In Real Estate Investing, particularly house flipping, very few things are as important to the overall success of the investment as is the home’s After Repair Value (ARV). Every segment of a transaction is critical in its own right and must be analyzed and managed correctly to allow for the greatest chances of success.
Different components such as over- or under-improving, employing the right contractors, properly marketing the property, and having a reliable money source are all key in any successful real estate investment. Each of these components are of tremendous consequence. However, in my opinion,correctly estimating the ARV of a home is the single most important piece of the house flipping puzzle.
With Real Estate Investing becoming more and more popular as the market continues to heat up, I have seen several novice investors be off on the valuation of their first deal. Many times, they are so eager to jump into this first deal that they do not fully consider all the components involved in obtaining a proper ARV. This is never a good idea. Simply jumping in does not ensure success- disciplined analysis and skilled management does.Depending on one’s cost basis in an investment, a variance of just 10% can be extremely costly. In today’s market where opportunities are harder to come by than in years past, a 10% variance may translate into several thousands of dollars and may even jeopardize the investment. Putting this into perspective:
If an investor values the flip project at $250,000 but ends up selling it for 10% less (or $225,000) and his/ her basis (includes purchase price, renovation costs, finance costs, ongoing interest payments, and holding costs) in this deal was $210,000, this would translate to a $15,000 gross profit as compared to a $40,000 gross profit. This would equate to a $25,000 (or 260%+) miss on your projected return!
This does not necessarily make the investment a bad one. However, making nearly 3x less than what one projected is never a good thing and frankly not for everyone. Each of these investments requires real money. While tangibly it may be safer than other investment vehicles, it can be painful to see your profits slip away due to something that could have been avoided by simply determining the right ARV upfront.
In order to accurately determine what your property’s ARV should be, an investor should take the following criteria into serious consideration. Many times appraisers serve important roles in both the acquisition and disposition part of the investment – especially when there is financing involved. These are the criteria that appraisers use when valuing a home:
1. Sale Date – The more recent the sale, the better. Many times this can be the single most telling criteria as home values are based on historical data. No data is more accurate that the most recent data.
2. Location – While homes come in all shapes and sizes, the neighborhoods and corresponding subdivisions where they are located are imperative. Never compare properties in neighborhoods that are superior or inferior to yours if you have healthy comparable sales data in your specific data.
3. Size (square footage, bedrooms, bathrooms) – While it’s hard to apply a rule of thumb to this one, you never want to compare your property to one that is significantly larger or smaller than your investment. As a guide, it may be a good idea to ask yourself, “Would the person who bought this house consider (or want to buy) my house?” If your home is 1,500 square feet and your comparable sale is 2,500 square feet, the answer is most likely no.
4. Year Built – Age matters. While many neighborhoods have homes with varying ages, your best comparable when comparing based on age is the one most like yours.
5. Amenities – Things such as garages, pools, outdoor living spaces, in-law quarters, etc. all impact value. If your house is the same as all of the comparable sales around you, but it has a pool, then your property should in theory be worth more. The same goes, however, if your house is the only one without a pool. In that case, your house should and will be worth less.
6. Quantity – NEVER value your property based solely on one comparable sale. Always look for multiple sales as the broader picture in real estate valuation. If certified and licensed appraisers use anywhere between three and nine comparable sales, why should your project rely on just one? The answer is simple. It shouldn’t.
7. Be Conservative – When analyzing comparable sales you should never assume that you will get the highest value on the market. While there is always the likelihood that you may sell higher than the competition, the reality is that not all homes sell for record prices. Any real estate investor should take a conservative approach to determining their ARV as chances are that home will sell somewhere in the middle of the pack (hopefully on the upper end though).
Though, generally speaking, most people have access to the same information to estimate the value of a home, the valuation of real estate, especially when it is subject-to specific repairs, is still very much a subjective practice. Even though we are all essentially equipped with the same tools, rarely will two (or more) ARV’s be exactly alike. Similar to many industries, the more data one obtains, the better informed one will be in making a decision. My advice to any new (or seasoned) investor is to compile multiple opinions of value and to lean on the expertise of industry professionals such as appraisers, real estate agents, lenders, etc. who are experienced and qualified to give such opinions. Having been in the industry myself since 2002, I have seen many different deals both fail and succeed. Generally speaking, the ones that fail are the ones that do not trust their due diligence while those that succeed are the ones that are disciplined enough to objectively analyze the due diligence that they have compiled from the numerous professionals that make a good real estate investment team. This disciplined investor is also the one that does not hesitate to pass on an opportunity when red flags arise including value issues.
In my line of business of hard money lending, we, as Lenders, require that all of our projects be appraised by a state certified general appraiser of our choosing. This allows us to have an uninterested party give us an unbiased and professional opinion of value. As a Lender, our appraiser’s reports are the single most important piece of underwriting and due diligence that we perform. They are intended not only to protect us as the Lender, but also the client borrowing the money (i.e. – The Investor). The direct protection that an investor would get from this process is that, should an appraisal not meet the minimum required value anticipated by the Lender, then the loan will many times not be approved. The Lender’s loan denial is never a fun thing but, in many cases, especially in hard money lending, it has proven to save people thousands upon thousands of dollars as too low of an ARV would expose the investment to unnecessary risk.
Video: Why Accurate After Repair Value Projections Are So Important