AMA - What Should I Pay For The Property?
Today is another AMA episode - Ask Me Anything
Danielle asks: "I am considering purchasing a 4 unit apartment building that is approved for higher density to six apartments. How do I know what is a fair price to pay for the property?"
When we buy real estate for a long term hold, or a quick sale we use a very similar approach that is pretty standard in the industry. The method is called “Residual Land Value Analysis “. Click HERE to download the Excel example for today's episode.
It’s a fancy term that basically means you need to work backwards from the answer to the question, or work backwards from the value of the finished product to the raw material that you are starting with.
So let’s construct a simple example of how to conduct residual land value analysis. For those of you that want to follow along with a spreadsheet, there is an example you can link to in the show notes for this episode. Just go to the show notes, click on the link and you’ll get a copy of the example.
We are going to run through the example twice. On today’s show we are going to examine the simpler case of a sale of the finished product, and on tomorrow’s show we look at the second case which has a couple of additional calculations when you are doing a long term hold project.
Imagine you found a property that is in a great area that is in high demand. You know that houses in the area are selling for $1,000,000 for a 2,000 SF home. How do you know what you can offer for the property in order to have a profitable project?
Let’s say that you have completed the comp analysis and you have a high degree of confidence in your ability to sell a quality product at that $1,000,000 price tag.
Your business is going run as a healthy business and I recommend that you set the profit margin for your business somewhere between 25-30%. I would start at 30% and as you get more experienced with strong and predictable systems you can lower your margin requirement.
So now you know the sale price is 1,000,000. If your margin is 30%, then your total investment should be no more than $700,000. That’s going to get you a profit of $300,000.
You need to subtract your transaction costs associated with selling the property like the realtor commission, the land transfer tax, the legal fees and so on. Let’s put all of that together and estimate it at 8% of your sale cost or $80,000. We are now down to $620,000. You expect to hold the property for a year and you are going to be paying interest on that money, as well as paying for property taxes and insurance. Let’s estimate that at $60,000. Now we’re down $560,000. You will need to pay an architect and engineers for the plans and permits. Let’s estimate that at $30,000. We’re down to $530,000.
We said the house is going to be 2,000 square feet plus a foundation and a garage. Our hard construction cost might be $150 per square foot for a product with somewhat better finishes and the foundation may cost an additional $50,000 to dig and pour. When we add all that up we are looking at $350,000 for the construction. There is additional site work to bring utilities from the edge of the property line to the foundation. We estimate that at $20,000. So now our total construction cost is at $370,000. We subtract $370 from our earlier subtotal of $530,000 and we get $160,000.
So the maximum price we would be willing to pay for the land in that instance is $160,000.
This exact same calculation applies to a flip. Your starting point might be a older home that needs a major renovation instead of a brand new construction. But the analysis is exactly the same.
On tomorrow’s show we are going to be going through a similar analysis for the case of a property that is a long term hold instead of a quick sale.