What Makes a Buy, a “Deal”?

They say any “guy” can make a baby. But it takes a “man” to be a father. Risking melodrama, I say any “guy” can buy a house, but it takes a “dealmaker” to buy a deal.

But this begs the question, in our niche of buying and selling or buying and refinancing single-family houses, duplexes etc—-what makes a deal a deal?

What if I told you that I had a formula that’s never let me down when I used to buy and sell a lot of houses? That allowed me to ignore the frictional costs of buying and selling. Namely, I could ignore brokerage commissions, title costs, escrow costs and even the fees and interest that I used to pay my hard money lender. The key is that the vast majority of these frictional costs expand or contract with the value of the property’s purchase and sale prices. What you really need then, is a formula that takes into account your purchase price, your renovation cost, your estimated rehab cost and whether you are in a falling, flat or rising market?

Here’s what you do next time you bid on a house:

1. Determine the renovated or after-repair value (ARV) of the property

2. If you are in a flat market, multiply this ARV by 80%. We will call this percentage the Max Cap Factor. The answer to this multiplication represents the most amount of capital you want to have into the deal if you were buying the property all cash. In other words, this represents your maximum total purchase price and renovation expense. We will call the answer to this multiplication the Max Cap

3. Determine your renovation expense

4. Subtract your renovation expense from the Max Cap. This gets you to the maximum amount of money you are willing to offer on a house

Now, what do you do if you are in a market with gently falling values? You lower the Max Cap Factor to account for falling values. For example, if you are in a market where values are falling 6% per year and you think your flip will take you 6 months or less to complete, reduce your max cap factor to 77%. This is because you believe values will fall 3% over your 6 month holding period. Conversely, if you are in a market with values rising 6% per year, you can adjust your max cap factor to 83%. This accounts for your expectation of 3% appreciation over your 6 month holding period.

That’s it. If you know what kind of a market you are in, what your ARV is and what your renovation cost will be, this formula will spit out the maximum amount for which you are willing to buy any given house.