Why most Real Estate Agents think I've Lost My Mind

Here’s the simple steps I do to decide on what is the true value of an investment, in this case real estate. It’s what I do and what drives most real estate agents and sellers crazy.

1. Replacement Value. If you had to start and create what you are investing in, what would it cost you to do that in a value-focused way? (not what the price would be today, but what you believe the value would be). If a property of 2,000 sq ft in size were to be built today, I would need to build it between $150-$200 a square foot, or $300,000 to $400,000. Add in the value of the land at, say, $50,000, and the replacement cost for that real estate would be $350,000 to $450,000. That would be my total value. I would need to purchase some $250,000* for it to be a valuable investment and a great deal.

2. Income Generation Value. As an income property, the building generates an income of $2,500 monthly in cash after all expenses, apart from the mortgage payment. If you paid $400,000 for the property, that would mean a return of 7.5%, or $30,000 a year. You can get 5% on a simple bond today, which must be subtracted from the 7.5%, leaving 2.5% as your return. Not very good for that purchase price of $400,000. At $250,000, the return of $30,000 per year is 12%. (30,000/250,000). Subtracting that from the 5% bond opportunity leaves a 7% return over that bond. That’s a pretty good investment. The value is from $250,000 to $300,000 on an income approach.

3. Pizza Value. This is a term I use to describe the possible slicing of property into pieces that, when added up, create value. Let’s say that the property has a large 2.5-acre lot. Zoning and your consultants state you can divide the lot into three parcels. One that includes the house and two other separate lots. The zoning also allows secondary dwellings on each property. Lots are selling for $100,000, but the value is $50,000 for you. You add $100,000 (2 lots X $50,000 each) to what you could earn if you buy the property. I NEVER add that to the purchase price. It is the pizza bonus you will earn if you make the deal. It simply means that you may be more likely to do the sale for $300,000, given the extra pizza value.

4. Price/Value ratio. This is simple. Let's say after doing the three steps, your gut tells you that the value for you to buy the property is $250,000. The listed price is $499,999. The seller wants twice what you believe the matter to be. You can offer $200,000 to anchor the seller and finish at $250,000 or offer $250,000 firm and final. If you don’t get it, you walk. Your checklist and system are only designed for you to create great deals. You can wait for the next one to come along.

A general rule is that the property I am looking at sells for less than 10Xs the annual income. In our example, that would mean a price of less than $300,000 before digging into more details. 

A property must cash flow significantly AFTER mortgage payments before I would even look at it. I simply substitute the going mortgage rates from the bond rate when calculating. You must add your downpayment to the calculation as a lost opportunity cost. It’s a rule I always follow.

The steps are the same when looking to purchase any investment. I use the real estate example as it is something I am most familiar with and do daily. 

There is no pressure ever to buy any investment. A seller, on the other hand, is often under pressure. That allows you to find a price that is a win for you and the seller. You must wait until that opportunity appears and then pounce. Simple.

*The assumption is that the property is of A or B quality and does not need any major repairs for at least 15 years.  It is not the best property in the neighbourhood, preferably one of the most modest, surrounded by more valuable properties.

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