can always afford to pay more when the seller finances the property. Particularly, the more attractive the terms are with regards to down payment and interest rate, the more you can afford to pay.
“How much to pay” depends on the direction of the market in your town. The newspaper may report that prices are moving up or down but every town has multiple markets. Some areas and streets will have foreclosures and short sales, while others have none. It is imperative to get the feel of the neighborhood by looking at all the houses and talking to the neighbors. Of particular importance is the percentage of home owners verses renters as this will have a huge impact on your future sales price.
In today’s market, the lack of credit for potential homebuyers has eliminated many retail buyers. There are many people who would like to own a home but cannot qualify for a loan. As credit becomes more available, more buyers will return to the market competing for the existing housing inventory.
The National Association of Realtors reports that the amount of inventory is dropping as not enough new homes are being built to meet the demand. Also, many older homes are becoming unattractive to the market. This is especially true in the Northeast and Midwest as the older housing stock has tremendous deferred maintenance, while real estate taxes and insurance tend to go up! Investors need to do their due diligence especially in regard to a future exit plan of the property. Always think in these terms: who can I sell this house to for more money than I am paying?
Short Sale and Foreclosures are all Cash Sales!
A distressed sale, a foreclosure or a short sale is not sold at market price. Often the house being sold is in poor condition with deferred maintenance and extensive repairs.
Foreclosures and short sales are all cash sales. However, when a street only has distressed sales, then the perception is that all houses have dropped in value. When the distressed inventory is gone, the prices of good houses in good condition will return to normal.
To learn more about investing in distressed real estate request my FREE course CLICK HERE
Normal Returns on Investment (ROI)
In a normal market, a buyer of an investment house might expect a net return from rents in the 4-7% range. In a distressed market, houses sell for less and the net return from rentals is higher. Today in many markets, you can make 8-12% net return based on today’s distressed prices. This is not normal and is only possible because of the bargain prices, not high rents.
The rental market is less volatile than the sales market. Rents did drop, but not as much as prices in hard hit markets. Rents are now recovering, and the rental market is likely to remain strong because of the large numbers of potential buyers who are renting today due to their lack of credit or dependable income. In Georgia we are experiencing strong rental demand.
You should know the trends in the job market and the rental market in your town. When jobs and tenants are disappearing, you might make your best deals, but it is a scary time to buy. When the job and rental market show signs of improvement, you may have missed the bottom of the market, but there will still be plenty of good deals. It’s much safer to buy when you know that you can find a good tenant than when you are uncertain about your ability to rent.
You don’t want to lower your standards and rent to a marginal tenant. In a soft market, drop your rents to attract (or maybe steal) a good tenant.
Three Ways To Evaluate A House Before You Make An Offer
Fair market value is the price that a willing buyer will pay a willing seller in an arm’s length transaction. Of course the credit market has a lot to do with how much a buyer will pay. When the credit is freely available, prices will be higher than in a tight credit market.
1. Market Sales – Current sales are the primary source of establishing value in a residential appraisal in a normal market. If the market is heavily loaded with distressed sales, then you actually have two markets. There is a market for distressed sales and another for sales of non-distressed (in good condition both physically and financially) houses.
Non-distressed sales can be few and far between. In a typical market, a distressed sale would not be considered as a comparable for a well-maintained house solve in an arm’s length transaction. Today in some markets, distressed sales are a majority of the sales making it difficult for an appraiser to find good real comps.
When Determining What To Offer, Look For The Trend In A Neighborhood
When looking for trends in neighborhood house prices, the challenge is finding houses that are “equal.” Every house has a unique lot, design, features, neighbors, and has been cared for differently.
The best way I know to compare values in a neighborhood is to compare sales of the same house, accounting for renovations, if any, and changes in the neighborhood.
Appraisers have to produce an appraisal report in a few hours, so they rely heavily on sales figures from public records. Although they try to find comparable properties, they can’t take the time to drive every street, and research every property to see if it is indeed a lot like the house that they are trying to appraise.
Look For Signs of Improving Streets and Neighborhoods
When you acquire a distressed property, the next step is to fix it. We have purchased and renovated a number of houses in the last thirty years.
Look for streets where others are fixing up houses to rent or to sell. The average sale price will climb dramatically on these streets in a short time.
Pay Attention To The Financial State Of The Owners
Are there a lot of Realtor signs advertising short sales (or just a lot of signs)? Short sales and foreclosures are an indication of the amount of debt (too much) on the properties. These properties will sell below the market, depressing the prices for a while. If you are buying on this street, calculate your best offer, and then reduce it by another 20%.
Look for Long Term Residents
One fun part about walking through neighborhoods and talking to the owners is finding someone who has lived in the same house for many years and knows the history and all about the current residents. We actually knock on the doors of houses next to the ones we offer on to talk to the local residents to increase our knowledge of the area. Many times the neighbors give us valuable information about the house we are attempting to buy and the local “make up” of residents on the street. You would be amazed at what we find out about and it certainly will impact our decision whether to move forward or back off. One of the best contractors I have used over the last several years came about as a result of knocking on a the neighbor’s door of the house I was buying.
A lot of long-term residents on a given street speak well of a neighborhood. Neighborhoods can go downhill, even with long-term owners, but I’d prefer to own in a neighborhood where people want to stay, not in one where they want to get out. Talking to people will give you the inside track on what is happening on a street.
2. The Income Approach
Another approach used to establish a property’s value is the income approach. Although with residential, this approach is typically given less weight today. It can help you establish what to pay for a house.
Houses are unique among income producing real estate. Some property has only an investment value. The only reason you would buy a commercial or industrial building is to generate an income, so their value is primarily based on income. A lower income results in a lower value.
A house has value separate from its income. A house is valuable to a user, and often this value is higher than the value it has as a producer of income.
In a “normal” market, a median priced house will rent for enough to give an investor 4-7% return. This is the return after expenses, but before income taxes. This also disregards the effect of leverage. When you finance part of your purchase, then your rate of return will be amplified. In order to compare apples to apples, compare incomes as if the houses were free and clear.
When you can buy a house that will give you a much higher return than 4-7%, then you have reinforcement that you are buying at a bargain price. Of course less expensive houses often produce more gross cash flow, but may also attract higher maintenance tenants, which leads to higher maintenance costs. Be careful to compare houses in the same general price range when comparing net incomes.
3. The Reproduction Cost Approach
A third way to determine value is to calculate what it would cost to reproduce a property. Of course a reproduced house would be new, so an adjustment for depreciation (actual) would be used to adjust the value of an older house.
In the price range that most of us buy houses for investment, the cost of construction would be in a fairly tight range. Different construction materials, block or brick instead of frame might have an impact on both cost and marketability. Some builders have good reputations for building quality houses and others build as cheaply as possible. These factors affect the long-term maintenance cost of a house and its value today.
The part of the cost that is less consistent is the cost of not just the land, but also the site preparation. If a lot is low, it may require tens of thousands of dollars in fill, compacting and grading before you can build. Likewise if drainage is an issue, you can spend an extraordinary amount installing a septic system. Additionally, if you don’t have access to a central water system, the well can be a big expense. These items can be expensive, but add little value to the house, as every house needs working plumbing and a building pad. Landscaping is not a big factor when buying a rental, but it can be expensive. Put little value on landscaping and site improvements.
To learn more about investing in distressed real estate request my FREE course CLICK HERE
In today’s market the reproduction cost approach to determining value is very important. If you are buying in an emerging market, and surely that is the best market to buy in; than this approach will tell the whole story. It’s hard to buy land and put all the improvements in for a property at less than $100 per square foot. It can be done, but with the cost of impact fees going up as well as the cost of building materials, it is unlikely. Especially looking forward.
Recently acquired property: 310 Forest Brook Dr.
$85,000 / 1,800 square feet = $47.22 per square foot
In a rising market, the market approach has advantages over the other two. Rents will lag behind price increases so the income approach will be low. And existing ready to move into houses will sell for a premium over a house to be built, so your houses will be worth more than reproduction costs.
In a falling market, the income approach is a good gauge. If you can buy a house and get an 8-10% return on your money when banks are paying a fraction of that, it’s a good deal. Combine that with the opportunity to buy with a low interest rate and you have a license to steal.
Your Perception of the Future Will Influence Your Offer
As your perception of your market will influence how much you offer, the seller’s perception of the future will influence how he responds to your offer. Find a seller who thinks the market is still going down and your chances of making a good deal go up. The public is always a day late when it comes to recognizing the top or bottom of a market.
In this market, the majority of sellers are asset managers for REO owners. It’s impossible to get seller’s financing from them. From these seller it’s strictly a cash deal and you may be better off financing these properties at a later date.
However, what’s wrong with a safe yield of 8% or higher with the potential for a huge upside in values? Free and clear houses add safety to your portfolio and many retirement plans have been built around free and clear houses.
If you have your money sitting on the sidelines, it’s time to reinvest in the good old USA.
You can do it for yourself or find a professional in the business to do it for you.
It’s never been easier to buy a bargain house in the United States. But where you buy, is every bit as important as to what you buy.
To learn more about investing in distressed real estate request my FREE course CLICK HERE
In the current issue article on distressed real estate the author gives a ridiculous example of a purchase by merely listing the address of the property below a picture without any information as to where it’s located forgetting about the key to buying real estate: loction etc.