294 - Garbage In Garbage Out

When analyzing potential deals there are lots of different formulas you can use to see if a deal with worth pursuing. All of these formulas depend on accurate data to generate an accurate end result.

 

The 1% Rule - Defined as the expected monthly rent divided by the ARV or After Repaired Value of the home. This rule is what I nickname the "Bigger Pockets Rule" because if you use this you will often find more room in your empty pockets due to the money being removed from those pockets. The rule can be helpful as a loose guideline to measure a potential investment opportunity however much more diligence and details are required to make an informed decision.

 

Potential Problems:

 

Is the monthly rent figure actual or estimated? Estimates cause the end result to be inaccurate. Sellers, Realtors, and Wholesalers tend to estimate income and expenses more often than not, which means your end result will not be accurate and can only be viewed as a very loose estimate.

 

Valuation in ARV, who determined the ARV? A Wholesaler or Realtor? Maybe the Seller themselves? If the after repaired value is estimated the end result is pretty much useless because most people won't get an appraisal done at this stage. As a buyer, you should maintain control over this data point. Only consider data that is applicable to the type of property being considered.

 

How to determine ARV :

 

Single Family Homes - Only use sold comps of "like-kind" properties. An example of a like-kind property would be comparing a 925 square foot home to a 975 square foot home, both having two bedrooms, located close to each other, and have similar lot sizes and amenities. It's real easy to get sloppy on this section especially when you want the end result to be higher to make you feel better about the deal.

 

ARV is generally used in a flip-type scenario, does not apply or matter if the property is an income property.

 

To determine the value of Multifamily, Office, Storage, Hotels or other income properties- Use Gross Rent Multiplier or Cap Rate

 

The formula to calculate GRM is: Property Price / Gross Rental Income = Gross Rent Multiplier

 

The formula to calculate Cap Rate is: Net Income / Purchase Price = Cap Rate

 

Calculating these figures using estimated numbers will always yield inaccurate results.

 

The real question is, should we go forward into negotiations and due diligence or not?

 

We can't pay a seller based on what a property "will do" but we certainly can pay based on what a property "does do". Listen in for tips on how to use these formulas in the way they were intended so that you can analyze more deals faster with lower risk.