Re: Help! Setting the L/O Selling Price? - Posted by David Finkel
Posted by David Finkel on November 20, 2001 at 17:29:21:
Ryan,
Here is my response to your question. It is a long answer, but I hope it will be a useful one. I cut it out of the manuscript for the next book my partner and I are working on right now. I hope you find it useful:
When you are creating your pricing for your properties it is important to balance the your desire to make the most money possible with your need to keep your workload low. What we mean is that if you get too aggressive with the pricing you will have to work very hard to move the property. If you are not aggressive enough with your pricing, then you lose out on part of your profit. Here is the simplest way we know to explain exactly how you come up with your pricing on your Rent to Own properties.
First, here are a couple of the background facts for this deal so we can make this role played scenario go smoothly for you: The house you are selling is valued at $245-250,000. The market rent for a 4 bedroom house like this one is $1,500 per month. The area has been appreciating at between 4-5% for the past two years. You agreed with the seller on a four year lease option where you pay a monthly rent of $1,400 per month and an option price of $225,000. You got the price down by using the negotiation strategies you learned in Section Three.
In case you forgot how to get the seller to lower their price, here is how the conversation probably went:
You the Investor: What were you asking for the property?
Seller: $250,000
Investor: And what did you realistically expect to get?
Seller: Around $240,000
Investor: Oh, $230-240,000? OK.
Seller: Not $230,000, I expected to get at least $240,000.
Investor: Oh, Ok? A question for you, if a real estate agent came to you and said they could guarantee you a sale at the full $240,000 would you let them sell it for you at that full $240,000 or you?d what, probably turn them down?
Seller: No, I guess I?d let them sell it just to be done with this.
Investor: Oh, that makes sense. Then their 6% commission would be?
Seller: Roughly $15,000.
Investor: OK, so that means that bottom line you would be getting?
Seller: I?d get $225,000. (BINGO! See how you let a few powerful questions lower the price by $25,000!)
Let?s take this information and create your pricing for the property. Your goal is to find a price for your tenant buyer that is below the anticipated future value of the property but high enough above your price so that you make a healthy profit. In our example we are going to sell the house on a two year Rent to Own.
First, you take the highest current value of the property and label that the current value of the house. Remember, properties are valued by how much other comparable houses have sold for, and it is impossible to put an exact dollar amount on any given house. Since you are selling with great financing in place you should always start your current value of the property at the highest justifiable comparable property. In our example that means the current value is $250,000.
Next you calculate what the house would be worth at the end of the two years at it?s current rate of appreciation. In our example the market was appreciating at between 4-5% so again we choose the higher end of that range. In this case we use the 5% rate of appreciation. A key point here is that you do need to be realistic on your rate of appreciation. If you talk with five different real estate agents in an area and they tell you the rate of appreciation for that area is: 4%, 4%, 5%, 5%, 12%, you need to use some commonsense that the 12% is not accurate.
To calculate the projected future value of the house, simply multiply the current value by 1.rate of appreciation as a decimal. In our example, multiply the $250,000 house by 1.05 to give you a one year value of $262,500. Because you are selling this house on a two year Rent to Own you need a two year value. You get this by taking the one year value and again multiplying it by 1. rate of appreciation as a decimal. In our example we take $262,500 and multiply it by 1.05 to come up with a two year value of $275,625. (See Figure 5.5)
Now we just need to choose a price that is below this two year projected value, above your option price of $225,000, and still a great deal for your tenant buyer. We recommend $259,980 for this house. (We could have been real aggressive and gone after a price like $269,980, but this is your first deal so we thought we would make it easier for you to sell. You can be more aggressive on the pricing of your next property!)
Next, we need to decide what rent to charge your tenant buyer. You start by charging the market rent. In this example the market rent is $1,500 so you start your rent for this property at $1,495 (which is the prettier way of writing $1,500.) Then you use an idea called ?rent credits? to bump up the amount of rent you are collecting. A rent credit is when you credit your tenant buyer with a portion of his rent towards his purchase of the property. For example, if your tenant buyer pays you $1,600 a month in rent you might credit him with $150 per month off the purchase price. This is your way of both helping your tenant buyer get a great deal and helping yourself get a larger cash flow out of the property. Remember, if your tenant buyer decides not to buy, you keep all the extra rent.
As for the option money you want to charge your tenant buyer, there is a simple formula that goes: AMAYCG. (?As Much As You Can Get!?) Typically you?ll collect between 3-5% of the value of the property as a non-refundable option payment from your tenant buyer. In our example you would be fine with an option payment of $10,000 (but wouldn?t complain if someone volunteered to give you $15,000.)
This is how you create your pricing for your properties. Ultimately the only way to know if your numbers are good is to have real buyers come through the house. If you aren?t getting people to say yes they want the property, there is something wrong with your pricing or the house shows poorly.
KEY POINT: Most tenant buyers are NOT buying price, they are buying monthly payments they can afford and an up front payment they can handle.
Now lets go back and learn how to talk through the numbers with your potential tenant buyers, John and Sarah. We are going to be using the sample ?Rent to Own? worksheet you see in Figure 5.6.
You the Investor: Do you know how the Rent to Own program works?
John: A little bit, could you explain it to us though.
Investor: Sure, you simply put down an up front payment which will all go towards your purchase of the house if you buy. Then you rent out the house. You have a set price you get up front that you can buy the house for at any point over the two year lease. It?s kind of a one sided agreement. I have to sell it to you at the agreed upon price but you don?t have to buy it. You have the option to buy or not buy. It?s up to you. Depending which option you choose, a portion of your monthly rent gets credited towards your purchase of the property. Did I make sense there Sarah?
Sarah: Sure.
Investor: OK, let me go through the pricing with you. The house is currently valued at $250,000. As you probably know, houses in this area have been going up in value at about 5% each year. If this house goes up at just this same 5% it will be worth $275,625 at the end of the two years. We set our price at below this to give you a large chunk of that future growth and to build in a profit for us as investors. Does that make sense?
John: Yes it does.
Investor: The price you have is just $259,980 which is over $15,000 less than the projected future value. You have three options to choose from. Option one is with a rent of $1,495. If you choose this option then none of your rent goes towards your purchase of the property. Option two is if you pay an extra $100 per month in rent, you?ll get $150 per month credited off the purchase price. Over two years that?s $3,600 of money being saved up to help you buy the house. And option three is for you to pay $200 extra per month. With this option you get $400 per month credited off the purchase price. Over two years that?s $9,600 credited towards your purchase. [Point to the Rent to Own Worksheet] How much up front money did you have to work with again?
John: $9,000.
Investor: Oh, $9-10,000?OK. [Using the Range Technique]
John: I guess we could manage $10,000.
Investor: Let?s just use that number for the moment as I go over how this works for you. As you can see your final price left to pay on option one is $249,980. Your final price left to pay on option two is $246,380. And your final price left to pay in option three is just $240,380. That?s over $35,000 less than the projected two year value! Did I explain that OK?
John: Yes.
Investor: Well John, which of these three options is most comfortable for you?
John: Hmm? what do you think Sarah?
Sarah: I think we should choose the second option. I like the idea of the rent credit, but I am not comfortable paying more than $1,595 per month right now.
Investor: OK Sarah, how about you John?
John: I?ll go along with Sarah and choose option two.
That?s how you walk your tenant buyers through the numbers. When you are talking them through the numbers make sure you go slow and let them be faster with the math then you are. It is important that you maintain the good feelings you have worked so hard to create earlier in this process. We recommend that if you have a calculator handy, let them work the numbers (with you telling them exactly what buttons to push along the way!)
Have you considered adding wording to your chapter that the percentage is not cut and dry, or something to that effect? Just because the market is rising 5% each year for that neighborhood, there are no guarantees it will continue at that pace.