Overpaying for a real estate investment - Posted by David Krulac

import · May 9, 2004, 4:07pm

Posted by Wayne-NC on May 11, 2004 at 10:10:33:

In so many words, you confirmed my belief about the term “overpay”. It is very easy to use that term out of context. You put it right back in. To reiterate what I said before ( and it is not new), something is only worth what someone else is willing to pay for it. You discribed all the “someone else’s” involved in a RE transaction. In my general and very broad statement, it applies to anything whether it is for sale or not. There are many different values to put on things (for lack of a better word). Monetary, intrinsic,sentimental,are some to name a few and they all determine a value to a beholder or a buyer. Anybody who overpays for an item or RE in this case is simiply establishing a new value, not necessarily overpaying. I don’t ever like to feel that I overpaid for anything. The only time that I have is when I buy something for a specific purpose and the intended value then drops to where I cannot sell it to anybody. Then I come to the conclusion that I over paid, but that is only established after the fact. Stocks, bonds, commodities, and futures can be good examples of this. RE can be too, but again, only after the facts, like a late discovery of a cracked foundation, zoning change, termites and the list can go on. You’ve got the idea. That can create a senerio where one can over pay! Like I posted previously, that sounds like a mistake. Thanks for a great discussion.

import · May 9, 2004, 4:07pm

Posted by David Krulac on May 09, 2004 at 16:07:04:

Frank Chin recently wrote about overpaying for real estate investment property.

That casued me to recall the book “Buy and Hold” by David Schumacher. In that book the auther talks about overpaying.

But if you are in an appreciating market and you are buying for the long term, then the price is not as relavent. Some people are saying that there is nothing to buy in today’s seller’s market. Some investor friends of mine are constantly looking for low priced properties and they want to buy them at discounts from asking price. That’s more and more difficult to do as low priced properties are not staying on the market for long, and the prices are often bid above the asking price. There is lessened opportunities to buy below market in a hot seller’s market like today.

However, that doesn’t mean that there are no buying opportunities. As Schumacher writes you should be looking for properties that you project will be of increased value in the next 20 years. If you project that 20 years from now the proeprty and the neighborhood will be down, then that’s not a neighborhood to invest in for the long term.

Another friend of mine was just speaking last week of the high transaction costs of buying and selling real estate. One sure way to reduce transaction costs is to buy and hold. If you have a holding strategy then you don’t have to pay real estate commissions, transfer taxes, income taxes, both state and Federal, recording fees, attorney fees and all the other closing costs associated with buy and sell. Wouldn’t it be sweet not to pay all those costs which could add up to be 30% or more of your profit. Keep that 30% at home by keeping the home. If you made a good decision on the selction of the house to buy, why now sell it to somebody else and pay all the transaction costs. Keep the property and let it pay you to keep it.

Now I’m not saying never buy and flip, either with or without rehab. But keep the best proeprties in your portfolio ad sell the dogs, not the other way around. People will want to buy your best properties and want you to keep your dogs. Don’t do it. Sell the “hot dogs” and keep the steaks (stakes) that sizzle for yourself.

David Krulac
Central Pennsylvania

import · May 10, 2004, 10:30am

Re: Overpaying for a real estate investment - Posted by Sean

Posted by Sean on May 10, 2004 at 10:30:47:

I just don’t agree with overpaying, EVER for a property. If you have the cash to ride out a 5 year + downturn with negative cashflow fine, pay whatever you want for the property… but that’s not good investing… that’s speculative at best.

As Frank has told you (and there are countless examples, Boston, California, Texas etc) even the hottest markets bust. When you buy strictly based on appreciation, you are buying with the same irrational exuberence that drove money hemoraging tech stocks to insane highs.

There is no excuse to buy properties without cashflow. If you intend to hold, and it doesn’t cashflow… simple answer is NEXT. Yes, it is harder to find great deals in hot markets… but even in the hottest markets you will find distressed situations, bankrupt owners, pre foreclosures, estates, relocations, divorce etc. They will be harder to find for sure, but they still exist.

I will not argue that buying and holding is the way to make yourself incredibly wealthy, I just don’t agree with the overpaying/negative cashflow philosophy to get you there. If you have the cash to lose, go for it, but there is no reason to.

If you aren’t getting a deal TODAY you aren’t getting a deal period.

I can buy a full priced property today, with break even or negative cashflow and see appreciation double it in 20 years… or I can buy a distressed property with cashflow today and see appreciation triple or quadruple my purchase price it in 20 years and have 20 years of cashflow to boot.

On holding I definately agree keep the plums and dump the prunes.

import · May 10, 2004, 4:37am

Its a Highest and Best use Issue - Posted by Frank Chin

Posted by Frank Chin on May 10, 2004 at 04:37:05:

Dave:

I’ve watched construction and development going on all thru my neighborhood. Mostly, functionally obsolete 1950’s or older housing on large lots been snapped up for development for denser housing, usually 3 attached 2 families. Sometimes, a homeowner would buy the place and build a SFH McMansion three times the size of the original on the lot.

As I posted previously, a friend told me that his neighbor offered him 450K on his old 2/1 when he wanted to move. When his wife and daughter objected, he listed it for 500K with a broker, thinking its overpriced, and was shocked that a bidding war started with a 508K initial offer ending with a 538K sale.

The big issue here is the struggle between buying for living in or rehabbing, i.e. using the home in its original form as compared to developing the lot for building denser housing in its place. Some frustated rehabber may offer my friend 450K, or far less, for his home reasoning that it’ll need 50K in upgrading, and make a 50K profit by selling it as a rehabbed home for 550K. It’s overpriced even at that.

Yet for the developer, he can pay 538K for the property, and for another 1MM, demolish the 2/1, and build 3 2-families. The asking price for them is now 899K each, for a total of 2.7MM combined sales price.

Looking at the numbers for the moment, it’ll cost the developer about 1.5MM to acquire and build, and sell for 2.7MM, 1.2MM profit spread.

With these spreads, the developer builder, he can easily bid even more, if necessary. For the rehabber, the propertty is worth 450K, or even less if applying the 65% ARV formulae.

What’s the conclusion??

In the NYC market, the rehabber is competing against the developer builder for whom the lot is worth a great deal more than the current obsolete use. As long as demand for the 2-families stay strong, the builder will always outbid the rehabber, because he is paying for making the “highest and best use” of the property.

And no matter how many homes the rehabber makes offers on, as long as zoning allows denser housing, the developer would always be a step behind him outbidding him. Unless the rebabber understands this phenomenom, he’ll be one frustated rehabber.

Another example of this phenomemn is the conversion of farmland to housing developments, which had been going on thoughout NJ for a number of years. The land is worth more to a developer to build housing as compared to someone buying the place to run it as a farm.

In fact, in Queens County where I live, there’s a struggle going on right now between a preservationist group wanting to buy the LAST WORKING farm here, vs a developer offering several million for the land. Its a woefully small farm, and certainly not worth several million as a farm. But as land for development, its worth millions.

As to the “buy and hold” aspect you mentioned, I wholeheartedly agree, but its a totally different aspect of the issue.

I’m not saying buying for rebab is not possible in Queens County. I was purchasing properties at 15% to 20% below market in the last HOT market here, where I had to look at over 100 properties to find just one. These properties does need a little work, and is not a great deal that many rehabbers on this board would like. But, with “buy and hold” as rentals, they have tripled and qradrupled in price. I didn’ make the money of the flip, I made it on the appreciation.

These properties are also at their maximmun zoning, and because I like the attached multies that minimizes heating costs, its not soemthing a builder would come in and overbid.

Another word on buy and hold rentals.

In following previous posts by Phil Fernandez saying he buy rentals for cash flow, and the appreciation is the gravy. For me, the appreciation was the big thing, and the cash flow now is the gravy.

Frank Chin

import · May 9, 2004, 6:08pm

Excellent Post nt - Posted by phil fernandez

Posted by phil fernandez on May 09, 2004 at 18:08:38:

nt

import · May 10, 2004, 1:42pm

Re: Overpaying for a real estate investment - Posted by rm

Posted by rm on May 10, 2004 at 13:42:14:

When you buy strictly based on appreciation, …)

He didn’t say he was buying strictly based on appreciation.

The thing to realize is that not everyone has the time/energy to find deals as good as you.

So, in purchasing at a higher price, someone could still achieve their goals… which might be different than yours.

import · May 10, 2004, 7:25am

Frank In Your Market… - Posted by phil fernandez

Posted by phil fernandez on May 10, 2004 at 07:25:20:

I can definitely see where the appreciation IS the big thing and the cashflow would be the gravy. The properties in your market place where you can get denser zoning would be more valuable to a developer.

Keep up your great posts.

import · May 10, 2004, 6:09am

agreed, different locales dictate… - Posted by David Krulac

Posted by David Krulac on May 10, 2004 at 06:09:02:

different strategies.

In my area, Pa. appreciation has not had the run up of NYC, or CA. Perhaps if I were in either area or others with high appreciation, cash flow would be the gravy.

My main point is that if your in for the long haul, which means either buy and hold rental, or in the case of vacant land just buy and hold, then the price is not as critical. You CAN overpay, if you buy in the best neighborhoods and hold for a long time. By the best neighborhoods, I don’t mean the highest priced neighborhoods. I mean neighborhoods that are strong today and will be strong still in 20 years. Declining neighborhoods, high traffic streets, some incompatible neighboring use are all not the best neighborhoods. With a long range prospective, good property and neighborhod selection, you can afford to even overpay, because 20 years from now it just won’t matter. In you example of the $538k house, even if one bought it to keep and not tear down and the values are growing, 20 years from now the difference between the $508K and the $538K house will be insignificant.

David Krulac

import · May 10, 2004, 3:27pm

Re: Overpaying for a real estate investment - Posted by Sean

Posted by Sean on May 10, 2004 at 15:27:50:

I fully agree different people have different goals. However even if you look at Franks messages you will see the buyers buying to build new denser housing are buying “deals” today… not hoping for it to be a deal tommorrow. They make sure they have good profit even if they are paying high money for the land today based on the structure of their deal.

The developer risks the slight chance of a huge rapid downturn before he completes the build, but his exposure is limited to a small time window, like most rehabbers and/or flippers.

There is always a deal to be had TODAY… the deals definately vary from market to market, but they are there.

import · May 10, 2004, 9:13am

“Overpay” - Posted by Wayne-NC

Posted by Wayne-NC on May 10, 2004 at 09:13:02:

I am somewhat troubled by the use of that term and a post of mine(Daized and Confused) several days ago to JohnBoy touched on this with no reply. In short, the highest bidder in a market determines market price. Something is only worth what someone else is willing to pay for it. That now becomes the market value. With that said, if you were to “overpay” for a property, could you turn around and sell it for what you bought it for? If not, maybe you did overpay and that sounds like a mistake. If the price was say, double, would you still buy it knowing that there is no positive return in sight? I doubt it because that would be overpaying. There is a point here where that term is correct, but where? I may be getting philosophically deep here, but is my thinking on track? Please advise.

import · May 10, 2004, 7:38am

Re: agreed, different locales dictate… - Posted by Frank Chin

Posted by Frank Chin on May 10, 2004 at 07:38:42:

Dave:

Exactly right.

The best example of your thesis is the home I live in now, a multi completed in 1987, the peak of the last bubble. The builder wanted 399K for it, and only got top offers of 360K.

He decided to refi, take the money out, but it looked like he took out a bit much, overleveraged himself, taking out 290K on my property alone. He built four houses on the site altogether. He loss all of them to the bank and I got it as an REO for 227K in 1993.

Currently, similar properties are going for 700K to 800K in the area. Had the builder not taken out such a large mortgage, but a smaller one that allowed him to cash flow, and hung on, he would’ve gotten out all of the profits and more.

Looking back, even if someone was fool enough to overpay for my house, 399K in 1987, he would’ve been OK today, with values doubling in 17 years. Probably a better appreciation than your part of PA.

But because I bought it as a distressed property in 1993, I enjoyed tripling of value in 11 years, a far higher compounded rate of return. Given that I put 10% down, or about 23K on it, the ROE is phenomenal.

Talking about the merits of “buy and hold”.

I was reading the other day that Imclone stock hit $80.00. That’s the stock that Martha Stewart got in all that trouble for selling at $60.00.

The conclusion of the article. “Buy and Hold” would’ve have worked out better for Martha.

Frank Chin

import · May 10, 2004, 4:56pm

Re: Overpaying for a real estate investment - Posted by David Krulac

Posted by David Krulac on May 10, 2004 at 16:56:08:

in my market you can overpay and still cashflow.

There are intangibles also. The 20 year forward vison of buying a property today that will still be in a good neighborhood in 20 years. Having invested for decades gives me some prespective on the long term.

I love to purchase at bargain prices. I bought 30 properties last year and 30 the year before. Most were very much bargains. However, I wouldn’t overrule overpaying for a property.

import · May 11, 2004, 5:18am

What is something worth ?? - Posted by Frank Chin

Posted by Frank Chin on May 11, 2004 at 05:18:41:

Wayne:

A property worth X dollars to you may be worth X+10K to someone else, or even X+80K to yet another. If we’re talking about HOT markets, then we may be talking about one or two available properties where different buyers, ie. the rehabber, the homebuyer, the developer are all evaluating them from their own perspectives.

So the term “overpaying” may not be appropriate.

My area is a good example. Commuting is a big hassle, and folks are moving back from the suburbs, and I’m 30 minutes to midtown from my local train station. Because of the scarcity of homes for sale, a homebuyer may be willing to pay 20K more for the property simply because it might save him an hour from his former 1-1/2 hour commute, and perhaps $100/month and up in commuting costs. And because at 5% interest rates, 20K extra would only be $100 more a month in payments, the savings in commuting may more than offset. The fact that my district has the best school system in the city is also part of the equation.

So his decision criteria is not based on whether he can sell it for 20K more next week as a rehabber would.

Then because of the denser zoning than allows a builder to build several houses on the lot, it may be worth 80K more than asking price to the builder. And the builder is not planning to sell the exact same house next week by flipping it, but instead add 1MM in value to it by building several properties on the lot.

So the only guy thinking about whether he can sell it next week for the price he got this week is probably the rehabber, or flipper, because he’ll be selling the same thing next week that he’s got this week. The homebuyer is thinking commuting and schools, and the builder is thinking denser zoning.

What’s the conclusion.

Its the REI law of realitivity. Everyone is paying the right price based on his own circumstance. The higher prices may only appear to be overpaying to the rehabber or flipper because he’s the only making the decision on the what the property is worth next week compared to this week in its “same form”.

Not so for the homebuyer, He’s thinking commuting and schools, and the change of circumstance is of some great value…

Not so the builder, he’s thinking denser zoning, and the profits that accrue from that is maybe of greater value.

On the other hand, supply and demand still holds. If the area had 10 properties for sale rather than two, (in other words, not a HOT market) then the home owner can pay market or below for one property, the builder can pay market or below for another, leaving several others left over for the flipper or rehabber to scavenge.

Still dazed and confused?? Hope this discussion helps.

Frank Chin