Should You Buy Real Estate Above Appraised Value that Requires Repairs?
When making an investment in real estate, especially for rental purposes, it's crucial to base your purchasing decision on solid, realistic numbers. Simply relying on potential rental income can be a risky endeavor and should not be the sole factor in your decision.
As a real estate appraiser, my advice is based on empirical data and market trends. The value of a property is determined by comparing it to similar properties in the area and considering market rents. If a property appraises at $12 million, it logically follows that this is its current market value.
Market Realities vs. Potential Profits
Investors sometimes overestimate the rent potential of a property, hoping for higher-than-market returns. However, this is a gamble. While some investors succeed, many fail, and this is risky behavior. The key is to base your offer on actual, verified numbers.
For instance, if you see a property appraising at $12 million, and you want to purchase it for $14 million, you should understand that this means you would be paying $2 million over market value out of your own pocket. This is a significant risk and should not be taken lightly.
It's important to have a thorough understanding of the property's current condition and potential future improvements. Often, a property may have deferred maintenance, which can lower its market value. If the property is suffering from deferred maintenance, it might not be able to command a higher rent due to active lease agreements and the current condition of the units.
Mathematics of Real Estate Investing
To illustrate the potential impact of the property's condition and rental income, let's look at a simplified example. In a market like Orange County, California, where we have a vacancy rate of 5% and typical operating expenses, a property that generates $1.6 million annually in rental income would appraise at $18 million, based on a 5% capitalization rate. The formula for value would be:
Appraised Value Annual Net Operating Income / Capitalization Rate
$18,240,000 ($1,600,000 / 5%)
This calculation clearly shows that the property's real value is based on its current and potential net operating income, not just the rental income.
Example Calculation:
Net Operating Income (NOI) $1,600,000 - ($80,000 * 5%) - Expenses
NOI $1,600,000 - $40,000 - Expenses
If the property cannot cash flow 'as is,' it's highly unlikely that it would be a viable investment, even with renovations.
Decision Making and Risk Assessment
The final decision is ultimately up to the buyer, but it's crucial to conduct a thorough risk assessment. Ensure you have a clear understanding of the market value, the property's condition, and the potential for future improvements. Work with reputable professionals, such as real estate appraisers, to get a realistic estimate of the property's value.
While revising your investment strategy based on hard quotes and specific numbers is crucial, it's also wise to take responsibility for your investment. Don't rely solely on the broker or the seller's valuation.
Remember, buying above appraised value with the intention of improving the property should be based on a thorough analysis of the costs and benefits. The potential for a return on investment should outweigh the risks, including the cost of any necessary repairs and the time it will take to see a return.
Key Takeaways:
1. Base your purchase on actual, verifiable market value.
2. Consider the current market conditions and conditions of the units.
3. Analyze potential renovations and their associated costs.
4. Ensure the property can generate enough net operating income for it to be a viable investment.
In summary, while there may be cases where purchasing a property above appraised value makes sense, it's a high-risk strategy. It's essential to consult with experts, conduct your research, and carefully weigh the potential rewards against the costs.