Episode #7 – Intro to Value – A Foundation to Determine an Accurate ARV for Houses
Welcome to EarlToms podcast. Today we’re going to do an introduction to value. I see this is a struggle with a lot of wholesalers. And now that we’ve covered some of the basics of how to enter the business, it’s important to know how to value properties when when you go look at them so that you can negotiate with the sellers and with the buyers. As a disclaimer, I actually used to get paid to value properties. I was an appraiser before I started investing. I’m going to kind of walk you through some of the simple things of valuing houses so that you’ll get a better understanding of it. It’s not hard if you break it down into the most simple of terms. So with that, let’s get started with it.
The first thing that that you want to look at is what is called the principle of substitution. It’s a principle that’s in real estate, economics, just about everything in life. One analogy I always use is you always buy what’s on sale. That’s something that we all do in our everyday lives. So when you go and look it at houses, it’s no different. What can you get that’s the best deal, what’s on sale? When you’re going out there, you have a $150,000 house, and the seller is wanting $144,000. But, you know, down the street, you have somebody else that will sell it to you for $120,000. Now that may be a deal. It may not, but you have to come to the conclusion of the is $30,000 enough equity that you can get that sold? What’s the best deal on that? If you look at things in a rational term, let’s say that you go to Wal Mart. There’s an item there that’s $5 but the exact same item is at Target for $10. You’re going to buy what’s on sale for $5. You’re going to save that $5. So everything in real estate is the exact same way. That’s what makes things deals.
I don’t know if a lot of you ever played Monopoly when you were growing up. But let’s just say that you had all four utilities and you had some hotels on them. You were getting max rent, max revenue coming in. But then you had an opportunity to exchange it for Boardwalk and you start building that now. Is that a good deal? If you ask me, I would say no because you’ve got four chances to make money versus two with having boardwalk if you have the other, and I can’t remember off the top of my head what the other one is, but you have to go through the negotiation process of realizing what’s actually a deal and what’s not. When you look at things that are happening in your market, you’re looking for what’s the best deal. What gives you the best opportunity? That’s where the comparison part of it comes in.
One big thing that I see people doing that is not correct is you’re comparing in reverse. You try to take your house and turn it into the house that you’re comparing. That’s not how it’s done. You take the house that you’re comparing and you turn it into your house. Let’s say that you have a fully renovated house down the street. That’s a $150,000 house. The house that you’re looking at you think needs $25,000 worth of work. You also have what I call a headache. To be able to do the work, to get it to that point of the $150,000 dollar house down the street that is fully renovated. When you do that, you have to actually subtract what is going on. It’s far from renovated, the cost of it, the time, the risk, and carrying costs. When you go in, you know your starting point. Just off of the renovation is going to be $125,000 to get you to a $150,000 completely renovated sales price. In order for you to make money now you have to subtract the money you want to make. If you want a 20% return you have to subtract $30,000 off of $150,000 sales price. Now you’re at $95,000 with what you’re expecting to be able to get that property under contract for. If you can’t get it for that, sometimes you know, you go for the 10% return, whatever is in your market and what gets things done.
Don’t take the house that you’re looking at and turn it into the house that you’re comparing it to now. To get to that price in a lot of ways, turn the comp into your house. For comparison purposes to come to the value you do the following. If the $150,000 house has hardwoods, your house has carpet. The comparison house is going to get a negative adjustment because hardwoods are more desirable in a lot of areas than the houses with carpet all through it. So in order to basically turn your house into the house down the street, you have to take the carpet up and now put the hardwood down to get to that value. But in order to compare it, you back out of it to take the hardwoods off. What would it sell for if it had carpet just like your house? It can be confusing when you just get started. But if you get in the habit of saying OK, this house that I’m comparing it to, What would it sell for if I turned it into the house that I’m looking at? That’s when you were able to come up with more accurate value of your purchase price so that you can make the best deals. So one thing that I always try to relay to people to help them understand it as well is another analogy.
Since I’m a guy, my analogy usually goes towards you know, women. But for women, if you look at a man that was not kept, he doesn’t shave his face, doesn’t cut his hair, you know, isn’t dressed nice, those kind of things. Well, he’s not going to get a second look and you’re going to have a negative opinion about him. The same is true for men when they look at women. If a woman is not kept, (she could be the best person in the world), but is she going to get a second look or get asked out for a date. So with the analogy, when you look at houses, if a house is in poor condition, can you make it look better? Can you? You do it like an extreme makeover for that house to be able to get it to the point to where it will sell. It will get that second look and a lot of times will get the first look because you don’t necessarily want someone taking a second look at it. You want them to bite on it as soon as they see it. So when you’re going through and you’re looking at these things, what I always call a Plain Jane house typically doesn’t doesn’t get a second look and I won’t go anywhere near it. What I call a Plain Jane house is just one of those square boxes that’s got that front little stoop. You know, whether it’s a two story, one story, it just doesn’t have a lot of appeal to it. So in order to overcome that, did you put a long front porch? How are you dressing up the front of that house to keep it from looking like Plain Jane? So what I always look for is what is actually going to sell? At the end of the day, it doesn’t matter where you are. The women are the ones writing the checks because they’re the ones that are looking, you know, is this safe for my kids to be around? Can she imagine raising her family around this? So when it comes to writing a check for the mortgage or for the rent, the women have the final say. Men go in and just kind of shake their head. Happy wife, Happy life. That’s how it is. If you can’t get them in the front door and it doesn’t look appealing to a woman, the odds are that it’s not going to sell for the maximum amount or it’s not going to rent for the maximum amount. When you fail in real estate, you fail with two things. You fail by price and you fail by appeal because if it’s overpriced, it’s never going to sell. If you can’t get somebody through the front door, it’s never going to sell or it’s never going to rent. If it does, the price will always correct itself because you’re either going to have to lower the sales price, or you’re going to have to lower the rent on it to be able to get its sold or get it rented. You need to take the approach, what can I do to make this the best? Do I go put on a fine dining dress do I put on a jacket and coat? You know, a full blown suit? Do I get my hair cut? What can you do in that aspect of comparison to be able to get the max value whether it’s a sales price or rent out of that property. That’s kind of a subjective thing because when you go across the country, there are different styles of houses so, you know, say out West they use a lot of stucco. You know, in the North and the South, they’ll use a lot of brick. A lot of it is due to climate. A lot of it is due to what people are used to looking at. You have to take that in your own market and figure out what is going to be the best in those markets and go from that point.
There are three things that are going to really determine if you’re on the right track. You need to analyze the demand for the property and for the area. You need to look at the utility of the property and you need to look at the scarcity of the property. That everybody really knows what demand is. Right now, we’re in a high demand market because the supply is low so prices are going up or they’re staying stable, depending on where you are when you think of utility. What that means is, how can that property be used? Does it have two bedrooms, three bedrooms? Does it have a yard? Does it have a fence? Doesn’t have a shed in the back for some storage? Can you keep your lawnmower back there? What’s the utility? What’s the use available for that property?
When you talk about scarcity, you’re looking at it partial because the utility of it. But scarcity more so involves, how many three bedrooms are available? How many properties are available with the larger lot? How many have a backyard versus a front yard? When you start looking at your value, you need to look at those three things and determine, is this the point where I pushed the value of it? Because the demand is is high, utility is high and the scarcity is also high. If all three of those things are high, it may lead you to make a higher offer. But if two of the three are low or one of the three are low, you need to go more on the low end of the value. What I always look at is, what can I do that will add value to a house? Do we renovate the kitchen, putting a roof on it, change it from carpet to hardwood, paint the house, things like that. There are certain things that will add value to a house, but you need to really understand what those things are. Kitchen nine times out of 10 will add value to the house. Adding another bedroom does not always offer more value to a house because you could do what they call is over-improve. If you know the standard is three bedroom and now you have a four bedroom, are you going to get the most per foot out of that? That fourth bedroom may not have a lot of demand. So you’ve got to understand your market for demand for a four bedroom. Yes, there’s more utility for a four bedroom because there’s more to be used. How many four bedrooms are available for sale or for rent? The bigger picture of it is to remember that you’ve got the demand, utility, and the scarcity. It needs to be high on all three of those if you’re ever going to push the value or push your offer. If all three are not high, it’s not a good idea to push it. When you’re looking at it, it falls in to utility a lot. But it’s not just utility because it falls in with demand and scarcity, too. A lot of times when people talk about it, it makes more sense to use utility with it. But it’s something called the highest and best use.
What you have with the highest and best use is four different test. Is it legally permissible? Which basically means zoning approval or code. Can you legally use the property for what you want to use it for? Another one is maximally productive. Does it make the most money? So think about this when you go into areas that are predominantly rental versus predominantly owner occupied. Which one of those is going to make you the most money? Typically in predominantly owner occupied areas doing a traditional flip is going to make you the most money. Traditionally rental areas, your sales prices are going to be a little bit lower because the demand is for rental. You make more money short term and long term by renting the property. The other is financially feasible. Does it make financial sense to buy, to renovate, to keep whatever property that you’re looking at? If it doesn’t make sense on it, then it’s not going to pass that test, and we’ll talk about the financials feasibility in just a little while. The last test is physically possible. Now in today’s world, you can pretty well build a house on the side of a hill side or mountain. But do you want to? Is it physically possible? I would think you can’t necessarily build a house in the middle of a swamp. You could but would you want to really to, so is it physically possible? Just kind of look at those aspects of would you really want to? If it doesn’t pass all four of these tests, then you’re not going to pass the highest and best use analysis of it. Whatever you’re trying to do with that property is going to cost you money. If you’re trying to sell a rental house as a traditional flip, you’re not going to make as much money. If you’re trying to sell a traditional flip as a rental house, you’re not going to make a much money. You have to look at all four of these tests as one. Whenever it passes all four of these test is when you’re going to make the most money, and whoever you’re selling it to is going to make the most money. It’s how you structure those deals that you’re doing that determines whether or not you and your buyer are going to make the most money out of it. So legally permissible, maximally productive, physically possible, and financially feasible. You passed those tests, you’ll have the most money on the table.
So to go back to the financially feasible aspect of it. There’s something that’s called obsolescence. There are three types of obsolescence physical, functional and economic. What obsolescence is, is just a fancy word for wrong. There’s something wrong with the property, the area, you name it. But there’s something something wrong with that scenario, so the the physical part of it is kind of easy to understand what’s physically wrong. This could be condition. If you need to renovate the house, there is physical obsolescence associated with that house. Functional obsolescence is a little bit harder to understand. So a couple of different examples, let’s say that you have a house that was built in 1940. One room in this house doesn’t have a closet. Do you count that as a bedroom? You can and can’t. The answers is 50/50. If it’s in an area of the house where you know it’s away from a main rooms, like a living room, kitchen, but it doesn’t have a closet. When that house was built, by the era of that house it was used as a bedroom because years ago they used to put closets in the hallway. Closets were not actually in bedrooms in the 1940’s. Technically, that’s a bedroom because that’s how it was built. By today’s standards you need to build a closet in that room to be able to legally call it a bedroom. But when that house was built, it was built to be used as a bedroom. Another example, let’s say that you have a second level or you have that same room that we were just talking about that doesn’t have a closet in it but just off of that room that doesn’t have a closet there’s another door that leads to a room that does have a closet. We’re calling that a bedroom. In order to get around that functional obsolescence, you need another entry, and you need to close that entry into the back bedroom off because functionally, having to walk thru one bedroom to get to another bedroom is wrong. That’s not considered right by any means, regardless of when the house was built. If you have to walk through a bedroom to go upstairs to get to a second level or go downstairs to get to a bedroom, that’s functionally wrong because it’s a private room now made public. So the functional part of that house has to flow. If it doesn’t, if it just seems off, then that’s functional obsolescence.
Now years ago, there’s a requirement in Fannie Mae that you’re supposed to actually walk into a house and there’s supposed to be a foyer. As soon as you walk through the front door, you’re not supposed to walk into a house straight into a public room. That would be considered functional obsolescence, as Fannie Mae wrote it years ago, and it hasn’t actually been changed. It’s still on the books. Another thing that a lot of you probably don’t don’t even realize when you go in these garden whole neighborhoods and you see these small little trees in the front yard, you’re wondering why they put these little bitty trees in the front yard? A requirement is that there is a shade tree in the front yard, so builders get around this requirement because they technically put a shade tree in the front. It’s not a shade tree when it’s built because it’s small, but it will grow into one. So whenever you go when you look in these in these little garden home communities and you see these small little trees in front, that’s the Fannie Mae requirement of a shade tree not actually providing any shade yet. It’ll take it 20-30 years to grow, to be able to provide the shade that the house is supposed to have.
So encounter and kind of summary closing whenever you’re. Whenever you’re looking at these properties. You have to make sure you were comparing the same thing as close to the same thing as you can possibly get. You don’t overstate the value, you go back and do your research on it because one of the easiest ways to figure things out is going through and looking at houses, taking their square footage and divided by their sales price so you can get a price per foot. If you’re comparing single level houses, you’re gonna get an accurate amount on that square footage of what it is selling for today. So you’re not gonna You’re not gonna have to go to another neighborhood. You’re gonna be able to break it down right then and there because you’re going to see the things that are causing the difference in sales price. So if you’ve got one that sold for 100 and $10 a square foot and you’ve got another one that sold for $120 a square foot, when you see these pictures of these houses that have sold, it’s gonna make sense to you where that $10 difference in the price came from. It may be a big backyard or it may be the hardwood versus the carpet. But if you go through when you see one now that’s down the street that sold for $80 a square foot. But it’s similar in size, same type property, those kind of things. Now, you know you’ve got either condition issue or you’ve got something that is wrong around at that house, and that’s gonna lead you to kind of investigate further or either say, I can’t use that whatever you wanna do with it. But when you break it down on the price per foot, you’re gonna start seeing these things if you’re again. If you’re comparing the exact same thing or is close to the exact same thing of what you’re dealing with, breaking it down by the perfect basis is gonna show you what’s going on with the with the comparable sales and help you get to that value. So if everything you know, go back to the $165,000 house and 100 and $75,000 house you’re gonna see Okay, The 165 sold for $110 a square foot, the 175,000 sold for 120 dollars a square foot. Where is that? $10. And it really may just be a simple is the $175,000 house had a bigger backyard. It may be that simple. It may not, but it gives you a smaller number to work with to kind of break it down, to be able to understand what the difference is and what calls that price. If if you follow this, you you’ll get to the point where you’re gonna understand value a little bit more. Just remember, you’re looking at apples and apples versus apples and oranges, because if you do that, you’re gonna stay confused. You’re not going to get the value right. And it’s always going to cause you problems down the road.
So we started today with just introductions and basic principles of things to do. We’re going to continue to do this on a progressive basis. We’re just starting with the foundation today, but we’re going to get more in depth with things to come, whether it be detrimental effects of the property, adverse possession, etc.. We’re going to get into these types so you can have a better understanding. I see it all the time. People say, why don’t I have any comps around? Eventually we’ll get to the extraction method so that you understand how to do that. You can actually start preparing your deals a little bit better from start to finish with your offers, with your sellers, and sell it to your buyers. We had to start with the foundation so that you get a better understanding of where you’re headed so that you can start putting together these deals together better. With that, I appreciate you listening again. If you’ve got any questions, feel free to make a comment. If you want some more information on that, you can visit EarlToms.com. There will be things on the site to help you build the business in general. With that, I will bring it to a close and we’ll see you again next week. Thanks for listening.