Deal Analysis Basics: Buying Equity
Primarily, there are three types of deals that real estate investors look for: equity, cash flow and/or owner financing. In this article, I will be covering equity deals.
The idea of buying real estate deals based on equity is simple: you are buying houses for a lower price than they are worth. A very simple example would be if you had a $100,000 house, you might buy it for $70,000.
But how do you know what a good deal for an investor is? When you are wholesaling houses to other investors, you need to know, at least in basic terms, what makes a deal good. So, let’s look at one of the most common formulas for buying houses based on equity. Your market may differ slightly (either higher or lower) and you will need to learn the nuances of your local market, but you can use this as a good starting point.
The formula for buying a house based on equity (often called the Ugly House MAO or Ugly House Maximum Allowable Offer) is:
70% of the After Repairs Value (ARV) minus the cost of all the repairs.
Let’s look at a few examples so you can see how this works.
Example #1: $100,000 house with $8,000 in repairs needed
In this example, we have a house that is worth $100,000 after the completion of all repairs. This figure is based on what similar houses have sold for. It needs $8,000 in repairs.
So, let’s plug it into the Ugly MAO formula:
70% of the After Repairs Value (ARV) minus the cost of all the repairs
70% of $100,000 minus $8,000 = Ugly MAO
$70,000 – $8,000 = Ugly MAO
$62,000 = Ugly MAO
In this case, an investor looking to buy the property would, at most – that’s what MAXIMUM in MAO stands for – pay $62,000. So, to wholesale this property you would need to buy it for less than $62,000 and add your wholesale fee.
Example #2: $200,000 house with $12,000 in repairs needed
In this second example, we have a $200,000 house that would need approximately $12,000 in repairs.
If you enter these numbers into the Ugly MAO formula, you get something that looks like the following:
70% of the After Repairs Value (ARV) minus the cost of all the repairs
70% of $200,000 minus $12,000 = Ugly MAO
$140,000 – $12,000 = Ugly MAO
$128,000 = Ugly MAO
If you wanted to make $10,000 as a wholesaler wholesaling this deal and thought an investor would pay the maximum, then you’d need to put this house under contract for $118,000.
Example #3: $600,000 house with $15,000 in repairs needed
In our final example, which is for more expensive housing markets, we are considering a house that has recent comparable sales in the $600,000 range. It also needs about $15,000 in repairs to be truly comparable in condition to the recent sales.
Let’s see what happens when you use the Ugly MAO formula with this one:
70% of the After Repairs Value (ARV) minus the cost of all the repairs
70% of $600,000 minus $15,000 = Ugly MAO
$420,000 – $15,000 = Ugly MAO
$405,000 = Ugly MAO
As you can see, investors that buy equity need to get substantial discounts on properties to be able to fix them up and either rent them out or quickly resell them.
An important thing to note is that the investor will likely not make the entire discount as a profit. There are actual costs associated with buying, selling and holding the property. If you use a real estate agent or broker to sell a property and the buyer negotiates the price down 4%, you’ve used 10% of your profit just in selling costs and negotiation costs, not including holding costs, fix up costs and more. If you have 1% per month in holding costs (mortgage payment, taxes, insurance, and maintenance) and you need to hold the property for 6 months to sell it, there goes another 6% of your potential profit.
With just these costs factored in and looking at the $100,000 house example, instead of seeing $30,000 profit the investor is down to a $14,000 profit. I hope this helps you to understand why the discount in the Ugly MAO formula is what it is.
Until my next post,
James
P.S. Need help learning both the art and the science of deal analysis? Most investors do need help with this and it is something we are experts at and teach to our Real Estate Investor Bronze Members.
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