“How much should I pay for a property?”
The answer to the question seems obvious:
“Work out the value after refurbishment. Take off the refurbishment costs, take off 20% profit and that’s the most you should pay”
So for example, on a property worth £2m after works, you would take off a 20% profit margin (=£400k) and your total costs of say £300k to arrive at a maximum purchase price of £1.3m, but and this is a BIG BUT…
This Simplistic Answer Misses A Number Of Critical Considerations!
- How sure are you of selling the developed property for £2m?
- How long is the property likely to take to sell?
- How sure are you of controlling the £300k of costs?
A property that will almost certainly sell very quickly for £2m or more is clearly going to be superior to one where £2m is an optimistic projection of value based on the market continuing to go up. Likewise, an experienced developer is going to be more certain of costs than a beginner.
Property investors will generally think about these issues, but it’s often instinctive and not hanging on a methodical framework. In this article, I am going to share one of the ways we think about purchase price at http://www.hawkblue.com/. We have found this method to be very useful for avoiding deals that look promising at the outset but in reality involve too much risk.
To keep things simple, let’s assume a buy, renovate and sell scenario within a 12 month period of time. Lets also remind ourselves that a deal like this is essentially a gamble. Placing a regular bet with a book maker does not make any sense because the odds are never going to be in your favour – in other words virtually all gamblers will lose money over the long term.
On a property deal, if you calculate the odds carefully, and they are heavily in your favour then you are making a wise decision – even if the occasional deal doesn’t work out as planned, you will make money over time.
Let’s Start With Evidence…
Here is a recent deal we did. The postcode is LE3 0LT. I will be using this deal as a case study for this article (you may want to open it in a separate window).
Start with this website http://www.rightmove.co.uk/house-prices.html. Type in the full postcode of the property, then on the next page restrict it to the last 2 years, look ¼ of a mile around, and choose the appropriate property type (e.g. flat).
Now you need to search for reasonable comparables. Look for properties with the same number of bedrooms. Since our case study is not new build, we filter these out. If few sold properties come up by the way, we would look for properties for sale and make a judgement on what they will sell for (beware: unless you know the market well, you could make your analysis less accurate so be realistic and talk to local estate agents!)
You should see something like this:
By the way, it’s really important here to get as much evidence as possible. If there aren’t many sales to compare against, then I would recommend adjusting the purchase price downwards to create an extra safety cushion. So for example, a bungalow in a village would be hard to value if the area has little turnover of property, so you would increase your profit margin to 30% or more (thus lowering the purchase price). Otherwise you may find yourself holding an illiquid property that could wind up losing you money.
At this point in the analysis it’s really, really important to think about how your plans might be derailed by unforeseen circumstances and how likely each of those events are to occur (rough guesses are ok).
- Property prices might plummet (as they tend to do every once in a while).
- Your builder could go under.
- Costs might go out of control due to unforeseen circumstances.
Most sane people would not play Russian roulette with a loaded gun for any amount of money, so why do it with your finances by taking on a deal that if it tanked, would wipe you out?
If You Cannot Afford The Worse Case Scenario… Walk Away!
The reason a deal like Cherryleas Drive was so good from a risk perspective is that we were not exposed to any really bad scenarios… Various armageddon scenarios such as fire damage for example were covered by our insurance policy so we did not need to worry about those.
It only needed a quick refurb so we were not exposed to construction risk, for example the builder going bankrupt and leaving us with a half finished development. The turnaround was quick, so risks related to property prices falling were eliminated.
We were exposed to a short lease risk, since the leasehold had only 49 years remaining. This is not generally mortgageable, so we mitigated this risk by getting a commitment to extend the lease at an agreed price with the freeholder. If the property had not sold we would have extended the lease and sold the flat later at a higher price.
Having thought about mitigating risks, we need to figure out the purchase price. For this property I can see 14 reasonable comparables. We pop these into column B of the calculator below (note: divide by 1000 so £92,950 becomes 92.95).
Thanks to Ben Collins for help with the chart.
To check the likelihood that we will be able to achieve a sale price of £75k (our minimum) I can pop 75 into cell E8 and the probability turns out to be 79% (cell E9). This is good but remember it’s only a guide since comparable sales included nicely done up properties that did not have a short lease issue – we account for this by lowering the probability accordingly.
The average sold price for this type of property is £82.7k (cell E2). The standard deviation is 9.5. This simply measures how spread out your comparables are. If they are pretty tightly grouped (stdev is low), then it will be easier to predict what the property will sell for. You will be able to see this in the normal distribution chart (click the other sheet from the bottom left)- a skinny blue line is preferable to a fat one.
The analysis now moves into a decision tree format where you will be able to see the various alternatives. You will need the probability that you have just worked out and this post walks you through how to finish the analysis.
So putting it all together, we have:
- Thought about what the property is likely to achieve in the market (by considering the evidence).
- Considered the worse case scenario and whether we could live with this (walk away if we cannot – its really dumb to play Russian Roulette for a bit of extra money).
- Worked out expected values based on various scenarios.
- Decided on a course of action (do the deal or walk away).
Oh and one final thing… Using only last two years of past sales data is not going to take account of a crash in the market which you will need to do in your worse case planning. See my blog post here for some suggestions on figuring out whether the market is currently under or overvalued. If you think the market is overvalued, then increase your desired profit margin to compensate.
Persevere with this. It gets easier (I promise!) and you will soon find that putting your potential deals through a rigorous analysis will force you to question ideas and beliefs that might have led to unwise investment decisions.
If you need some guidance feel free to drop me an email on firstname.lastname@example.org and I will point you in the right direction.