As a real estate investor how do you know if what you see on Craigslist™, The DEed XChange™ or from any other source is actually a deal?
The article is about how to determine, if you have a deal.
Use the maximum allowable offer (MAO) formula, which is a rule of thumb framework that provides real estate investors with a way to determine a ceiling when making offers to sellers of distressed property. If you are seeking to wholesale “flip” you need to know this formula since your buyers will follow this model when evaluating your deal.
The typical real estate investors formula for buying property is:
The after repaired value (ARV) – 30% – the cost of repairs needed to get it to the ARV = the maximum amount investors will pay (MAO)
ARV – 30% – Repairs = MAO
ARV = $125,000
Minus 30% ($37,500) = $87,500
Minus Repairs* ($18,750) = $68,750
Therefore $68,750 is the most another investor will pay you for this property. Be prepared because most investors, especially in a buyer’s market, will not pay MAO and will try to get the price down even lower.
Repair estimates are based on what it will take to get the house to the ARV based on other similar homes in the area that have sold for the ARV price. So if a house sold for $125,000 and did not have granite and hardwood floors, don’t factor these expensive repairs into your estimates. When estimating repairs cost for properties which you’ve never seen this is a basis formula I use:
Multiply the square footage of the house by one of these amounts:
- $10 – if it appears the house needs minimal work
- $15 – if it appears to need moderate work
- $25 – if it needs a total rehab (these are one’s that are boarded up, with visible damage in the most recent picture you find)
Of course this is NOT an exact science but it does get you pretty close to determining if the selling price is a deal or not. Once you have the property under a written contract you need to have a local licensed general contractor give you a true written estimate.
In our example let’s assume the house has 1,250 square feet of living space and needs moderate repairs (1250 X $15 = $18,750). Remember, in order for you to make money you need to have a contract to purchase the property in our example for $68,750 or less! Your profit is based on the spread between MAO and your contract price. A good initial offer in this case would be $50,000.
Of course, if you are not a wholesaler, you don’t need to subtract the wholesale profit. Then your offer could be as much as $68,750.
The simple premise behind the “maximum allowable offer” is that savvy landlords and rehabbers are most likely to do a property investment analysis with the aim of buying distressed properties at 70% of value (a 30% discount) for a house in perfect condition.
Such a discount gives a rehabber the margin for “fixing and flipping” and the rental property investor gets a better opportunity for cashflow-positive properties.
Potential Problems With MAO Formula
The most important thing to remember about the MAO formula is that it’s designed to keep you from overpaying for property.
And it does a good job with that…
On the other hand, this advantage can be negated if you over-estimate the value of the property. So it is very important that you know how to properly value property. When in doubt, ask a Realtor! If you’re really in doubt spend spend a few hundred dollars and have the property appraised.
The next potential complication in the use of MAO is in under-estimating repairs. This may be the most dangerous and most common mistake made by real estate investors.
As you progress in your real estate investing career, you need to learn how to walk through a property and quickly develop a repair estimate. When you are buy properties outside of your area ALWAYS get 3 written estimates from local licensed general contractors. Even with these professional estimates, make it a habit to leave a cushion in your deals to account for hidden costs. A cushion not a cavern, if you pad it too much you’ll never find a deal.
The last potential difficulty with using the formula occurs is when market conditions suddenly change. One of the reasons why the 70% formula works is because private mortgage lenders (also known as “Hard money lenders”) often used it as their “loan-to-value” (LTV) limit – the ratio of the amount they lend to the value of the collateral that secures the loan.
When conditions change, these private lenders will usually revise their lending criteria downward. If you don’t stay on top of things, you could end up locking up deals at prices higher than investors in the area are willing to pay or able to finance.
Tip use the local paper or Craigslist and search “money to lend” in the real estate section. Call a couple of them and find out their LTV limit for the area where your subject property is located. Form a good relationship with these lenders, even if you do not use them yourself. It is very possible to market the property with their funding. In return some are willing to give you a referral fee of 1-2 percent “points” if your buyer uses their money.
Using the MAO formula, managing potential problems and strategically using the tips provided you will be able to spot a deal quickly and earn a nice profit.
As always, here’s to your success!
Creator of The Deed XChange