Wednesday, June 10, 2009

What constitutes good value in a real estate purchase.

Its funny how many times in the last few months that I have heard brokers tell me a property is a steal or I would be crazy to miss out on this opportunity.

I was recently looking at a house that was originally listed at $805,000 in 2007. ( A seller can ask what they want the do not have to justify this figure to anyone and it is not justified by anyone)
The property only received a few offers which were all around $450,000. (This in my opinion establishes true market value as a property is worth what someone is willing to pay for it not what the seller is asking for it)
The house was unsurprisingly foreclosed upon by the bank who owned the property at around $395,000. (cost of borrowing)
I was told with confidence by the broker that I could have the house at $350,000 and another broker corroborated this telling me it was a "steal" at $350,000

So here is my question..... how did the brokers establish the initial value of $805,000 and how do they know it is a steal at $350,000.

I think the initial value was a market gut feel, which is what happened so often in the leadup to the crash and was a massive contributory factor. This is what I think the house can be sold for based upon the common hysteria in the market and if I ask it and there are no comparable sales it creates a market value of its own.

Why did the developer not sell it at a profit at $450,000 - was he lead by the brokers and the promise of higher returns or was he greedy??? It is hard to tell but so often I have sold properties below the value I think they are worth and seen them resold by others for more within a year or so.... however if i crystalized a profit on the transaction then I came out ahead in my opinion as I was able to move forward to the next deal with more cash in my pocket than Ihad originally. I never attempt to sell at the very top of the market as it can easily move down during the transaction and may well not close.... at which point a profit making situation becomes a loss and a possible black mark on your credit.

Funnily enough there is a property in the same development nearby which stands the developer at $750,000 which is beautifully built and has fabulous Viking appliances etc. Whilst this is great for winning awards etc when a developer gets personally involved in the property there are all manner of upgrades that go in that are not supported by the development, type of buyer looking at the property or the market.

Why am I suggesting a $250,000 value for the property when I am being told it is a steal???? I have owned and managed rental properties since I was 16 years old. If I know i can only rent a property for $1800 a month then I make the following calculations.

$1,800 x 11 = $19,800 (I leave out 1 month for renting fees, vacancy and refurbishment as experience has taught me this is most likely with any non commmerical property)
$2500 = Taxes, HOA's and other associated costs

$17,300 is my total income for the property - I am thinking a 7% yield would be fair - ideally Iwould like 10-12% but seeingas I can lock my loan at around 6% today that makes sense as you will see later.

Therefore my multiple is 14.25714 to give me a 7% yield


I would then subtract my closing costs of $2,471 and I have my exact offer price.

Now what has been happening is people have been ignoring these calculations and subsidizing the mortgage in lue of a return from Capital Appreciation - This is a dangerous gamble though as you have brokers fees, early repayment on mortgage etc associated with selling a property and would have to see at least approximately 8% appreciation just to cover carrying costs.

When one takes the emotion out of property and looks at it in the same fashion as a commerical property or business decision we receive a firm indication that the market is far from bottoming out in certain areas. I personally would advocate that appraisers and realtors are required to go through this type of process and produce similar maths to establish a selling price.

California is correcting well as I was saw a trailer on PCH in Pacific Pallisades that would have been $280-350,000 at the height of the market is around $95,000 - 1/3 of its original suggested listing price.

Copyright Jonathan Rose 2009 - Creative Commons License

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