How To Find a Good Deal on a House
Why one person’s trash is another person’s treasure
If I had a nickel for every time someone told me they’d be willing to buy a property if it was a “good deal”, I’d have a shit load of nickels. The thing is, everyone has different perspectives on what a “good deal” is. A home might be priced in such a way that it’s a good deal for a long term holder, but it might be a terrible deal for someone looking for a fix-and-flip profit. In this blog, I will tell how I coach my clients on finding “deals” and explain why the beauty of “good deal” is in the eye of the beholder.
Defining a Good Deal
The first thing we must do is define what a good deal is to you. Each of us has different financial constraints, risk tolerance, and perspectives based on our backgrounds and values – among other things. For these reasons, a “deal” is going to look different to each of us.
If I have a lot of cash and like big risks with the potential of big rewards, doing a fix-and-flip project might be the goal. If the opposite is true, and I have limited funds and a lesser appetite for risk, then maybe a long-term buy-and-hold strategy might fit our needs better. In both cases, buying the house at a discounted price might be our goal, but HOW MUCH of a discount is required to make it a “good deal” might be different. Typically a fix-and-flip investor needs a deeper discount (i.e. higher reward) because of the high costs and high risk involved. There can be a lot of volatility for investors who fix-and-flip homes because they are financing the repairs and need quick turnaround times. So they need to make a lot of money to offset the times when they lose a lot of money. Whereas a buy-and-hold investor likely has less expensive financing available to them (i.e., lower risk) so a “good deal” might look like a smaller discount off the market value (lower reward).
A “good deal” depends on who you are and what your wants and needs are.
Cash Flow Needs
If a real estate buyer wants strong cash flow – the net monthly cash inflow into their pocket after expenses – then a “good deal” is going to look like a property where expenses are low and revenue (in the form of rent, laundry income, etc.) is high. Rather than a property that has low cash flow but appreciates (goes up in value) with more velocity.
For example, someone who is entering retirement age might have a need for increased cash flow in order to eat and pay bills now that they are no longer working. Owning a property where the appreciation is high might be a great return on investment, but you can’t pay for groceries with the equity in a property.
Real-Life Scenario
We had a client with a roughly $2 million building in San Diego. Because it was a commercial industrial building, the available financing was limited. It was also one of only a few industrial waste properties in town. They were able to store hazardous waste materials, which wasn’t allowed in most other types of buildings. Because of the rare nature of the building, it had A LOT of value to large companies that stored hazardous waste. But because the available financing was limited, the monthly payments for our client were high. They had high revenue but also high expenses, limiting cash flow. The overall return on investment was high because the property appreciated quite a bit each year. It averaged 7% appreciation, but its cash only flowed to the tune of about 4% for a total return on investment of about 11%. (These numbers are overly simplified but for the sake of this article we’ll leave it at that). So with this property, their cash was coming to them at about $80,000 per year on their $2 million dollar asset.
The client was retiring and wanted more cash flow with which to live in retirement years. The appreciation of the industrial building was nice for their net worth, but it did not pay the bills. So they sold the industrial building and spent the money on a large apartment building in another state. This apartment building had much greater cash flow than the industrial building – about 7% cash flow. Seven percent of $2 million was bringing them $140,000 per year, almost doubling their annual income. However, apartment buildings in this part of the country only went up in value by about 1-2% per year on average, so the total return on investment was about 8-9% (again, overly simplified but you get the idea).
So does that mean they sold a “good deal” and bought a “bad deal”? No!
That means that for this person with their risk tolerance, their unique financial situation, and their goal to get to a certain monthly income in retirement, $140k per year in cash flow was a “good deal” for them. Someone with a longer time horizon and a regular paycheck might have preferred to stay in the industrial building at a higher overall return, but those criteria did not describe this client of ours. So the swap of the industrial building for the apartment building was a good deal for them. The financing of the apartment building also had much friendlier terms, which allowed the client to breathe a little easier. Their comfort level with the apartment building was a positive return to them, which more than offset the 1-2% per year in financial returns they were missing out on.
Discounted Purchase Price
Most people think of a discounted price when they think of a “good deal” on residential real estate. But HOW MUCH of a discount is required to make it a “good deal”?
Well, again, it depends on the buyer.
Someone who fixes-and-flips properties carries a lot more risk. Risk comes in the form of higher financing costs, less buyer-friendly financing terms (such as higher rates and shorter payoff times), and the inherent construction risk of having to put in more money than originally planned in the event of a construction issue. The fix-and-flip buyer faces greater construction costs, longer hold times, and the reality of unforeseen issues with city permits and utilities, so their costs have the potential to skyrocket in a hurry. In order to stay in business, these flippers must earn huge rewards on the fix-and-flip homes that are successful so they can cover the potentially large costs they incur when one is not as successful. Thus, fix-and-flip buyers tend to ask for deep discounts when buying properties.
A retail end-user buyer (i.e. someone who is going to live in the property) looking at the same home doesn’t have these same risks. . Typically, financing for end-users is at lower rates, longer terms, and friendlier payoff terms. Sure, the construction risk might be similar, but the holding costs and quick turnaround times are not an issue for the end user. At lower rates, an end-user is going to be able to hold the property for a less expensive price tag. And over the long term, end-users can offset market risk by holding for a longer period of time. Thus, the end-user won’t need as steep of a discount in order to call it a “good deal” because there is less risk and typically more willingness to take less financial reward because they get the added intrinsic reward of living in the house. In short, an owner-user is willing to pay more because their goals are different. They have the intention of: “I am going to live here and love the neighborhood and the house”.
Real-Life Scenario
House is listed for $700k. The value after repairs is $800k.
Flipper:
$800k sales price after repair - $20k in financing costs - $30k in holding & repair costs - $40k in selling costs = $10k profit
$10k profit / $800k = 1.25% return on investment
This is typically not enough of a reward for the flipper’s risk so a $700k purchase price is not a “good deal” for this buyer
End User:
$800k value after repair - $10k in financing costs - $25k in holding and repair costs - $0 selling costs (we’re not selling, we’re living here for a while) = $55k in equity right out of the gate, PLUS…
the buyer gets the benefit of enjoying the house for many years to come
the buyer gets to send their kid to the local school they love
It has a community pool
The buyer gets to experience a 5.5% average appreciation in the next 3-10 years they own it.
$700k is a good deal for this buyer!
Added Home Value - Highest and Best Use
Two buyers, Andrew and Brent are looking at the same house trying to determine if it’s a good deal. It’s 700 square feet in Pacific Beach, and it’s currently worth $800,000. The seller is asking $800,000.
Buyer Andrew looks at the marketplace and sees many of these houses selling around this price. This is a ‘regular’ market rate, says Andrew, it’s not a “good deal”. Buyer Brent, on the other hand, looks at the zoning regulations and realizes an owner can add an additional 1,400 square feet. Being a really nice guy, Brent tells Andrew, “You can buy this property at $800k, spend $350k to add 1,400 square feet, and you’ll have a 2,100 square foot house which is worth $1.6million. And you’ll only be in it for $1.15 million. This house is basically a $500k discount. A great deal!”.
But Andrew says, “I barely have enough money to buy this $800k house, let alone an additional $350k to put into it. Besides, I don’t know anything about construction, and it seems way too risky for my liking. What if something goes terribly wrong with construction or gets delayed or doesn’t get permitted? I wouldn’t know where to start, and I wouldn’t be able to sleep at night”. For Brent, this is a good deal, but for Andrew, it’s above his financial capacity and experience level, so it is not a good deal.
Opportunity Cost
Randy has $5,000,000 in the bank. He rents a modest 2-bedroom apartment for $3k/mo. He “throws away” money every month in rent rather than owning a house. A beautiful condo just like his apartment comes up for sale. It’s $720,000. Randy could easily pay cash for this condo, saving $3,000/mo. The rent savings alone is a 5% return on his $720,000. Saving $36k per year plus getting 5% appreciation ($36k increase in value) means Randy would be getting about a 10% return on this $720k.
It seems like this would be a “good deal” for Randy. Is it?
It is not. Why? Because of something called opportunity cost. Randy has other opportunities with this $720,000. It turns out Randy is an MIT Educated financial genius. He trades stocks and averages a 28% return on his actively managed investment portfolio every year. So if Randy took this $720k and put it in real estate to earn 10% per year he would actually be taking a 18% per year LOSS on this money by not using it for other opportunities.
How To Find a Good Deal
As you can see, not every deal is a good deal. Even “good deals” on paper aren’t good deals for every person. So in finding a good deal, the first thing we need to do is answer the question: “What is a good deal for me?” Once we know the answer to that question we can start hunting for our good deal.
Here are some ways you might find a good deal:
By marketing directly to homeowners who don’t have their properties on the market.
The reason why you might find a deal here is that you are the only one negotiating. When sellers have multiple buyers to choose from or an experienced agent helping them, they are more likely to be in a position to maximize themselves. But when you are the only option for the seller, the supply/demand curve is tipped in your favor, and negotiating a good deal becomes more likely. Also, you can deal with them directly (rather than their agent) and build rapport with them, which can help you get a deal price and terms in your favor
You can go to investment clubs and network with investors in your local area.
As we’ve discussed above, active investors might have a lead or an opportunity for a property that’s a good deal for you but not a fit for their needs. You can be there as a resource for these people to help get properties sold/bought that they might not otherwise have been able to manage.
Networking with real estate agents can be a good way to find a deal as well.
We agents have conversations with potential buyers and sellers all day long. And lots of sellers say things like, “I don’t want to put my house on the market, but if you know someone who would give me X price or Y terms, I’d be willing to sell”. So if you know what kind of deal you're looking for, an agent might know someone who’s willing to do that kind of deal.
The conversation we are having is PERSONAL finance. So while the financial math might make sense on paper – risk tolerance, your unique financial circumstances, and your personal experience are absolutely factors that come into play when analyzing whether something is a “good deal” for you or not. You also must know how to analyze risk, how to do basic math on the deal, and how to legally protect yourself. If you do these things you have just as good a chance as anyone to find a deal that works for you!
Brent Edwards (aka Brent the Broker) is a residential real estate agent and Realtor in San Diego, CA who helps clients buy and sell homes in San Diego, California and all surrounding areas. Brent is a highly-recommended Realtor in San Diego by family, friends and past clients. Call Brent today at 619-550-8070 if you have any questions about real estate in San Diego or you'd like to buy or sell a home.
