The biggest reason fix and flip investors lose money is they make mistakes estimating the after repaired value (ARV). Getting the value and the repair budget right, or at least close, is essential to your success. Analyzing numbers on a deal is easy, but coming up with the numbers to plug into your formula can be tricky. Here are five mistakes I see investors and real estate agents make when they are trying to calculate their ARV.
Not Adjusting Comps: It is well known that we value real estate from comparables, or comps. Comps simply means comparable properties that have recently sold or are for sale. We also know that we want our comps to be in the same area and the same size. But what if you can’t get something that is exactly like the house you are trying to value? Have you heard the term “apples to apples”? This holds true in real estate. If you cannot compare an apple to an apple, you need to adjust the comp to be an apple. Let me elaborate.
Let’s say you have a 1,200 square foot house. You find a great comp, but it is 1,400 square feet. To use the 1,400 square foot comp, you will need to take the price it is listed or sold for and adjust the number down to compensate for the house being larger. Basically, the subject property is expected to sell for less because it is smaller in size.
The mistake is to not adjust comps and using a larger house as the value. Adjustments do not stop at square footage, however. Common adjustments could be garage stalls, bathrooms, amenities, view, basements, and location, which can all impact value.
Location: I often hear that a standard for location would be within quarter or a half mile from the subject property. I guess that is OK, but my question would be is this a radius we are looking at? Most often, that is exactly what investors and agents do. Take a half mile radius. The problem with that is you might be pulling comps in neighborhoods that are not similar. Sometimes crossing over a river, rail road tracks, or a major arterial can completely change the area appeal. It is much better to look at the map and try to stay in the same area or neighborhood, which very well could mean comps that are farther away than other options.
Other mistakes when it relates to location is negative site influences. On busy roads, close to liquor stores, across from commercial space, on a lake or off a lake and distance to public transportation can all play a role. The last thing you want to do is try to value a house on a busy road and only use comps inside the neighborhood. Buyers will demand a better price for the negative influence of the busy road. Knowing you need to make an adjustment for location is the biggest issue, but the problem is how much of an adjustment will you need? Well that is why property valuation is an art and not a science. You will be guessing here a little, but here are two good ways to accomplish this:
- Find a comp that sold with a similar influence and use that as one of your comps, even if it is a little older or farther away.
- If you cannot find a good comp with a similar negative influence, try to find an older comp with the influence (even several years old) and compare that to houses without that influence and see what the price difference was back when it sold. Knowing how much of a discount was needed for the location in the past can help you craft an educated guess on what it will be today.
Square Footage Adjustment: With the exception of newer developments where all the houses are similar, using a price per square foot model is a mistake. I do see real estate professionals, even ones that have been in the business a while, find an average price per square foot in the area and multiply that by the square footage in the subject property. You can get lucky and get close to accurate on this, as long as the size of the subject property is very average and comparable to the comps, but it is more common to miss your value using this strategy. The actual adjustment for the difference in size above grade will be closer to 1/4 to 1/6 of the average square footage price in the area. You can ask four different appraisers and get four different answers for how they come up with the adjustment to use for size. I will typically use 1/5 of the average price per sq foot in the immediate area, unless the average price per sq foot is pretty high, then I will use 1/6. This is not a formula, this is just a quick way for me to get close.
Let’s assume you are in an average neighborhood and you use 1/5 to keep this simple. Going back to our example of the 1,200 square foot subject and the 1,400 square foot comp. If the average price per square foot in the area is about $140 and the comp sold for $200,000 I would adjust the $200,000 sold price down $5,600 so the adjusted value of my comp is $194,400. Confused? Let’s look at the math. Starting with the average price per sq foot in the area, I would divide that by 5. $140 PPS / 5 = $28 PPS. In our example, there is a size difference of 200 feet, so I multiply 200 by $28 and get $5,600. Since the comp is larger than the subject, I would expect the subject to sell for less, so I subtract the adjustment. $200,000 – $5,600 = $194,400. Remember, this is the indicated value using one comp. You will want to use several comps to get an even clearer picture of value.
Finally, above grade square footage is much more valuable than below grade. Even though you can double your finished square footage, you will get nowhere near double the value for the house. It is extremely rare for us to see a finished basement add enough value to even cover the cost of finishing it. I would call some appraisers in your area to see what they adjust for basements, both finished and unfinished, or dig into comps with basements and without to try to find what an adjustment should be. In the markets we lend in, we will typically see $10 to $15 a foot for unfinished space and another $10-$15 for finished space.
Bedroom Adjustment: This is an easy mistake to make, but in most cases, we don’t see a difference in values for bedrooms. A 4-bedroom home does not necessarily sell for more than a 3-bedroom home. If the houses are the same size and one has an extra bedroom, it is likely giving up something that a buyer may want; like a formal dinning room or a master suite, or it could just mean that the 4 bedrooms are all small, while the 3-bedroom home has 3 roomy bedrooms. Buyer appeal is based on their needs, so it is unfair to say that a house is worth more just because it has an extra bedroom. Except for rare cases, we do not see our appraisers adjusting for bedrooms. If a home is bigger and has an extra bedroom, it is worth more. In that case you are capturing the increase in value in the sq footage, not the bedroom count. If you adjusted a comp for size and bedrooms, you would be making two adjustments for the one room.
Believing Someone’s Opinion: I just had a client lose $10,000 on a deal because he believed the wholesalers opinion of value. He was pressured to give a large deposit on the spot to secure the home and did not have time to do his own research. Based on the comps provided by the seller, the deal worked. When he brought the deal to me, I quickly saw errors in the comps that were provided. I showed him why the comp selection was flawed, and how he would need to adjust the comps to get a more accurate value. One comp was twice the size above grade!!! The very next day my client went to the wholesaler armed with the data I provided and asked for his $10,000 back. The wholesaler denied the request and then spread the word that Pine Financial is way to conservative. My response is that if you want a lender to fund bad deals, we are not your lender. I would rather pass on a deal than fund something that my client is sure to lose money on. Investors choose to work with us because we are not about the deal, we are about the relationship. We have no trouble giving you the advice you need to build a successful real estate investing business.