Accurately estimating value is a critical skill for a foreclosure investor. It means the difference between profit and loss.
Market value determination
There are several approaches to determining the value of a property.
MLS based CMA. A comparative market analysis (CMA) is a common method for determining the value of a property. A CMA based on multiple listing service (MLS) data typically organizes properties in three categories: sold, pending, and active. The report includes properties with similar square footage, age, condition and amenities. Adjustments in the value are made for any differences from the comparable properties. Recent solds provide the best comps as they indicate what a buyer actually paid for a particular home. Pendings are useful even though they don’t indicate the actual purchase price, as they provide an indication of the type of properties and list prices that have recently attracted buyers. Active listing are also valuable, in that they are the current competition for your property – you likely have a winner if you have a nicer property to offer, at a better price than the competition, while still making a great profit.
Public record comps. Public records are another source for sales comparables. The primary downside is that they usually aren’t readily available for 1-2 weeks after the data is available in the MLS. Still if you don’t have access to MLS records, this can be a valuable tool.
Foreclosure comps. The prevalence of foreclosures in the area surrounding your property can have an impact on value. This is especially important for fix-and-flip investors, who will be competing in a few months with properties still in the foreclosure pipeline but not yet listed today.
Like a CMA, a foreclosure comps report uses the value of similar properties to help indicate the value of a property using three categories: bank owned, auction, and preforeclosure. The difference is that the comps are other distressed properties and discounting trends at auction are taken into consideration to see how they can impact pricing. The report also gives you a view into the near future to see what other nearby distressed properties will be hitting the market in the next few months. Those properties will affect the asking price, both now when you’re looking to buy, and in a flipping strategy later when you’re looking to sell.
Median area income. Comparing median area income to property values provides a sanity check on a valuation. If the median household income in the neighborhood is $65K and the houses are valued at $700K, you may want to reconsider the purchase, given that the average household can afford little more than $250k. A lot of people ignored the sanity check and bought homes at prices that were artificially inflated by the government-encouraged market delusion that prices would only go up, not down. Those are the same people who lost a third or half their home values when the unrealistic and unsustainable curve reversed. This may not impact you in a wholesale flip, or even a fix and flip, but like musical chairs you don’t want to be the last one standing.
New home prices. A volatile market can create illogical juxtapositions. A developer can come into an area and build quality houses valued more sanely than the older houses whose values were inflated and whose owners still cling to the hope that they can salvage some of their equity. See the Tales from the Trenches: A perfect valuation storm below.
Appraisals. A professional appraisal gives you a more solid estimate of your specific property with all its unique features and flaws. Most residential real estate appraisals use the sales comparison approach, which is a more formal version of the CMA discussed above, but usually includes a more detailed analysis of the differences between the subject property and the comparable properties to better refine the value. Just remember that the appraiser probably doesn’t have access to foreclosure comps, so you should still adjust to the impact coming foreclosures may have before you are ready to sell.
Automated valuation models (AVM). An AVM is a value derived from mathematical modeling algorithms and a database of properties. It can be produced in seconds, compared to the time required to do comps or a professional appraisal. It’s a good starting point, but may fail to take into consideration important details. See Consider context below.
It’s a Feature: Sources for valuation
ForeclosureRadar provides an AVM value and also links to sites such as Zillow.com, which also provide AVMs.
Consider context. Consider property A and B, which are across the street from each other and are identical with the exception that A backs to a freeway and B backs to a greenbelt. Property A will most likely sell at a noticeable discount compared to property B. These are not features of the property itself, but the context in which the property is located. This information might show up in the MLS, but probably not in public records or in an AVM. See the Tales from the Trenches: A perfect valuation storm below.
Tales from the Trenches: A perfect valuation storm
In 2006 I bought a 1985 single-story house backing to a freeway a few doors down from a similar house valued at $355K. It required repairs because the owners had been running a meth lab in the house. The plan was to pressure wash the walls, upgrade and flip it. When the inspectors came in I discovered the law had recently changed. They used meters that checked below the surface, under the paint into the drywall for residual chemicals. In the end I had to gut it down to the studs, including cabinets, drywall, ductwork, even toilets.
I expected to flip it in three months but the testing and extensive repairs took six months. I listed it at $325K and got it in escrow. Then the buyer’s agent called. They had backed out, walking away from their deposit of a few thousand dollars. I asked why and the agent said that instead of buying a 20-year-old restored 1300 sq. ft. house they were buying a larger new house for less. It was just down the street.
I drove out to the property and saw a big sign advertising a new development coming soon a few blocks away priced “From the mid $200s”. The delay in flipping the house had come just as the market was turning and builders were scrambling to unload inventory. I had to drop the price, eventually selling it for $265K, taking a loss not only due to unexpected rehab costs, but also because of the rapidly changing market conditions.
Despite the loss, I was lucky. In 2011 similar houses are now priced around $135K. Foreclosures in that area can be picked up on the courthouse steps for even less.
As-Is vs Repaired Value
In a quick flip, you sell the property as-is, with no improvements.
Most people believe that you make more profit on a fix-and-flip than an as-is sale, but that is not always the case.
In some situations, it makes more sense to sell a property as-is for a lower price than to repair the property and hope you’ll recover the costs by meeting market values. Home buyers might more quickly jump on a property that needs a little work for a good value and take advantage of the opportunity to make the home their own, rather than move into a market-ready house which has been updated and repaired according to someone else’s tastes.
Do an analysis to estimate what you can get for the repaired value of the property in comparison to a quick sale value.
Tales from the Trenches: Selling as-is
I once bought a property that was in good enough shape to get financing but needed $20K of repairs to get it up to a full market value of $220K. I would have expected it to sell as-is for $200K, or perhaps even $195K because of the hassle for the buyer in fixing it up to market condition.
Before doing the repairs, I put the property on the MLS for 10 days as-is for $200K. I advertised it as a fixer and said that if it didn’t sell in ten days, I would pull the listing, do the repairs, and re-list it for $220K. It sold as-is for $205K, netting $5K more in profit than if I had done the repairs.
I believe this happens because buyers typically overestimate the value of their sweat equity and underestimate the out-of-pocket costs repairs require. It was a clear win for me, with both a higher net profit, and a much faster return on investment.
There is a potential problem with listing a property as-is. Undiscerning buyers or agents may use the past listing for a comp, affecting your ability to sell the property for a higher price after completing repairs. The solution is to extensively document the as-is condition and describe the repairs needed in the original MLS listing so that anyone who views that listing understands exactly why the price has increased.
The secret of maximizing the repaired value of a property is to focus on the areas that provide the best return on investment. For every $1K you spend in repairs and upgrades, you need more than $1K of increased value. This means focusing on the right rooms (such as bathroom and kitchen) and the right repairs (such as high-quality paint in a neutral color scheme and increasing curb appeal).
You need to develop a system for generating good ballpark estimates before purchase during whatever inspection opportunity you have, which may be as much as hiring a licensed inspector in a preforeclosure or REO situation, or as little as a view from the street in an auction situation.
Some investors get a sense for the general condition of the property and then assign a certain amount of cost for repairs, such as $7 or $10 per square foot. Others make a significant effort to see inside or even get inside to know with a greater degree of confidence the accuracy of their ballpark estimates.
Take into account not only square footage, but the age of the property. Even if it’s well maintained, a house built in the 1950s will cost more to get into shape than a house of the same size built in 2005. Older homes are more likely to have termites, dry rot, foundation problems and other issues.
Here’s an example of the system one lender uses when estimating repairs for REO properties.