PART TWO: Identifying a Really Good Deal involves Setting Emotion Aside… at least in the First and the Final Analysis

This is Part Two of a blog entry published on August 15.  I ended the discussion in the last entry with the notion of what might be an advisable mindset when searching for a great investment property.

Let me use a real example I encountered recently, without identifying anyone personally.  These people are relatively young, relatively new investors.  They work hard to save, pay their bills and seek to build a strong future for themselves and their family.  They understand that this current real estate market offers extraordinary opportunities and they want to get involved.  So we have set certain search criteria and, based on the financial factors first, we have identified some properties worthy of further investigation.  Not surprisingly, all the properties identified are REO’s (”Real Estate Owned” by a bank or other lender).  We have targeted properties that are relatively new because they will likely require less maintenance in the near term.  We have focused on good school districts because tenants who are responsible enough to research and identify good schools are also likely to be responsible lessees.  And we have researched comparable sales and active listings to make sure these properties are listed at prices that may provide some “instant equity” when they are purchased.  However, bundling all these factors together usually means that the subject property is in less than ideal cosmetic condition.  Walls may need to be painted… carpet may need to be replaced… appliances may be missing.  The property was in foreclosure, after all; it is very sad, but some people even remove light fixtures and cabinets before they vacate a foreclosed property.

These young investors and I looked at three REO’s that fit all the above criteria, and they all needed some degree of cosmetic repair, but they were priced at the lowest end of comparable properties in their subdivisions.  Then they decided they would like to take a look at a new home– actually, a home that had been built about a year prior, but that had never been lived in.  The original builder of this community had gone bankrupt and another builder bought the assets out of bankruptcy and was continuing the community.  The house was clean and smelled new… there was plastic over high traffic areas to avoid damage to carpeting… no repairs needed here!  One of these investors loved the home.  It would be easy to rent, wouldn’t it?  She did not really even want to think about the “numbers.”  The home “felt right.”

I tried to explain why I thought two of the three older homes we had seen earlier in the day presented much better value– by the numbers.  But I promised to pull up comparable sales and listings in this new community, and I did so that evening.  It turns out that the current builder had purchased this new home for about 50 cents on the dollar out of bankruptcy, along with several other inventory homes in this community.  He had them on the market at the highest list prices in this community– about twice what he paid for them.  Now, while I would not begrudge a risk-taker like the current builder from making a return on his investment, I would prefer that profit not be made at the expense of my client(s).  If they had purchased this “new” home, they would have had a very nice, neat, new house in the real estate portfolio.  But they also would have no equity in it whatsoever.  In fact, it is possible that homes in this community will decline further in value for a number of reasons before values stabilize, and if they had purchased at or near the top of the price range, they are the people who would have had the greatest risk of seeing larger declines in the value of their investment.  That kind of misfortune is really wholly avoidable in this current real estate market!

Any “old time flipper” can tell you it is possible to take almost any older home and make it look, feel and smell like new– in many cases for less money than the uninitiated might think.  In the case of the “older homes” we had seen prior to the new one described above, some paint and carpet would have transformed them.  They were otherwise only a few years old, having been built within the last 5-7 years.  But comparable properties in their communities had sold and/or were priced in excess of 25% higher than the subject properties.  Walking through a home that is dirty and has been abused may not give the prospective buyer a warm and fuzzy feeling, but it can surely pay off.  The buyer needs to look first at whether the numbers make sense.  Then he or she can consider the emotional factors.  And finally, the decision should be based largely on the financial analysis– the projected return on investment (”ROI”) during ownership and upon resale.  These things are all quantifiable, within reason.  There shouldn’t be a lot of guess work involved.

Of course, this is not only true for investors.  In this buyers’ market, the same principles hold true for owner-occupants who would like to maximize the value of their purchase.  It is likely to be the largest single investment anyone makes, after all.  In my view, it would be a terrible shame to waste the opportunities available to everyone in this market by making a decision based only– or even primarily– on emotion.  There is always plenty of room for emotional considerations.  Analyzing real estate is really as much an art as a science, but there are some pretty fundamental (and quantifiable) principles that an investor and an owner-occupant would be well advised to focus on.