June 16, 2016
Joe Fairless

Why You Should Do Your Due Diligence After Putting a Property Under Contract

Lee Arnold is a season private moneylender who sees over 200 loan applications a day. In my conversation with Lee, I was able to get a lender’s perspective how he believes investors need to be approaching deals to beat out the competition, especially in today’s competitive market.

The best advice Lee would provide to investors, whether you are a fix-and-flipper or buy-and-hold investor, is to do your due diligence quickly and then fine-tune it after getting the property under contract.

Many markets are heating up, with inventory levels being at 15 days or less, yet Lee sees many investors limping into deals where they are coming to the property with their clipboards and their contractors to perform a detailed financial analysis on the property before actually putting it under contract. While they are onsite doing due diligence work, 20 other investors are putting in all cash offers.

“You can’t steal in slow motion” is an adage Lee likes to use in describing this situation. If you find a good deal, you have to move quickly, or else someone will “steal” it from right under your nose. In today’s competitive market, you can no longer “do your due diligence then write an offer.” If you want to have a chance of actually closing on a property, Lee advises that you must “write the offer ‘subject to’ a contractor inspection and obtaining financing.” Get it under contract, then do your detailed due diligence. However, obviously, you don’t want to go out and blindly put properties under contracts either. You want to find a happy medium. Lee believes this happy medium involves looking a two numbers.

  1. What is the property worth?

You need to understand how to quickly look at comparable sales in the market. Make sure that the comps are very close to the subject property you are looking to acquire and do an apple to apples comparison. For example, if the subject property is 1600 sqft with 3 bedrooms and 2 bathrooms, then compare it to other 1600 sqft homes within a ½ mile radius that have the same number of bedrooms and bathrooms. In doing so, you will be able to realistically determine what the property will be worth because everything you do as an investor is based on the after repair value (ARV).

  1. What can I get the property for?

Once you determine what the property will be worth (ARV), then you can use that to calculate how much money you can pay for the property.

A quick formula that Lee uses in order to determine this number is the following:

70% of the ARV – Repair Costs = Purchase Price 

Based on his experience, he quickly determines the repair costs using a repair factor based off the year the property was built:

  • Built in 2010 – Repair factor = $6 per sqft
  • Built in 2005 – Repair factor = $11 per sqft
  • Built in 2000 – Repari factor = $16 per sqft
  • If the property is in really rough shape – Repair factor = $25 per sqft

All in all, Lee finds that a general rule of thumb when calculating the repair factor is approximately $1 per sqft per year to bring the property up to standard (with a +/- 10% to 15% variance)

For example, if the property is 1000 sqft and was built in 2000, using Lee’s quick calculation, the estimated repair costs would be $16,000 (1000 sqft * $16 per sqft). Let’s say you run the comps and the ARV is $200,000. Using Lee’s formula, then you would submit an offer for $124,000 (0.7 * $200,000 – $16,000).

Lee has found that this formula accounts for closing costs, capital costs, carrying costs, sales costs, and a 15% to 18% profit on that transaction.

Once you have the property under contract, now is the time to perform your detailed due diligence. At this point, (following the example above) get your contractor out to the property to determine if the $16 per sqft repair estimate was too high or too low.

Also, keep in mind that you should look at these two numbers independently from what the property is actually listed for. Too many investors worry about what the seller’s asking price is, when that number really has no bearing on what you, as an investor, needs to be concerned with. Determine what you need to purchase the property for in order to make the profit that you want. If you can’t get this profit at the current list price or the seller is unwilling to negotiate, then you just simply walk away. 

Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.

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