The object of investing in real estate is to make money. Whether a rental property is purchased and held for months or for years, the goal of every real estate investor is to sell investment property for a profit.
In this article, we want to discuss how to budget for that resale profit by estimating the eventual sales price of a rental commercial inspections less the total amounts that you will invest from purchase until resale.
Estimate the Sales Price First
Resale price is always dictated by the buyer. Buyers determine the price at which you can sell your income property. Never add your dream profit or rehab costs to your purchase price to estimate a future sales price for that income property. When you plan for profits, start with the price that a reasonably well informed buyer will pay for your property.
How do you determine that price? Research recently sold properties that most closely resemble your building. It is difficult to compare a 5-unit apartment building to an office complex, therefore select properties that are mostly identical to your property in configuration, condition, and location.
Appraisers and tax assessors typically use a market cap rate to estimate rental property value. So determine at what cap rate those properties on your list sold for and apply it to your own property. Don’t be shy to confirm the cap rate you plan to use with a local appraiser or a qualified real estate professional.
Stay conservative. Beware of pricing your property as if it were a cut-above the rest. For budget purposes, stay on the safe side and aim for a sales price that sits somewhat below the highest-valued income property in the area. The closer you push toward (or above) the top price limit of the area, the more difficulty you will face in trying to get your price—even when your property is expected to show clear superiority over the others.
Estimate Costs
After you’ve set a realistic sales price for the property, develop your cost estimates—what it will cost you to achieve that sales price.
Just bear in mind that investors are only going to pay you for the income that the property generates. Cost-plus pricing doesn’t work. Investors aren’t going to care how much money you put into the kitchens or landscaping, they will just be concerned about how much rent the tenants are willing to pay due to those improvements.
Structural issues, of course, are a different matter. The building must have a sound infrastructure such as a roof, electrical, and plumbing. The warning here is simply not to expect an investor to pay you for a superfluous grand over-hauling of the building.
Learning how much you might spend to upgrade the property is a skill that should develop through experience. In the meantime, until you get the hang of it, you can follow these suggestions.
- Research materials cost. Visit home improvement suppliers, lumberyards, and hardware stores. Talk with knowledgeable store personnel. Learn alternative solutions to various types of common problems and price/quality trade-offs.
- Educate yourself. Many home improvement centers offer classes and seminars for beginning remodelers, renovators, and rehabbers. Study books and magazines devoted to this subject.
- Consult property inspectors. Accompany your property inspector as he performs your pre-purchase inspections. Ask for advice about potential costs and remedies.
- Secure multiple estimates. Contractors and trades-persons typically provide free cost estimates. Discuss with them alternative ways of curing any property deficiency.
- Talk with property owners. Ask those who have improved their properties to tell you what they know. Learn from their experiences.
Sales Price – Costs and Profit = Acquisition Price
Okay, let’s look at an example: You find a property for sale at $500,000 that after your improvements is expected to sell in one year for $780,000. You further figure that your costs and profit to achieve that sale in one year will total as follows:
Acquisition expenses and closing costs = $5,000
Cost of borrowed funds (interest) = 20,883
Selling expenses @ 6% = 46,800
Materials for fix-up = 42,000
Labor = 22,000
Closing costs at sale = 7,800
Profit = 25,000
Total = $669,443
Result: $780,000 equals what you estimate to be the realistic selling price of the income property so you should not pay more than $610,567 for the property.
Your sales price $780,000
Less: Costs = 144,433
Less: Profit = 25,000
Maximum acquisition price = $610,567
By setting a realistic (conservative) future resale price and then backing out your costs (also realistic) and required profit, you set a top limit for your acquisition price. With this technique, as long as you accurately estimate all of the costs associated with purchasing, repairing, and disposing of the rental property, you guarantee yourself a profit in your next real estate investment.