The following is a guest post by FMF reader Apex. He has been investing in rental real estate for more than four years and is authoring a Real Estate 101 series, posting every Friday, based on his experiences. (To read the series from the beginning, start here.) The series is designed to give prospective investors the basic tools they need to succeed.
It’s a long journey to get to the point of making an offer on a property. You have probably looked at dozens of properties. You have run numbers on many of them and you have finally found one that you are interested in purchasing. The only question left is how much to offer.
Of course you want to pay as little as possible. To do that you have to know what a property is truly worth. For all the different valuation metrics that are available there is only one that matters. This may surprise some people because it isn’t based on a calculation or some measure of actual value. A property’s worth is simply what other buyers are willing to pay for it. That’s it. That’s what a property is worth. Some may protest. What about what it cost’s to build it, or what kind of return you can get on it, or what its intrinsic value is? Those are all different measures of the value of a property, but you don’t get to purchase on those valuations, you purchase on market price. That is the only valuation that matters when you are a buyer or a seller.
This can be both good and bad. Sometimes the market values things at more than they are truly worth. Sometimes it values them at less. This means a property may be valued at a price that will not work as an investment, and that’s why you have to know your numbers. But you have to get passed the idea that your numbers have an influence on what a property is worth, because they simply do not. If you are buying a pure investment property such as an apartment then investment numbers are going to be a factor but it still comes down to other investors. If they are willing to pay more than you, then your numbers are irrelevant. Your first and most important job when determining what to offer is to know your market. You need to pay close attention to what properties like the ones you want to bid on are selling for. That gives you a very good idea of what the property you want to buy is worth. If that price is too high to allow you a good investment return, then you will need to consider other types of properties.
The second thing you need to assess is the competitive demand for a given property. Certain properties are in higher demand than others. Good single-family homes for example have many homeowners bidding on them so you are competing with a much larger pool of buyers than if you were buying duplexes for example. If you want to buy a property that is in higher demand you will have to factor that into your bidding process. If you are bidding on a property that has multiple other bids submitted, your bid will need to be competitive. You will need to combine what you know about the market value of properties like the one you are bidding on with how much competition you have. I have walked away from some properties simply because there were too many offers. To be competitive I knew I would have to bid more than I wanted to pay so I simply moved on to greener pastures.
A good example of this process is a property I purchased almost three years ago. I knew from experience that the market for that particular property was $130-$135K. I had seen a handful of other bank owned properties just like it sell in that price range. The bank listed the property for sale below market price at $117K. As a new investor it is important not to let the asking price be an anchor for your valuation of the property. Asking price is just a starting point and it may have no relation to a property’s actual worth. Remember, market price is the only valuation that matters, not asking price. That property was worth close to $135K and I knew it. Of course the asking price does tend to act as an anchor for many buyers which tends to hold down their offers, so I was eager to put an offer on this property before too many other buyers found it. I had planned to put in an offer in the mid $120’s. This offer would be under market but above ask and I was hopeful that if things moved quickly I could pick it up at a discount.
I was prepared to put my offer in on the second day it was listed but found out it already had 5 other offers in only one day and would likely get more before the bank stopped taking offers. My agent and I discussed the situation. We speculated that there were probably a couple buyers who didn’t really understand the market and thought they could purchase it for what was being asked or perhaps even below. There were probably a couple investors who knew it was below market but were trying to pick it up at a discount like I was. Then there were probably at least one or two savvy investors or buyers who knew the market well and were willing to bid close to market. I knew this property made very good money at its true market price and I was convinced it was likely that one of my competitors did too because likely they were bidders on some of the other properties I was comparing with as well. The difference of a few thousand dollars in the asking price would make almost no difference in the long-term returns or the cash flow of the property. Given that, and the strong demand for this property I decided to offer just above the known market range at $136K. Two days later my offer was accepted.
You almost never find out after a deal what any of the competing bids were, but in this case the listing agent told my agent that we barely won the bid, probably because it was so close. The next closest bidder had offered $135K, exactly what the market price was. That is no coincidence. They knew the comparable sales prices and likely made the same calculation I had. They just calculated $1,000 too low. That was nice confirmation that we had calculated correctly. Keep in mind this purchase was in early 2010. The housing market could not have been in worse shape at that time. Properties were being purchased below ask all the time. It would have been very easy to rationalize that you simply don’t pay over asking price in that market. But asking price is irrelevant. This price was wrong. The bank may have purposely chosen the price to attract extra demand and bring in extra bidders, or they may have just mispriced it. The reason doesn’t really matter. What matters is I knew what it was really worth, I knew the competition on this property was strong, and I knew the price it made sense at for me. All those things allowed me to buy a great property at the right price, and at a price that offered a very good return.
I would love to have gotten that property at $125K, or $117K, or $110K. Likely some of my competing bidders thought they might be able to get it for that, but they were wrong. That property was not available at those prices. There were at least two bidders that day at the true market price. And here is the thing, there usually are. If your competition is soft on a property or non-existent then you can usually get it for a discount, but if you have limited competition then likely the discount you are getting is the actual market price.
Now there is another strategy that some investors take, which is to attempt to buy properties at well below market prices. This strategy can work but it tends to not be very easy. Investors who use this strategy will typically make a lot of offers before they get one accepted. The properties this works best for tend to be diamonds in the rough.
Why would a property sell for well below its market value? Even if a seller is desperate, there are other buyers out there who would bid on a good property. Typically there are reasons a property would sell at such a low price. It is in a poor neighborhood. It has difficult structural issues. It just simply needs a lot of rehab. This is the diamond in the rough. Hopefully you can actually turn it back into a diamond!
This can be a time consuming strategy that involves a lot of failed attempts before success, and this is typically followed by a significant rehab project. I simply do not have the time for that nor do I seek those types of properties at this time. However there is another reason I don’t chase these types of deals right now and that is because I simply don’t have to. There are hundreds of great properties out there in good neighborhoods, that are highly desirable, and that generate very good investment numbers. They won’t quite generate the kinds of ROI numbers you can get if you are able to purchase a diamond in the rough with a low-ball offer, but that is not my highest criteria for success.
The last thing I want to mention is the difference between purchasing from an owner and purchasing a foreclosed property directly from a bank. When purchasing from an owner you are dealing with their emotional attachment to the property but also their need to sell. There is usually some room for negotiation here but there can also be a stubborn refusal to accept reality. You cannot make them sell the property at market price if they don’t want to.
A bank is the exact opposite: Unemotional, unattached, and no need to sell the property on a particular schedule. However, you also cannot make the bank sell at market prices if they don’t want to. When buying from a bank, if the price is too high, there is only one thing that will change that and that is time. The property that I used in my column on “Running the Numbers” was one that the bank had originally listed for $20K higher than I purchased it for. I knew that price was wrong. The correct price was around $125K but they had listed it for $144,900. I let it sit on the market for 3 weeks and then I offered at $115K. My agent told me that was too low for the bank to consider, but I wanted to attempt to meet at the market price. It turns out he was right. They countered at $138K, so I raised my price to $122K. They came back at $137,500. They were telling me that they were at their bottom price. Now the truth is I was willing to pay up to $130K for this property and if they had continued to negotiate we could have easily ended up there. But banks don’t work that way. They generally have a formula that involves regular reductions in price over time. One week after they had given me a bottom dollar of $137,500, they dropped the price to $134,900. I waited another month and they dropped it to $124,900, just like clockwork. I immediately offered exactly at the asking price and the offer was accepted in a day. There were two other offers that came in as well. This shows they had finally gotten to the true market price for the property. The price that I knew was right because I knew the market. When they got to the market price they got multiple offers for the property. When they were over priced they received no offers.
What I am hoping to get across is that a property will sell for what its market value is. Even an accepted low-ball offer is usually selling at market value. There is something about that property that makes it so that no one else wanted it at that price. Your job is to find properties that have good numbers when they are sold for market prices. There will likely be a day when that gets tougher to do. Until it does, there are plenty of good deals to be had. You simply have to know your numbers, know your market, and know your competition.
Updated: To read the next post in this series, see Finding Your Niche.
This sort of thing happened to me while I was looking to purchase a foreclosure to fix up and live in. The bank had it listed at $108k but I knew it needed at least 20k in repairs. I offered 60k expecting to have them bite since the house had been vacant for almost 2 years. As it sat, damage was occurring, the wooden floors were buckling due to the humidity in lower Alabama. I figured if I had to come in and do all the fixing, I might as well try to get a steal. I'm not sure if what I have heard were tall tales or not, but I had been told houses under foreclosure could go for 50% below the asking price depending on the situation. It didn't work out for me though, they didn't respond to my offer and a few months later somebody purchased it for 80k. I was too low due to my lack of knowledge.
Posted by: JayB | October 12, 2012 at 10:42 AM
This is a great point. I've never thought too hard about the market value of a house. We have always looked at the expected rental income and based the price we were willing to pay on getting the desired return. Our realtor tells us the "comp price" of the property, which we use to help inform our offer price, but it's a pretty simplistic evaluation based on the $/sf of a couple of recently sold nearby homes.
Speaking of waiting out the price, though, our first ever offer (at about $10k less than asking on a foreclosure) was rejected. 6 months later the same property's ask price dropped down to our offer price and they called us back. We got it at our original offer price.
Posted by: Jonathan | October 12, 2012 at 11:16 AM
@Jonathan.
Your experience is exactly what I meant about time being the only factor that will change the price a bank will accept. It is a bit surprising to me that it took them 6 months to come down $10K but whatever the bank's schedule for adjusting price you simply have to wait them out if you have offered below what they will accept.
As to thinking about market value versus expected rental income, I think a combination of those two values is a good evaluation tool. When looking at houses if the expected return results in a price that you can see is below market for that type of house that will give you information that can help you make decisions. In an instance like that you would typically have 3 choices. 1. Look at other properties whose comparable market sales prices give you the returns you are looking for. 2. Accept lower returns and bid on the properties you are looking at with market prices. 3. Bid below market prices on these properties and expect to do a lot more looking and have a number of rejected offers hoping to eventually get one that will work.
Alternatively if you only look at desired returns it is possible the market price could be even less than your desired return (this is probably not typical but it's possible).
If you go into offers without knowing market prices you are going in a bit blind and handicapped. It's always a good idea to try to get an assessment of what that property is likely to sell for based not on what you want to pay, but based on what others are willing to pay for it.
Posted by: Apex | October 12, 2012 at 11:31 AM
Apex, I'm glad that you're writing this series. Thanks for sharing your expertise/experience.
Posted by: Rich@MoneyWisePastor | October 12, 2012 at 05:40 PM
@Rich,
Thanks for the appreciation. I am enjoying writing it. I hope you are finding it informative. If there is anything I don't cover clearly enough or with enough detail please feel free to ask questions. I will try to answer if I feel I have the experience to do so.
Posted by: Apex | October 12, 2012 at 05:48 PM
@JayB...no, it's not a rumor at all. I recently helped a friend put in an offer on a house for 95k, that sold for 165k just 18 months prior. It was teetering on foreclosure, and the seller was looking for a short sale. I was skeptical that the offer would be accepted, as the Realtor made a point to tell us that an offer of 124k was declined just a couple of months earlier. Much to my shock, the bank and seller accepted the offer within an hour. You just have to stay patient, and remain "unattached" to the deal. It's okay to walk away! ;)
Posted by: Ben @ Bedrock PF | October 12, 2012 at 06:12 PM
I too am really enjoying this series, thanks for writing it Apex. (and thanks to FMF for hosting)
My dad and I have bought the 'diamond in the rough' properties which were fixer uppers but that was before the crash. That worked well fr us but it was a different market and different situation and my dad is very capable doing rehab. On my own I don't do that since I'm not nearly the handyman my dad is so I wouldn't tackle major fixers myself. How you go about buying properties does certainly depend on your own situation, skills and goals plus the current market conditions.
Posted by: Jim | October 12, 2012 at 06:49 PM
@Ben
That situation is not quite the same as what JayB was referencing. He was talking about a foreclosed property that you could pick up for 50% of what was being asked. This was not a foreclosure and there was no asking price from the bank.
In the situation you describe the 18 month old sale price is not really relevant. A lot of the properties I bought for 130K sold for 300K 2-3 years prior. That's why properties are in this situation because their valuations plummeted.
As to the previous offer of 124K being declined and them taking the 95K offer a few months later, one doesn't know what valuation metrics they used to re-assess the current value. Although a drop of 30K in two months does seem a bit aggressive.
I must say that something does sound strange though. You are saying you actually got a bank to agree to a short sale in 60 minutes? 60 days is usually a miracle. How on earth did that happen?
Posted by: Apex | October 12, 2012 at 10:02 PM
"This was not a foreclosure and there was no asking price from the bank."
If it was bank owned then doesn't that mean they acquired it via foreclosure?
Posted by: jim | October 14, 2012 at 04:09 PM
@Jim,
Yes it would. This was not bank owned yet though. Ben had said it was teetering on foreclosure which I suspect means the bank had probably already done a sheriff sale but was still waiting for the redemption period to end so they had not claimed the property in foreclosure yet. Ben also said the seller was looking to do a short sale and that is what the bank approved.
So it still required bank approval but it was not yet bank owned and as such there was no advertised price from the bank. Many people don't realize this but the asking price in a short sale is a price chosen by the seller who is the original owner, not the bank. The bank then has to approve the sale price. The asking price in a short sale is even more irrelevant than the asking price on a normal sale. You can some times offer exactly what was being asked and the bank will reject it because they had no input into the asking price and consider it too low.
Posted by: Apex | October 14, 2012 at 07:45 PM
@Apex
This question is a bit off topic but still related to rental ownership. Earlier this year we had a discussion regarding depreciation and the benefits of paper losses with rentals. I mistakenly thought my paper losses were helping me on taxes. You corrected me then but I've since been set straight by my CPA. When your income is above $150k, losses don't get deducted. Not to get too far off topic but at high incomes you get the "double whammy" on taxes - higher tax rates plus loss of deductions and credits.
Anyway, is it even worth it to depreciate assets if your rental is a loss on paper? You not only lose the benefit of the loss but you also set yourself up for the tax penalty later when you sell without getting the tax break when you depreciate. So, do you depreciate your rentals? I'm asking because now I think I'm going to stop since I get no benefit. Can you even do that?
Posted by: texashaze | October 15, 2012 at 12:43 AM
Thanks for the input Ben and Apex,
It was surprising to me that the bank was unwilling to bite given the property had already been a huge loss along with the current state of it sitting vacant. Also, I was willing to put down 40% on my offer and I have excellent credit. I guess in the end they did the right thing because somebody came along and made a better offer than me. This was almost exactly a year ago, so I thought it was a great time to offer since the housing market was still trying to turn the corner. I am glad it didn't work out though in hindsight, I ended up finding a better property that I am very happy with.
Posted by: JayB | October 15, 2012 at 09:52 AM
@texashaze,
I have covered this question before but it gets asked a lot and it's extremely important to get it correct so I am going to review it in detail again.
First a review of deducting "paper losses". When you depreciate the property you may have a net taxable loss even if you have net positive cash flow or profit. This is the paper loss you are referring to.
The IRS has a special category for rental income/loss. It is considered passive income/loss. Your wages are considered active income or earned income. You can deduct passive losses against passive income in other investments with no restrictions. However you can only deduct passive losses against active income with limitations. The limitations are that you can only deduct up to $25,000 of passive losses against active income. This begins to phase out at $100,000 with you losing $500 of deduction for every $1000 of income over that amount until it is totally phased out at $150,000.
This inevitably brings up the question of whether or not one should even take depreciation in this situation. This is usually driven by a misunderstanding of what it means to have the deduction phased out or to "lose" the deduction.
So lets lay out the facts so we are clear on this.
1. You NEVER actually lose the "paper loss" or deduction. It is merely carried forward to the next year and the next indefinitely until you are actually able to take it, or you start to have net taxable profits. The deduction is then applied against those profits so in future years where you do have profit you don't pay any tax on them until your carried forward deductions are exhausted. If you ever sell the property all your carried forward deductions are applied at that time against capital gains.
2. The IRS requires you to take depreciation. Taking depreciation ensures you get the benefit based on #1 above. Failing to take it ensures you are double taxed by the IRS and will cost you dearly. When you sell a property the IRS requires you to pay recaptured capital gains on the amount the property was depreciated. But here is the kicker: They do not base this on actual deprecation taken but on the depreciation schedule of what you should have taken. If you didn't take the depreciation the IRS will make you pay the recaptured capital gains taxes as if you had taken it.
In all circumstance you want to take depreciation. It never hurts you and will eventually help you. The fact that it is delayed does not make it a detriment, its just not an immediate benefit in that case. It will eventually be a benefit, so you always want to calculate your depreciation and report it on your schedule E even if you have to defer it and carry it forward.
Your tax accountant should be able to tell you how the carried forward losses work. If your tax accountant suggests not taking the depreciation, that's a bad sign.
Posted by: Apex | October 15, 2012 at 10:33 AM
@Apex
Thank you for the response. That answers quite a bit. My CPA didn't suggest not taking the depreciation, I was just thinking I'd lose out as described in my earlier post. However, the carryover makes it better. If my income never drops below $150k by the time I sell, then based on your response, the carryover will be applied then.
BTW, this stuff gets confusing... the government sure doesn't make life easy for the "makers" of the world. It would be interesting to see how much better the economy would be without all the government bureaucracy and rules.
Posted by: texashaze | October 15, 2012 at 11:05 AM
"BTW, this stuff gets confusing... the government sure doesn't make life easy for the "makers" of the world. It would be interesting to see how much better the economy would be without all the government bureaucracy and rules."
Holy cow, you've got that right...My mom's a CPA, and I am an engineer and love numbers, but my eyes seriously glaze over when we start talking about taxes. The words "tax implications" drive me nuts.
Posted by: Jonathan | October 15, 2012 at 11:35 AM
"A property’s worth is simply what other buyers are willing to pay for it. That’s it. That’s what a property is worth." Couldn't have said it better myself. People get caught up in the popular home valuation websites but those dont paint even half the picture.
Posted by: Adam | October 15, 2012 at 04:42 PM
The rules we're talking about are a result of the 1986 Tax Reform Act which actually simplified tax codes overall. They cut passive loss deductions and curtained depreciation in order to cut back on people holding losing money properties as tax shelters. Effectively ending loopholes abused by some. In other words you're complaining about the Reagan Tax Cuts...
Posted by: Jim | October 18, 2012 at 05:29 PM