As I mentioned in my last post, 0ne of the easiest mistakes to make in renovating houses is to overestimate their After Repair Value (ARV). In this post, I’m not going to delve into motivations for inflating a house’s ARV. After all, I’ve done it to myself, so far be it for me to cast asparagus on anyone else. I’m just going to talk about how it happens, and there are only a few ways:
- Use the wrong comps.
- Mis-time the market.
- Make the numbers fit the model.
I originally planned to talk about all three of these risks in one post, but I soon figured out it would be way too long. Click here to open all posts on this topic.
Use the Wrong Comps
We rely on comparable properties—”Comps,” for short—to make our educated guesses at a house’s ARV. If we base our estimate on the wrong comps, we can really screw up. The rule of thumb is to only use comps within a mile of the subject property. But even if all the comps are within a half mile, they may not be appropriate to our estimate. We must always consider:
- Neighborhood boundaries
- Major streets
Neighborhood boundaries are often marked by major streets. Any time you cross a major street, you’re likely to find the character of the neighborhoods surrounding the properties vastly changed, and the neighborhood influences property values. We looked at two houses in Temple that were on opposites sides of a road. The neighborhood on the north was 20 years younger than the one on the south, but the properties in the older, established neighborhood were higher than the newer houses to the north where it turns out the ground was more mobile, leading to more foundation problems (condition).
But we also evaluated a house in Round Rock where a very similar floor plan in the house directly behind the subject house—a privacy fence separated the two back yards—was worth about $20k more. Why? The subject house had once been the edge of development. All the houses one street over were 25 years newer and in much better shape thanks to a stronger neighborhood association. The subject house was worth considerably less after renovation than the house directly behind it. This was despite the subject’s proximity to a park and an elementary school. The numbers on the subject property were very attractive if we used the more newer, more appealing houses as comps but not when we only used houses on the same street.
When evaluating another house in Belton, we were given comps that were on the other side of the Interstate from our subject property. Even though the “comps” had sold for more than $200k, our subject would have been overpriced at half that. Given that we were looking at a renovation budget of at least $60k, the $50k asking price was way beyond what we could reasonably pay.
The condition of the properties makes a big difference, too. When buying, if you only look at houses in similar condition to your subject’s current state, you can under value the ARV. But if the houses you use to price your purchase have already been renovated, you could end up paying way too much. The tricky part of buying a house to renovate is keeping both of these numbers in mind when you decide how much to pay.
Here are some basic tactics that will help you ensure you pay the right price for the houses you buy:
- Ensure your comps are as close to the subject property in size, age, and desirability as possible.
- Keep your comps close in proximity to the subject as you can.
- Don’t cross major roads, but remember to deduct value if your subject or comp is on a big road.
- Try not to use properties more than a half mile away from the subject.
- Mark sure the kids who live in the comps attend the same schools and ZIP code as your subject. I’ve seen the house across the street or next door go to a different school. Certain schools can be a tremendous motivation—in either direction—for parents.
- Always at least drive the neighborhood yourself before you decide to buy. If you can’t, make sure someone whose livelihood depends on your team’s profitability does.
- Keep both the current value and the ARV in mind. Make sure there is enough room between the price you’re paying and the ARV to pay for the rehab, your holding costs, and your profit.