How To: Analyze a “Below-Market” Deal

I personally believe that a reasonable analysis of the local economic fundamentals points to another ten to fifteen percent decline in Seattle-area home prices. However, I also believe that barring a major economic catastrophe that slashes wages and dramatically increases unemployment, buying in today’s market can be a good move if you can find a home at the right price.

Homebuyers in the market today have the ability to minimize downside risk in a way that has not been possible since the bubble buying frenzy begain around 2003. While everyone relaxes and the housing market pauses over the Christmas / New Year holiday break, I thought it would be nice to spend a little time going over a few strategies that will help you keep a cool head if you’re thinking about buying in 2011.

Here are the subjects I’ll be covering this week and next:

  • Comparable Sales
  • Nearby Rents
  • Historic Pricing

I’m also open to suggestions of additional ways of analyzing value, so if you’ve got any topics you’d like me to cover in this series, drop a line in the comments.

The first post will go live at noon today. Enjoy!

How To: Analyze a “Below-Market” Deal


About The Tim

Tim Ellis is the founder of Seattle Bubble. His background in engineering and computer / internet technology, a fondness of data-based analysis of problems, and an addiction to spreadsheets all influence his perspective on the Seattle-area real estate market.

27 comments:

  1. 1
    Patrick says:

    I’m not sure I understand your claim “Homebuyers in the market today have the ability to minimize downside risk in a way that has not been possible since the bubble buying frenzy begain around 2003.”

    The things you list – comps, nearby rents, and historic prices – were all available in 2003. The fact that some people ignored them doesn’t mean they’re new tools that allow us to minimize downside risk. When you talk about minimizing downside risk I was expecting it would follow with something like hedging techniques (which do a better job of minimizing downside risk than simply “buy low”). In essence, when you buy real estate, also buy an offsetting position in an inverse real estate fund. Inverse funds are something that the average consumer did not have access to in 2003, unlike comps, rents, and historic pricing data. In theory, you could virtually eliminate both your downside and upside, which is great if you’re buying a home as a place to live, not an investment, and just want to sleep easy at night.

    I haven’t found the right hedge vehicle yet (because most have high expense ratios and/or don’t actually track well to the inverse index), but am still looking and would be interested in suggestions if you have any ideas in this area!

  2. 2
    ray pepper says:

    Heres the MOST simplistic below mkt deal formula..aka..GEM…IT MUST FIT ALL 3 of these categories!

    1. If I buy this today can I dump it tomorrow and still make a profit based on current comps? i.e. will my deal be the BEST DEAL ON THE BLOCK by at least 18%?

    2. If I rent it will I cover the nut with taxes, insurance, upkeep, repair, and maintenance AND factor in the % of downpayment you used that could have been invested elsewhere.. Will you have a return of at least 15-20% on your money while renting this?

    3. If you desire to live in it….What would it cost to simply rent this home? Then calculate everything you did in # 2 and you will know in a heartbeat if you are buying a GEM or joined the masses of Bagholders waiting for a recovery!

    Its just that simple!

  3. 3

    RE: Patrick @ 1 – I wasn’t an agent in 2003, so I won’t comment about then. But your ability to get a bargain in this market is much different than in pre-2008 markets I did see. Gone are the days of having to take off work to see a brand new great listing so that your offer can be one of several considered. Also, the attitude of sellers is much different. Even ignoring price, you’re more likely to get a better house–one without as many compromises.

    About the only negative change I see for buyers is that the amount of equity sellers have is less, and a smaller percentage of sellers have considerable equity.

  4. 4
    David S says:

    And don’t forget there is a 10% loss upon signing due to the retail to wholesale conversion of the ‘investment’ / ‘asset’ that needs to accounted for on the balance sheet. It’s called the asset liquidation fee in my book. Because many of us don’t broker our own properties we pay all of it to flip, turn around or resell anything. Bicker that it is 9% if you want, in my world it will be 10%.

    To me, the asset liquidation expense continues to be the biggest hit real estate can be dealt. And I understand it doesn’t factor in as much if I plan to stay in the house for 20+ years, yea sure.

  5. 5
    Scotsman says:

    RE: ray pepper @ 2

    Ray, it appears you’ve gotten a bit more conservative in the definition of a gem. That’s good, but you’re still early. Pardon my asking, but I know you’ve discussed this before- how many of the “gems” you and your investors have purchased over the last 4 years have already gone back to the bank?

  6. 6
    The Tim says:

    By Patrick @ 1:

    I’m not sure I understand your claim “Homebuyers in the market today have the ability to minimize downside risk in a way that has not been possible since the bubble buying frenzy begain around 2003.”

    What I mean here is that while buyers from 2003 to 2006 could certainly analyze comps, look at rents, etc. there were virtually zero opportunities available that were a good value. And even if there were good values that presented themselves, buyers had very little time to do their due diligence.

    Remember stories like this?

    We were to present our offer the next evening as one of 10 offers (!). I told my realtor that I’d rather pay too much for the house than lose it. We debated how far over list price we needed to go to win the bidding war. We decided on a strategy to just go in with a blank check and I went to the store to buy little pink running shoes for the soon-to-be-born baby girl as a sweetener to the deal.

    We gave them a signed contract with the amount line left blank and told the sellers to fill in whatever amount it would take to get the house.

    From 2007-2009 the frenzy died down, but prices were still too high in most places to find any decent values. In my opinion, it’s only just now that we’ve gotten back to the combination of a calm pace of sales and almost reasonable prices that makes the market ripe for potentially finding value.

  7. 7

    Save Baby Save

    Imagine walking into a realtor with a bag of cash and buying your house without:

    a. Sellers that can’t afford to sell “under water” units.
    b. Sellers that think the “Hay-days” of 2006 will come back soon.
    c. The few buyers there are, that aren’t paying way too much [because of a and b].

    Even if you buy a house with bag of cash and pay too much; your monthly payments are just property tax, upkeep and insurance. If your wages decrease with time, you can still smile.

  8. 8
    GH says:

    Tim, I agree that you can get a good deal in the current market.

    I purchased a home in July 2010 for $13,000 below the appraisal. The sellers had listed for six months, had no real offers, and were forced to accept my reduced bid.

    (Comp sales in my neighborhood since July are consistent with the appraisal price.)

    Once you subtract for tax savings + principal payments, I’m paying about ~$1000/month to live in a neighborhood that rents for $1400/month. And that assumes NO appreciation.

    I look forward to read your articles on this topic. Thanks for the great website!

  9. 9
    ray pepper says:

    RE: Scotsman @ 5

    lets see…as of this week we have gladly returned a total of 6 GEMS in Oregon, Washington, and Nevada with 3 more that will be on the way. Should be 10 when its all said and done. However, a couple of the guys want to keep two of them so most likely 8.

    Scotsman they were GEMS to the last day though when you factor they were rented up until last day of ownership with full disclosure to the tenants. The tenants were delighted to get their cash for keys bonus bucks and some continue to reside in the residence Thanks to Obama and his 2009 Tenants Rights of Foreclosure.

    You see Scotsman anything that drags down a portfolio must be eliminated immediately at the 1st signs of toxicity. We did this 3+ years ago but YES, kept them rented till the day of death. Liquidity remains as strong as ever and every Friday ready to reload again…

    Just a MAJOR shift in gears in 2006 when Nevada started its death spiral. It was the single best decision the 3 LLC’s ever made. We have already reloaded 6 properties that fit all 3 Gem scenarios listed above with 325k in liquidity looking every week.

    Personally I bought 3 homes closing on one just 2 weeks ago in Gig Harbor and all 3 of these are MINE independent of the partnerships since I logged all the time. We can join the millions and cry and complain or adapt to what has occurred. We chose to engage and this new era of real estate I find BETTER then ever!

  10. 10
    GH says:

    RE: softwarengineer @ 7

    You bring up an interesting point.

    Many people I talk to are huge fans of buying real estate with cash.

    I’ve never understood that.

    To me, home equity is illiquid and generates no return. I bought my home in July 2010 with 0% down, and the seller’s paying my closing costs. The only thing I paid for was the home inspection.

  11. 11

    “Many people I talk to are huge fans of buying real estate with cash.

    I’ve never understood that.”

    A couple of good arguments for paying cash:

    1. Peace of mind. If you want to be able to stay in your house for a long time, and you’ve paid cash for it, chances are that you’re going to be able to afford the property taxes. There’s no mortgage. Also, interest rates on savings accounts and CDs are insanely low right now, so isn’t buying a house with cash the equivalent of earning 4.25% on an account?

    2. Cash talks. If a seller is looking at two equivalent offers, but one is with a 3.5% down FHA loan and the other is all cash, which do you think he will choose?
    As a real estate broker, I’ve represented buyers who lost out to lower, all cash offers, even with my clients having 20% down in their offer.

    I know, there are also good arguments for not paying cash. You have less invested, making it easier to walk away, etc.

  12. 12
    Lo Ball Jones says:

    If you are devious, and with all today’s information research sites, you might enter in another factor: buyer weakness. How is his income. What means “a lot of money” to him. Is he wanting to take a job in another city? What are the property taxes…are they making his home unaffordable?

  13. 13
    Drone says:

    RE: GH @ 10
    I don’t think I’ll be able to buy with cash, but I’d like to if I could. Here’s why:

    I realized that, over my lifetime, I’ll be spending an absurd amount of money just in interest payments. Payments for a house, payments for a car, payments for credit cards. This money is a voluntary TAX on me! If I can dodge the Banker Tax, then I’ll have more money left over for investments, or vacations, or whatever I want.

    Tons of people intuitively understand that paying interest on credit cards is a Bad Thing. Some understand that paying interest on cars is also a Bad Thing. So why should houses, with their much higher cost, be any different? I intend to follow the path of many savvy investors who have gone before me and pay as little interest as possible in all areas of life.

  14. 14
    Patrick says:

    RE: The Tim @ 6

    Okay… well basically my point is that buying low doesn’t really limit your downside risk significantly. It certainly is nice that buyers have more time to do due diligence now, and that it’s easier to get a property below market price. But market price is just a relative value judgment. Just because you get a property 5% below “market price” doesn’t really mean downside risk is limited. If the market goes down 15%, on paper you still lost 10% + closing costs. It’s like if you buy stock in a company that is trending down and eventually will go bankrupt (but you don’t know that at the time), and you bought the stock later than your friend, thereby getting a 5% discount from their price and thereby having less downside risk – well, it really only means you’re going to lose 5% less than your neighbor.

    Also, I doubt that 2003 had all properties perfectly priced – in other words, if at the time most properties were 30% overpriced, and you could find one that was only 25% overpriced, then you were getting a below-market deal. I do think there are probably more properties now that are priced out of line with market, so that’s good news for buyers. In other words, market pricing inefficiency is occurring now (but is occurring towards the downside), and market pricing inefficiency was also occurring in 2003-06 (but was occurring in the opposite direction, upside, benefiting sellers).

  15. 15
    GH says:

    RE: Ira Sacharoff @ 11

    Perhaps asset protection is a third argument? If I recall, Washington State homestead laws protect up to $125,000 of home equity. And I would assume it is more difficult for creditors to seize home equity than a savings account. (This is an assumption, I’m not a lawyer.)

    If a person is risk-averse, I can see how paying off your mortgage looks like a smart move.

    I’m in my early 30’s, and tend to take big investment risks. Maybe that’s my disconnect.

  16. 16

    RE: GH @ 15

    Actually, the Older Rich Elite are Renting for Investment Risk Reduction too

    Selling their investment anchor debt [the house] and renting instead. They say it’s driving rents higher, but in the long run, IMO, it drives home prices lower [supply and demand] and that can drive rents down too [especially where rent and buy are about the same costs].

    I heard the President of PEMCO sold his home arond 2006/2007 and was renting in Bellevue.

  17. 17

    […] that’s around twice that amount at a minimum.How To: Analyze a “Below-Market” DealIntroductionComparable SalesNearby RentsHistoric PricingPosted in Features | Tagged appraisal, comps, how-to, […]

  18. 18
    GH says:

    RE: softwarengineer @ 16

    At first, I thought you were crazy. Rich are renting? Absurd!

    But I did an internet search, and lo and behold:

    “Rich Americans Ditch Home Ownership For Renting”
    http://www.cnbc.com/id/40260336

  19. 19
    Scotsman says:

    RE: ray pepper @ 9

    I agree with you Ray that income property will be the way to go at some point in the future, but not now. I’d rather buy two properties in the future than one now, even if it looks like a deal compared to what it was 3 years ago. And I’d rather have perfect credit and credibility to go with my savings when the time to buy comes than a couple of upside down or low equity properties and questions about past defaults. Patience is hard for a go-getter though.

  20. 20

    By GH @ 10:

    To me, home equity is illiquid and generates no return. I bought my home in July 2010 with 0% down, and the seller’s paying my closing costs. The only thing I paid for was the home inspection.

    The return generated is the right to live in the home. Think of it as the rental value. And it’s tax free.

    The person who paid cash is paying for taxes and maintenance. You’re paying that and interest.

  21. 21

    By GH @ 15:

    RE: Ira Sacharoff @ 11 – Perhaps asset protection is a third argument? If I recall, Washington State homestead laws protect up to $125,000 of home equity. And I would assume it is more difficult for creditors to seize home equity than a savings account. (This is an assumption, I’m not a lawyer.)

    Savings accounts are easy to seize, unless they’re in an IRA, etc. If you owe money to the bank that the account is at it’s even easier–they can just offset without even getting a judgment.

    The homestead protection is actually a bit greater than the $125,000, because absent your house being worth more than that in equity, no one is going to bother. In the context of a bankruptcy the rule of thumb is 10% more, so someone with a $1,000,000 house gets a greater exemption ($225,000) than someone with a $200,000 house ($145,000).

  22. 22
    Ben says:

    I am not rich but I ditched owning for renting about 9 months ago. I don’t like that I don’t have full control over when I move out of my place, but I am getting a killer deal on rent and if I decide to strike and buy again it will be easier because I will just be able to move from renting to buying.

    To be honest buying again is something I have mixed feelings about. I like the idea of having more choice – there are nicer places to own than buy as a rule, which makes price comparison hard sometimes. But the hell of selling a home that I experienced this in past year has made me gunshy about ownership.

  23. 23
    One Eyed Man says:

    Tim, although most here would certainly agree that its better to obtain a lower purchase price than a lower interest rate, it might be worth looking at the trade off between waiting for a lower purchase price and accepting a higher interest rate with a couple of present value computations for different holding periods. For example, if one assumes they can save an additional 7% on the purchase price by waiting one year but will pay an additional 1% on an 80% financed 30 yr fixed mtg, how many years do they have to hold the property for an immediate purchase at the lower rate to be financially beneficial. You could also assume either no appreciation from the bottom or perhaps appreciation at the historic norm. It’s pretty basic but it might be interesting to look at a couple of sets of numbers including perhaps a high interest rate example just to throw NAR a bone.

  24. 24
    ray pepper says:

    RE: Scotsman @ 19

    “And I’d rather have perfect credit and credibility to go with my savings when the time to buy comes than a couple of upside down or low equity properties and questions about past defaults. Patience is hard for a go-getter though.”

    Patience is good but due diligence is better. Questions about past defaults?? Thats a funny one. I assure you that going forward the millions who made the CORRECT financial decision and returned their properties to the banks will be loved even more then those who continued to hold. Wanna know why? Because they have the CASH and let go of the lead weight around their necks that remains STILL upside down in 10 years. Its all about the CASH Scotsman, even more so going forward. Bagholders will be buried and life will run them over.

    If it makes you sleep better at night then thats on you but I suggest a couple of Ativan and maybe joining Vestus or Data Snap so you can educate yourself before dipping your toes in the next 3-10 years. Keep waiting for the “bottom” and be very patient, if that helps you sleep at night but you can make the same mistake even when we arrive at your “bottom”. There will be no “bottom” Scotsman. Gems will come and go right by you every year of your life while you wait.

    Live your life Scotsman……..Its so much more fun then watching it from your perch.

  25. 25

    […] be looking at a home that is priced below market.How To: Analyze a “Below-Market” DealIntroductionComparable SalesNearby RentsHistoric PricingPosted in Features | Tagged appraisal, how-to, […]

  26. 26

    […] a good deal (again, depending on the neighborhood).How To: Analyze a “Below-Market” DealIntroductionComparable SalesNearby RentsHistoric PricingConclusionPosted in Features | Tagged appraisal, how-to, […]

  27. 27

    RE: ray pepper @ 24 – I continue to think you’re delusional here. For one thing I’m seeing a lot of people filing bankruptcy who did give their house back to the bank quite some time ago. They gave the house back because they were financially unstable, not because they were underwater (although if they weren’t they could have sold or more likely refinanced like they probably did five years ago).

    It would be interesting to try to track that the other way around–look at deeds in lieu and see how many file bankruptcy more than six months out, but within two years.

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