IC Elesson: Are You Making this Huge Property Evaluation Mistake?

As you probably know, evaluating properties is one of the most important skills an real estate investor has to develop. Unless you can figure out the value and repair costs of a property, there’s no way to make an intelligent offer.

And there’s a particular evaluation error that I see over and over in your questions that you need to commit to memory, and never do.

This error involves evaluating rental properties that are in outdated but livable condition, or rentals that are currently occupied but aren’t stabilized. What these 2 situations have in common is the fact that the cost to fully stabilize them—that is, make sure all the mechanical systems have at least 5 more years of useful life, and that all cosmetics are updated to good condition for the area—than it does to do the minimal work to rent, or keep renting, the property.

For instance, a full stabilization might cost $15,000, but when you see the property with the badly outdated kitchen and bath and the 30 year old furnace, you think, “The furnace woks, the tenant seems ok with the kitchen and bath, so really, it just needs weather stripping and that tree cut down”, and you put a repair cost of $2,500 on it.

The problem comes in the next stage, when you do the formula that tells you what to offer. Imagining that the ARV of the property is $70,000, you do this math:

$70,000                                                                                                                                                         X.7                                                                                                                                                                     -$2,500 in repair costs                                                                                                                            $46,500 sale price

Which means that you might offer $38,000 for the property.

The problem is, you SHOULD HAVE done the math this way:

$70,000                                                                                                                                                         X.7                                                                                                                                                    -$15,000                                                                                                                                                    $34,000

Which means your MAO is more like $26,000.

The mistake in logic is simple: you used the after-repaired value (which is the correct thing to do) to start, but then didn’t actually account for all the repairs that would put the property into true after-repaired condition. As a result, you didn’t leave the buyer the 30%  or so in potential equity, because when your buyer (in example A) does the $2500 in minimal repairs, he still has another $12,500 to spend to stabilize the house. He’ll be “all in” for $51,000 on a $70,000 house, which is clearly too much.

It’s NOT Ok to say, “but my buyer won’t do that work, he’s kind of a slum lord”. It doesn’t matter whether the work WILL be done, it matters that it MUST be done in order to bring the property into after-repaired condition.

Evaluate your potential deals right, and you’ll make the right offers. Make the right offers, and you’ll sell your deals and make the profit you’re here for.