Help with knowing the value of a home and seller financing - Posted by Candace Huber

Posted by Sean on May 13, 1999 at 13:00:07:

No, I have no idea what purchase price would have come up with. I haven’t done any due diligence on the properties.

On the other hand, I know I’d be getting a 2 percent spread. I’m happy to borrow money at 7 percent and invest it at 9 percent. I’d be happy to have several trillion dollars on those terms. Wouldn’t you?

As for minimum profit, I loaned a friend $5.00 yesterday and they’re due to pay me back tomorrow $5.01. So I guess I’m willing to go as low as 1 cent profit per deal.

Help with knowing the value of a home and seller financing - Posted by Candace Huber

Posted by Candace Huber on May 12, 1999 at 21:58:12:

I am brand new to rei and I need a lot of answers. How do you find what a home is worth? Is the only way to get an appraisal? Or is there some other way to do this? Also when you have a seller finance you are they just keeping their mortgage and you are making payments to them. Or do they need to get another loan. I have a lot to learn so any help in the right direction would be appreciative. Stay tuned for more questions as the days go buy.

Agree with JPiper, Jim Beavens - Posted by Baltimore BirdDog

Posted by Baltimore BirdDog on May 14, 1999 at 13:04:47:

Candace,

Sean’s assertion that you should determine your own cap rate based upon the financing that you can get for the property and in turn use that cap rate to determine the price you’d be willing to pay for the property is incorrect. I think JPiper, Jim Beavens and others have established that:

  1. the market via sales of comparable income-producing properties, not the investor, determines the cap rate that should be used to calculate the FMV of a particular property;

  2. the type of purchase-money financing which can be obtained has no bearing on the cap rate which should be used to value an income property. Any value added to the deal due to terms of financing depends upon what each purchaser can negotiate with either the seller or his/her own lenders. Furthermore, any financing advantage to the buyer due to his/her external lenders would probably not be communicated to the seller, giving them a reason to hold out for a higher price for their property as a result.

In addition, while a drop in prime rates may affect the availability of financing and increase demand for income property, the FMV and the cap rate would only be affected AFTER a new market has been established with sales of comparable properties which occur as a result of the increased availability of financing. In fact, an argument can be made that the FMV and cap rate for income-producing residential properties would DECREASE as a result of lower interest rates. Easier financing could lead to more renters turned homeowners. Fewer renters means lower rents and/or less income for multi-unit rentals. Less income translates to a lower cap rate!, and;

  1. how the property is viewed by the market, not how an individual investor views the property, determines how the value of a property should be calculated. Jim Beavens describes this very well in his post but I’ll attempt to sum it up here. If a market primarily consisting of investors sees a certain type of property as income-producing, then an income approach using the cap rate in conjunction with all of the other factors impacting the property (“general economic stability and outlook, local economics, governmental policies, tax advantages, outlook for appreciation, availability of credit, etc.” to quote JPiper) should be used to determine the amount that an ALL CASH buyer would be willing to pay. On the other hand, if the market consists primarily of SF homebuyers, then comparable sales, as well as the same set of factors, should be used to determine the FMV that an ALL CASH buyer would be willing to pay. The line between investor and homebuyer market becomes less clear when the number of units ranges from 2-4. As stated above, value added by financing depends on an individual’s circumstances which may or may not be communicated to the seller at the discretion and advantage of the buyer.

Thanks to all for a very insightful thread. It’s really helped to clarify this issue for me. Best of luck to everyone in their investing.

-Jeremy

Disagree with JPiper - Posted by Sean

Posted by Sean on May 13, 1999 at 10:54:23:

It all boils down to what you are going to do with the house. If you are going to buy it and try to fix it up and/or resell it in a short period of time you have to pull comps just like he said. You can enlist the aid of a real estate agent to do that.

If, however, you are buying this house to put a renter in it then the house is worth to you what income the house will produce. That means you have to figure a capitalization rate.

Capitalization rates are not a hard and fast science. It’s more a matter of determining how much profit you want/need to make out of the place. Personally I insist that my capitalization rate be at least 1% more than the interest rate I can get on a loan, and preferably 2% more.

Here’s an example: You find a unit that rents for $900 a month and the vacancy rate in the area is 10 percent. Your gross income per year will be $9,270. Assume we are able to examine the seller’s Form 1040 Schedule E on the property and we determine the annual expenses to be around $4,175. That means if we buy this property it will produce $5,095 a year.

The seller is willing to take a loan at 7 percent a year. Accordingly you would like to get a capitalization rate of 9 percent. So you take $5095 and divide by .09 and you get $56,600 is the price I’d offer.

Now let’s say the guy is asking $80,000 for this place. Using the same numbers we can determine if we paid $80,000 and we were getting $5,095 a year we’d be getting a 6.4% return on money. Since the interest rate on the loan is 7% we’d essentially be borrowing money at 7% and investing it at 6.4 percent. This is clearly a losing proposition.

That doesn’t mean I’m not willing to pay $80,000 for the house it just means I’d have to have the seller offer me a loan at 5.4 percent interest or lower. It may very well be that this house’s highest and best use is not as a rental.

If you FLIP or REHAB or RESELL WITH OWNER FINANCING use COMPS.
If you RENT/LEASE use CAPITALIZATION RATES.

Re: Help with knowing the value of a home - Posted by JPiper

Posted by JPiper on May 13, 1999 at 09:31:00:

There’s only one way to find the value of the house?..you look at recent sales in the area for comparable property. You can find this information in some areas through title companies or the court house. In all areas realtors will have recent sales. If you use ANY other method to arrive at the value of the house it will lead to distortions.

JPiper

Comparable Sales - Posted by J.P. Vaughan

Posted by J.P. Vaughan on May 13, 1999 at 09:30:44:

I disagree strongly with Karl Grube’s post below. There
is only ONE way to determine the value of a single
family house: comparable sales.

You need to find out what similar houses in the same
area have actually sold for. Title companies usually
have this information. In CA and in other states you
can ask a title company to send you a "Property Profile,"
which will include recent sale information.

J.P. Vaughan

What’s the house worth? - Posted by Karl Grube

Posted by Karl Grube on May 13, 1999 at 08:46:46:

Here are a couple of ways to price a house. (1) Builders Estimate: Have a builder estimate the replacement cost of the house. Add the cost of an improved lot. There are computer programs that will do this estimate such as Marshall-Swift Home Estimate (2) Insurance Estimate: Builders replacement cost of house. Subtract the depreciation of major features such as roof, plumbing, furnace, etc. Add the value of the lot to your price. (3) Tax Assessor: An estimate for tax purposes which usually is based on market sales prices. (4) Real Estate Broker Estimate: Similer or comparable houses sold within a 1-3 year period and adjust for inflation. Be careful that the houses are nearly identical in construction and features. (5) Rental Income Approach: What does the house rent for? $750 per month yields $75,000 market value. Rule of Thumb 10:1 ratio rent to price (6) Investor Estimate: Annual gross rents less overhead - taxes, maintenance, insurance, interest, assessments, etc. The bottomline figure is what you are comfortable as a return on your investment. … 8% / 12% / 15%

Foolishness… - Posted by JPiper

Posted by JPiper on May 13, 1999 at 15:05:25:

Now that I have some time, I thought I’d address this bit of foolishness regarding capitalization rates in both your post here and your post below.

First, it appears that you don’t understand the use of cap rates. Cap rates are never used in isolation as you have just done. An estimation of the value of property using cap rate is done by determining cap rates for comparable properties that have sold. Once the prevailing cap rate is determined for comparable property, that cap rate is then applied to the net operating income of the subject property, so that the value of the subject property may be estimated.

And by the way, this is undoubtedly PART of the reason why appraisers NEVER use cap rates for estimating value of a single family home: there is little, if any, data publicly available for determining operating data for single family homes in any given area. What’s more, MOST single family homes ARE NOT rental property. Therefore there is absolutely NO operating data whatsoever. Try getting a Schedule E from a guy who’s been owner occupying his home sometime. Try finding comparison data. Frankly, what you suggest is absolutely foolish.

Further, for the purpose of cap rates financing is not considered?..that’s the whole point of a cap rate to begin with. It’s used to compare rates of return on comparable properties. Financing is not properly a part of this comparison because your financing and my financing may be different. Does your ability to do financing versus mine change the value of the property? Obviously not. While I see how you’re attempting to use the cap rate, this is NOT it’s purpose, nor has it ever been. You appear to be reinventing the wheel with cap rates.

Obviously I’m not suggesting, nor is anyone else, that rental income is not an important subject, in particular as it applies to a rental house. But using that income to determine value is a fool’s game. Using your cap rate as an example, one of the houses that I own would be worth TWICE what I think it’s worth?.and frankly, what I think it’s worth is higher than what many would think. Talk about distortion!

You determine value of single family homes based on comparable sales. If you’re going to rent it, you would want to run the numbers, along with estimates of operating expenses, to determine your NOI, and then your cashflow considering your financing. Some properties will not cashflow because the rents are too low versus their value. Does this change their value? Not at all. But again, this doesn’t lend any merit to a capitalization approach for estimating value of a single family home. That is total foolishness.

JPiper

NEVER Use Cap Rates on 1-4 Units - Posted by J.P. Vaughan

Posted by J.P. Vaughan on May 13, 1999 at 11:28:43:

I think it’s fairly common knowledge that you should
never use a cap rate to determine value on a SFR.

Re: Disagree with JPiper - Posted by JPiper

Posted by JPiper on May 13, 1999 at 11:01:17:

Sean:

Glad to see your disagreement. I currently have 4 houses I’d be happy to sell you. Name your cap rate.

JPiper

Putting it that way… - Posted by Sean

Posted by Sean on May 13, 1999 at 16:36:31:

…I can agree with a good portion of what you say. I do, however, reject J.T.'s blanket “NEVER USE CAP RATES ON 1-4 UNITS” statement.

I think a person should always determine what capitalization rate is being OFFERED. A person who is willing to sell a property with an NOI of $10,000 for $100,000 is OFFERING a 10% capitalization rate.

As to your question about financing, I would say YES financing offered with/on a property DOES affect the value of that property. A person might argue that the definition of FMV is the price that would be offered for an all-cash deal. If that’s the case, FMV is irrelevant for this forum because we’re all doing creative financing, aren’t we?

Consider this: If the prime rate suddenly dropped a point, wouldn’t the FMV of your properties increase? Wouldn’t the capitalization rates of your properties change? I think we can agree that they would.

Appraisal - Posted by Sean

Posted by Sean on May 13, 1999 at 12:53:31:

Capitalization rates should be used for all income-producing properties whether they are 1 unit, 10 units, 100 units, or a parking lot.

Common sense can tell anyone that a property that produces $1,000 a month is worth half as much as the property next door that produces $2,000 a month (all other factors such as deferred maintenance excepted).

Similarly two condominiums placed side by side with identical amenities, identical size, identical floor plan and identical views will have different values if the home owners dues for one is twice that of the other.

Sure - Posted by Sean

Posted by Sean on May 13, 1999 at 12:14:47:

I’ll buy all four of your places. You carry back an AITD or land contract at 7 percent. The purchase price will be determined on a 9 percent capitalization. The term of the note will be no payments for 30 years, unpaid interest to accumulate, but not compound. All money due will be paid in a single balloon payment.

I’ll give you $100 down on each property and you pay all costs of the transaction. Have we got a deal?

Re: Putting it that way… - Posted by JPiper

Posted by JPiper on May 13, 1999 at 17:29:58:

Just to reiterate, the capitalization rate is the rate of return based on the net operating income given an all cash investment in the property. The financing method has NOTHING to do with a cap rate. Don’t confuse what a cap rate is, or it’s use, with your financing method.

If the prime lending rate suddenly drops tomorrow, does that increase the value of properties, does that change the cap rates? Well no?not necessarily. Perhaps you’d be interested in reviewing the recent Japanese experience, where interest have had significant declines accompanied by falling real estate values. Or perhaps you’d study the depression here in the US, where real estate values declined amidst falling interest rates. Or you could take a look at the 70’s, with rapidly rising property values amidst rising interest rates. Cap rates are determined by investors, and what they will pay for a given income stream. Probably one of the components that investors look at to determine what they will pay is the interest rate level. But other factors may well include general economic stability and outlook, local economics, governmental policies, tax advantages, outlook for appreciation, availability of credit, etc. So the answer to your question is that if the prime lending rate were lowered, we won’t know what happens to the cap rate until some sales take place. That’s the whole point?.until then it’s simply a matter of speculation.

Does the financing affect the value of a property? My answer is no (I’m aware that others may see this differently). BUT, there is a value to special types of financing. Think of it this way. Let’s say you’ve got 5 comps all at $100K. You have a 6 th comp at $110K, which when you check into it you discover was financed by the owner. What would you say the value of property is in that neighborhood? My answer is $100K. Can you imagine a first mortgage lender agreeing that a property is worth more if the seller were to carry a second? To me a property is worth what it’s worth without financing concessions. But financing concessions have their OWN value, separate from the property per se. And by the way, what these financing concessions are worth to one person may not be worth the same thing to another person. If I have cash to buy a property, the fact that a seller will give me financing at 110% of value is uninteresting and unimportant to me. That “special financing” in fact still has to be repaid, and it will be repaid at a cost. And as much as you and I have debated this issue, it will create additional leverage and therefore risk. But then again, if you have poor credit and no cash, special financing has its appeal. But the value of special financing lies in the financing, not in the property itself.

JPiper

Different uses for different people - Posted by Jim Beavens

Posted by Jim Beavens on May 13, 1999 at 15:07:53:

The point that Piper and JP are trying to get across is that the way an investor values a property and the way a homeowner value a property are very different things. You’re mistake is in assuming that all single-family houses are income-producing properties. Maybe it’s an income-producing property to YOU, but not to a potential homeowner. And the house is only worth what a typical buyer would be willing to pay. With a commericial property, that typical buyer is a fellow investor, who cares about nothing but $$$$. Thus the cap rate is a useful tool for unemotionally comparing the monetary return of this investment versus some other investment. But with a SFH, the typical buyer is a potential homeowner, and with them you have a pesky little thing called emotion enter the equation. Cap rates are useless here; people make buying decisions on things like whether there’s enough natural light, whether the garage has a workbench, and other things that have no bearing on what kind of rent the property could bring in.

If your acceptable cap rate says a house is worth $70,000, but all other similar houses in the area have sold for $50,000, then you’ll have that For Sale sign out in front of your house for a long time (and be waiting a long time for the bank to loan you money on this property).

I do agree that the cap rate is a useful tool for any income-property, but only when analyzing a property as a potential investment. The cap rate filters all the complexities of owning real estate down to a simple yield, which can be compared with the yield of other investments, whether it’s real estate, stocks, bonds, paper, etc. Although even here the use is questionable when dealing with 1-4 units because the lending criteria is so loose. There could be commercial buildings all over the place with 12 caps, but that little house with an 8 cap might be worth it because you might be able to swing a 100% NOO loan (this gets into the cash-on-cash aspect that Leapfrog brought up).

The only time you can go the other way, ie using the cap rate to calculate the value instead of the other way around, is with commercial real estate, where the ONLY consideration is income. And as I already pointed out, income is only one of many considerations when we’re talking about SFHs. Keep in mind the line starts to get blurred when you get into 2-4 units. Here you have a pretty good mix of owner-occupants and investors, so which valuation method to choose becomes somewhat more subjective.

One other mistake you made in your original post is coming up with a cap rate all by yourself. Nobody “decides” what cap rate they will buy at, the cap rate for the most part is dictated by the market. Piper probably salivated at your proposal to buy his properties at a 9 cap, since in many areas of Kansas City properties commonly go for cap rates of 12-15% (remember, Jim dubbed the midwest the “land of positive cash flow” ;).

The bottom line is that you can value a property any way you want, but whatever way you choose is irrelevant, since you personally have no bearing on what the property might be worth. The value is only determined by what the next guy might pay for it, so your valuation analysis should be done with that one underlying concept in mind.

Re: Sure - Posted by Charles - DFW

Posted by Charles - DFW on May 14, 1999 at 01:40:07:

Don’t the terms of your purchase agreement cloud rather than help your point?

$100,000 purchase price @ 7%, with no payments, and no compound interest. So in 30 years you pay $100,000 + 210,000 accumulated interest. $310,000 in 30 years has a present value of $38-40,000.

So it seems to me that your financing terms, in effect discount the purchase price about 60%.

With these kind of terms you could atleast pay closing cost!!

Charles,

Re: Sure - Posted by JohnBoy

Posted by JohnBoy on May 13, 1999 at 12:36:15:

What happened to being satisfied with only a $30 a month profit?? :slight_smile:

Do you have any idea on what your purchase price would be at 0 payments and a 9% capitalization rate based on the annual income??

Re: Putting it that way…borrowing on the cheap - Posted by chris

Posted by chris on May 14, 1999 at 01:55:38:

Let me first say that I’m not yet ( nowhere near actually ) @ your level of expertise, but I have seen Jim Napier speak and am now reading his book on the time value of money ( Invest in Debt ). I suspect he would say that borrowing cheap money is preferable to paying all cash. I respect your knowledge as well, so if you would please review your opinion on debt I’ll be gratefull . I know you must have done this before , but since I’ve just recently discovered this site , I have to ask. Thanx.

Inflation/Deflation, etc. - Posted by Sean

Posted by Sean on May 13, 1999 at 22:48:16:

Ok, but all of those situations can be explained by inflation/deflation trends. In the late 70’s inflation was going at better than 10 percent. People also felt that property values were rapidly escalating. But were they?

Sometimes your property hasn’t increased in value, but rather the little pieces of paper that we call dollars have decreased in value.

If a property goes up by 15 percent in a year, and you sell, but the prices of goods and services have gone up 12 percent in the meantime how much of a gain has actually been realized? Have you gained more than if your property had gone up 4 percent and goods and services did not go up at all?

It’s about investor decisions, yes, but it’s also about supply and demand. Imagine that 25 percent of buyers can qualify for a loan at the current interest rates. Suddenly the interest rates drop with everything else remaining constant. Would it be reasonable to believe that more people could qualify for a loan?

Wouldn’t that cause an increase in demand while the supply of homes remained the same? That would translate into an increase in prices, right?

A change in price without a change in the income produced would result in a change in the capitalization rate. All these things are interconnected.

Re: Salivating? - Posted by JPiper

Posted by JPiper on May 13, 1999 at 15:23:53:

I salivated?? You mean you didn’t??? Seems to me the sale of your properties at a 9 cap might be an excellent idea!

Matter of fact…a 9 cap has got to be full market value+ in most areas of the country.

JPiper