Dennis Norman Musings

By:  Dennis Norman

Dennis Norman

How many times have you heard something like this from an agent or seller trying to convince you how good a deal is?

I find it funny how often people will base their definition of a “good deal” on the relationship of the price you can buy it for to either what the price the seller was asking or to what it sold for before.

I just don’t see how these two things come into play with regard to the value of a house or whether or not it is a “good deal”. 

Case in point: Yesterday I was sent a list of a dozen homes that could be bought for a small percentage of what they previously sold for.  One was a house I was told could be bought for $3,000 – $5,000 that sold for $82,000 at the end of 2005 and the other could be bought in the same range and sold for $80,000 in late 2005.

So if, based upon the prior examples, I told you that you could buy a house for 5% or less of what it sold for a couple of years ago it would seem like it must be a good deal….right?  Well, in this example, wrong….I spoke with a couple of investors familiar with the homes today and they were not interested at any price due to the condition and location.

So how can this be?  Well, for starters, the high sale prices I quoted that took place recently were obviously inflated prices above actual value.  This could have been the result of sub-prime mortgages that often resulted in inflated sale prices due to the enormous fees that had to be paid out of the sale proceeds to the lender as well as the fact in many cases the houses were being sold to unsophisticated buyers that were really just “buying” the financing and taking the house with it…therefore researching and negotiating a realistic price did not enter into the equation. 

Another thing that comes to mind along these lines is from a personal experience several years ago:  My wife and I were looking at condos in southern Florida on the gulf coast.  We were considering buying one with the idea of putting it on a vacation rental program for most of the year and then using it ourselves a few weeks a year.  Now mind you, this was during the “boom”, but the prices were, in my opinion, insane.  We were very interested in one development but were told we would have to pay $850,000 for a two-bedroom condo there….however, the agent said the unit had “excellent” rental income history; $35,000/year (before the 40% fee to the management company).  I’ll spare the long story but basically the deal made no economic sense whatsoever and I conveyed this to the agent.  His reply was simply to show me all the other similar units that had sold for the same price.  When I reminded the agent that a vacation rental property is an investment and asked how it made any financial sense at these prices he didn’t have an answer other than that area is very popular with Europeans, particularly Germans, and they were willing to pay the price.

I think we should call this “lemming” investing….just follow behind someone else and do what they do without questioning whether it makes sense.  In my past days in the speculating business we often referred to the “greater fool theory”.  We would see investors overpay for a property banking on finding someone more foolish than them to buy it from them.

My point to my rant is that I would suggest to investors today when looking at and analyzing deals disregard what the home sold for a couple of years ago…disregard how much “under asking price” you can buy it (what good is it to buy it at 50 cents on the dollar if it is overpriced to start with by 100%?) and certainly don’t base your opinion of value just on what another investor just paid. 

I’m assuming most investors out there today are looking to buy homes for rentals rather than resale in this market.  If that is the case I think it is easy to determine if deals make sense.  The way I would approach buying rental property today would be simple…I would determine the following:

1. What rent can I realistically expect to receive for this house in this market?  (I would be a little conservative…if it takes you 4 or 5 months to lease the place you just killed your cash flow…you want the rent to appear to be a “good deal” to a tenant…this will attract better quality tenants and get it leased faster)
2. Figure all expenses of owning and operating the property as a rental (ie: property taxes, property insurance, owner-paid utilities, property management fees, lease-up commissions, etc as well as a reasonable amount for maintenance and capital improvement reserve).  Then break this out to a monthly cost.
3. Deduct your calculation in #2 from #1, this will determine your gross monthly cash flow.  Theoretically if all you wanted to do was break-even on your rental then this would be the monthly amount that you would have left for debt service (not sure why you would be satisfied breaking even though, unless you felt you had a significant amount of equity and were just waiting for better times)
4. Determine how much cash flow you think you need from the rental based upon your risk, amount of money invested etc and deduct from the gross monthly cash flow in 3 above.
5. What’s left after doing the calculation in #4 is what you have left for debt service.  I would then plug that into an amortization calculator as the payment, put in the loan term (personally I would suggest 15 or 20 year amortization max) and the interest rate then compute how much of a loan this supports.  This amount along with whatever down payment you are making will be the total maximum price you can pay for this property and achieve your investment goals.  I would not go over this number.  In fact, even though the income justifies this price, prior to paying it I would still do some comps to make sure that the price is not high in this market.  My guess is it won’t be if the numbers work out on the investment side.

My last bit of advice is don’t fall in love with any deal….if it doesn’t work, isn’t the right price, or just doesn’t feel right, walk away….there are plenty more deals out there.