ROI Starts with Understanding the True Value of the Property You Are Going to Purchase
The Bottom Line for Investors is Still the Bottom Line
by Rick Sharga
Perhaps nothing is more important to the success of a real estate investor than properly valuing a property. Over-paying for an investment property is one of the most common mistakes made—particularly by inexperienced investors—and can often be the difference between making a reasonable return on an investment and financial ruin.
To a certain extent, investors buying properties to rent have a little more latitude than fix-and-flip investors, since they probably have a longer time horizon, and are less dependent on making a short-term profit on a sale. But, particularly in the case where a property is financed, the costs of over-paying can add up over time in terms of higher interest payments and lower monthly cashflows. And ultimately, when it’s time to sell the property, the profit will be smaller since the purchase price was higher than it should have been. But ultimately, most properties go up in value over time, so the rental property investor can make an error in valuing a property and still come out ahead in the long run.
This is especially true in a housing market like today’s, with high demand and low inventory driving home prices to unprecedented levels. According to a recent report by RealtyTrac parent company ATTOM Data Solutions, median home prices nationwide rose 16 percent year over year in the first quarter of 2021 and were up at least 10 percent in most markets across the country.
During what has now become a nine-year U.S. housing-market boom, equity has continued to improve because price increases have widened the gap between what homeowners owe on mortgages and the estimated market value of their properties. Freddie Mac recently noted that homeowner equity had increased to a record $23 trillion, as overall housing stock values rose to over $33 trillion.
The ATTOM report said that the percentage of homeowners considered “equity rich,” (homeowners whose mortgage debt was less than 50 percent of their home’s value) had risen in 41states from the fourth quarter of 2020 to the first quarter of 2021. On the other end of the spectrum, homeowners who are seriously underwater on their loans (owing more than 125 percent of their home’s value) decreased by 49 percent during the same period.
But the ATTOM report did suggest that some markets might be better than others for investors looking for good deals. For example, there are parts of the country where there are still a large number of homeowners who owe more than their homes are worth and might be candidates for short sales with their lenders. The top 10 states with the highest shares of mortgages that were seriously underwater in the first quarter of 2021 were all in the South and Midwest, led by Louisiana (13 percent seriously underwater), West Virginia (10.5 percent), Illinois (10.4 percent), Arkansas (9.2 percent) and Mississippi (9.1 percent). These are also all states where home prices are still affordable enough that an investor can buy a property, rent it out at a reasonable rate, and generate positive cashflow—something not as easy to do in some of the higher priced states like California, where the median property price is now over $800,000.
Clearly, even though home prices don’t always go up in a straight line, the odds are in an investor’s favor if they plan to hold a property for any significant period of time. A small overpayment by a rental property owner—especially in one of the lower-priced markets noted above—can look somewhat trivial a decade later when a property has doubled in value, assuming the landlord has charged market-priced rent and kept the property occupied most of the time.
For fix-and-flip investors, valuations can be a lot less forgiving
The two most common mistakes made by fix-and-flip investors are overestimating the value of a property and underestimating the cost of necessary repairs. A 10 percent swing on these estimates, especially in an expensive market, can wipe out most or all of the profits. Flippers are also sometimes victimized by market timing—paying top dollar for a property expecting home prices to continue rising, only to see a market correction.
In today’s red hot housing market, the temptation is to spend whatever it takes to buy a property, since prices have now gone up nationally for over 110 consecutive months, and demand continues to outpace supply. But it’s important to watch trends carefully, and to remember that local market conditions don’t always play out the same way the national headlines might suggest.
Just to use two items from recent news headlines to put this into perspective, consider supply chain disruption and inflation—both results in one way or another of the COVID-19 pandemic.
Flippers need to factor in material costs to their repair estimates. It seems unlikely that many of them planned on lumber prices increasing by almost 300 percent in the past year, but that’s exactly what happened. They probably also didn’t factor in appliances being on back-order for six months or more, yet real estate investors, homebuilders and homeowners alike are all still waiting for that new washer and dryer. For an investor with relatively high cost financing, extra months waiting to market the property can mean lower profits.
As for inflation, many market analysts warn that if inflation continues to rise, mortgage rates are likely to follow. Most housing market experts agree that an increase in interest rates by as little as a point could seriously weaken demand among prospective homebuyers due to the historically high price of homes—affordability has been propped up by low interest rates and would suffer significantly if those rates suddenly went from 3 percent to 4 percent. Usually, this scenario results in home price appreciation slowing down, or even prices falling slightly. That’s good news for a flipper getting ready to buy a home, but not good news for a flipper who just bought one and now needs to sell it at a profit.
Due to competition from institutional investors and homebuyers, flippers are already seeing their profit margins squeezed today. ATTOM also reported that gross margins on a flip dropped from 41.8 percent in the fourth quarter of 2020 to 37.8 percent in the first quarter of 2021—the smallest margin in 10 years. Gross profits (defined as the difference between the median sales price and the median purchase price paid by investors) fell from $71,000 to $63,500 during the same period. While these are still healthy profits, the downward trend may be why the number of flips also fell to its lowest level since 2000—only 2.7 percent of home sales in the first quarter were fix-and-flip sales.
The bottom line for all real estate investors is still the bottom line. And in order to maximize it, it’s critical for investors to not only do the fundamentals (like following local market sales and pricing trends, getting accurate comps, checking online estimated values, and doing accurate repair estimates), but also to understand how some of the bigger picture trends can have an impact on their ROI.
