Time is of the essence, right? Most (good) realtors possess those quick math skills that help them distinguish the best opportunities from the not so great ones. Used properly, they allow us to ensure our clients make sound decisions and end up with the best possible outcome.
But you, too, can be a number crunching wiz!
We’ve laid out some good rules of thumb below:
The New Home Premium
Builders will use the accepted premium to help them value homes or determine the price for raw land in a new neighborhood. Because construction costs are fairly stable, what really drives this premium is what value buyers place on buying a new home. If you have two homes similar in almost every way, including price, but one is brand new and the other is 10 years old, a buyer is going to go with new. But how does the decision change if the new house is $30k more? Or $50k?
Being able to calculate this premium is critical when a buyer faces these kind of options. The premium for a new home can be anywhere from about 7-20 percent, depending on the difference in age and other factors. The premium is definitely going to be higher in desirable neighborhoods where there simply isn’t much new stock. And if so-called old stock is only a few years old, that’s going to bring the premium down. It is also very useful in helping sellers price property in areas where new housing is close by.
The ‘Lot to Improvement’ Ratio
This is not as complicated as the name might suggest. It’s essentially how much of the total property value belongs to the land versus the structure. Here in the greater Richmond metropolis, lots tend to fall between 20-30% of total value. So a home that is priced at $400,000 would likely have land between $80,000-120,000. Many factors can influence this ratio. But if most factors are about equal, this is a good range.
Be careful, though. This rule of thumb can vary greatly from region to region. And some of these ratios can be pretty radically different. Just take a drive up 95 to DC/NOVA, where land, at a premium, can grab approaching 50% of the ratio in many neighborhoods. Same goes for the Outer Banks for lots close to the water.
This measurement can come in handy in areas where spot lots linger on the market and a building opportunity in a mature area is offered. It can also be useful when deciding whether or not to build or buy an existing home AND it can be extremely useful in understanding likely appraisal values when building a home outside of a typical subdivision (rural areas, mixed use areas or mature infill areas.)
Another application which requires use of some rules of thumb (due to a lack of good comparable sales) is the ‘tear down’ or ‘pop-a-top.’ You’ll find more of these situations in dense urban areas with little developable land. So some builders will find existing homes close to a city center and find that the land is extremely valuable.
Put these two calculations together and builders have a good start figuring out which opportunities to seize.
$X per $1000
If you hear someone talking about $5 per thousand or $7 per thousand, they’re figuring out a mortgage payment.
On a 30-year fixed-rate mortgage, the monthly principal and interest payments (also called P&I) should be right around the number of thousands borrowed. Put another way, a 30-year loan where the buyer borrows $300,000 would be $300 x 5 or $1,500. Get a calculator out and the precise number is $1,443—pretty close. Tack on taxes and insurance, raise the interest rate by 1%, and the monthly payment would be closer to $1,800.
(Mortgage Rates can be found at the bottom of the blog…)
This calculation is most useful in the beginning stages of the home search. It works in most, but not all, scenarios, and is really helpful to get a rough idea of what the home should cost to own on a monthly basis. Don’t forget to take mortgage insurance into account, and know that the calculation will change for different loan lengths.
Cash Flow, Down Payment and Break-Even
If you can put zero down and break even on the property, you’ve probably made a good deal.
If you put 10% down and break even, you probably made a market rate deal.
If you have to put 20% down to break even, I’m not sure it’s worth your effort unless there’s something else going on besides pure profit.
Agents, especially residential agents, love to include “Cash Flow Positive” in the marketing materials. What does that even mean? Put enough money down, and you’re going to become cashflow positive. It’s just math. What a buyer really needs is to know how much cash is REQUIRED to make the property flow…for the reasons stated above.
This is especially critical when you are seeking investment property. In those cases, you are really seeking return on your equity (cash). Every investor has (or SHOULD have) investment criteria guiding their decisions, which may cause them to seek different types of property (multi-family versus single; land versus net leased investments; or single tenant versus multi-tenanted), the value of the rents relative to the value of the property should make sense (this is also known as the CAP Rate or Capitalization Rate.)
When all is said and done, if you put down 20% and aren’t putting cash in your pocket each and every month, then you need a really good alternative reason to buy.
Expense Ratio
When investors are analyzing a property’s income potential, they will throw around the term expense ratio. It’s the amount of expenses—utilities, taxes, insurances and repairs/maintenance—relative to gross rents. I will not shock you when I tell you that older properties yield higher ratios, newer ones lower ratios. And buildings with more tenants often yield better ratios.
A four-unit apartment building in the Museum District renovated in 1980 may have a ratio as high as 40% of gross rents while a 30-unit renovated property with new windows might run closer to 25%.
Other Metrics to Know
In addition to the number crunching laid out above, there are certain metrics (or inputs) that all good agents pay attention to. Each one, when combined with any of the calculations above, can help you arrive at accurate valuations without too much work. Spend some time around experienced, sharp agents, and you’ll see them create sophisticated analysis without ever wielding a pen or calculator, simply because they understand the rules, including these below. You will be impressed…
All good agents, investors and developers should know the following inputs (and the 2016 answers):
- Construction Cost per SF – A good agent has a pretty decent idea of how much construction costs are running. Knowing how much 1 SF of new construction should cost is a valuable tool in understanding where the market is. This also goes for renovation $/SF, as well as the different types of construction (single family, commercial, attached, vertical, etc.)
- Current Mortgage Rates – It’s important to have a feel for not only where the mortgage market is, but where it is headed. Keeping an eye on economic data and understanding where the risk points are is incredibly helpful in the overall decision making process.
- Market Values per SF The $/SF for resale varies by age and location. Having a sense for whether or not the Robious Road corridor trades at a premium or discount to the Nuckols Road corridor is critical, especially when working with out of town or first time buyers..
Conclusion
Crunching numbers does require you to use some generalizations. With those, you’re going to have a higher degree of variance. If you keep your eye on the metrics and use the right calculations, you will be right (or pretty near it) far more often than you are wrong. And if your crunched number falls outside the generally accepted range, that doesn’t mean the property isn’t valuable. But you definitely need to do some more digging.
Ultimately, these guidelines are intended to offer initial insight. But serious consideration of a transaction requires thoughtful analysis. As you become more comfortable crunching numbers, you’ll avoid mistakes and save more time.
