Rules of Thumb

Rules of Thumb.
Back-of-the-napkin math.
Smell tests.
Gut feelings.
Field tests.

These are all terms we have heard used to describe ‘quick and dirty’ analysis.  In real estate, it is always the goal to find the best opportunity in the market and by understanding some basic ‘rules,’ you can quickly separate the good deals from the bad ones and increase the likelihood of avoiding a mistake.

Here are some of the rules we (Realtors) use every day…

The New Home Premium

Builders tend to use this to help them price homes and/or decide to purchase lots in a new neighborhood.  While the cost of construction is an obvious input to pricing, the real driving force is the market’s preference for new housing over existing housing.  Stated differently, what is the premium a buyer will pay to buy the new one over the existing one?  If a relatively similar new home and a 10 year old home are both priced at $400,000, a buyer will almost always choose the new one.  But what if the comparable new home is $20,000 more? $40,000 more?? $60,000 more???  As a matter of a fact, this exact technique was used when working on the Citizen 6 Project on Floyd Avenue.

When is this useful?  Knowing how to value this premium is helpful when either a new home or an existing one is an option for a buyer.  Depending on the age of the home and the number of new homes available, the premium for a new home can be anywhere from about 7% to up to 20% (we wrote an article about this exact topic here.) In neighborhoods where there is a distinct lack of new homes, the premium is likely higher and when the existing home being compared is less than 3 years old, the premium is far smaller.  It is also very helpful in helping sellers price property in areas where new housing is close by.

The ‘Lot to Improvement’ Ratio

The ratio of ‘lot to improvement’ is really what percentage of the total value of the property is the market assigning to the land.  Stated simply, how much of the TOTAL value of the property is in the land and how much is in the house.  In the Richmond region, the value of the lot tends to be anywhere from 20-30% of total value…meaning that a home whose price is $500,000 is built on a lot whose value is roughly $100,000 to 150,000.  Factors such as age and neighborhood obviously impact this ratio, but for housing with high degree of similarity and in neighborhoods less than 20 years old, this measurement will hold pretty steady.

Beware, however, that this rule of thumb is hyper-local as different regions, depending on a myriad of factors, can have radically different ratios.  Assuming that a lot/house ratio in Richmond is the same as other bordering regions is not necessarily a good idea. As an example, the DC/NOVA market approaches 50% in many neighborhoods and the Outer Banks, especially along the ocean, can see ratios even higher.  Charlotte, NC, despite a population well in excess of Richmond, trades at a remarkably similar pricing structure to us.

When is this ratio useful?  This measurement is especially useful in areas where spot lots have been left over and a building opportunity in a mature area is offered.  It can also be useful when deciding whether or not to build or buy an existing home AND it can be extremely useful in understanding likely appraisal values when building a home outside of a typical subdivision (rural areas, mixed use areas or mature infill areas.)

** A Special Note ** Another application which requires use of some rules of thumb (due to a lack of good comparable sales) is the ‘tear down’ or ‘pop-a-top.’  With the trend towards population increases in the urban cores where new housing is challenging to create, many suburban builders have sought to massively upgrade existing homes closer to the City center which under-utilize the land upon which they sit.  The combination of Lot to Improvement + New Home Premium ‘rules of thumb’ can give the builder a good idea of what the finished value of the improved home should be.

$X per $1000

When you hear someone saying $5 per thousand or $7 per thousand, they are generally computing a mortgage payment.

In a 30 year mortgage, the monthly principal and interest payments (also called P&I) will land pretty closely to the interest rate times the number of thousands borrowed.  Stated differently, a 30 year mortgage where the borrower is loaned $300,000 would be $300 x 5 or $1,500.  In actuality, the P&I on $300,000 at 5% is $1,443, which comes out pretty closely to the estimate.  If you want to add in for taxes and insurance, bump the interest rate by 1 point and do the computation again.  If a borrower secured a $300,000 loan at 5%, the P&I + T&I (remember to add 1 to the 5%) would be loser to $1800.

(Want a sense of current mortgage rates, you can find them here…)

Where is this useful? It is most useful in the beginning stages of the home search and in discussions with less experienced home buyers.  While this technique (once again) does not work in all cases, it does work in most and can give the borrower a decent idea of what the home should cost to own on a monthly basis.  Be careful to adjust upwards for loans where mortgage insurance is involved or for loans with amortizations less than 30 years.

Obviously, getting the client to a qualified mortgage lender is the best practice, but sometimes, some ‘back-of-the-napkin’ math is required.

Cash Flow, Down Payment and Break-Even

This is a personal rule of thumb, but I don’t think I will get an argument from most:

• If you can put no money down and the property breaks even, it is probably a good deal
• If you put 10% down and it breaks even, then it is probably a market deal
• If you put 20% down and it breaks even, then I probably would pass (unless there is another angle to the investment)

It is common to see in remarks on a property brochure (especially from residential agents) that a property is ‘Cash Flow Positive’…it drives me nuts.  Almost every property is cash flow positive if you put down enough money.  If you purchase a property in cash, it BETTER cash flow positively!  What needs to be said is how much cash is required to make the property flow…for the reasons stated above.

When is this useful?  When you are seeking investment property, what you are really seeking is return on your equity (cash.)  While each and every investor has (or SHOULD have) investment criteria guiding their decisions which may cause them to seek different types of property (apartments versus single family or land versus net leased investments or single tenant versus multi-tenanted), the value of the rents relative to the value of the property should make sense (this is also known as the CAP Rate or Capitalization Rate.)

The bottom line…if you put down 20% and you are not putting cash back in your pocket each and every month, then there had better be another reason to purchase it.

Expense Ratio

The expense ratio is a measurement investors use when analyzing the potential for income producing property.  The expense ratio is the amount of expense due to utilities, taxes, insurances and repairs/maintenance that a property will experience relative to the gross rents.  As one would expect, older properties will have higher ratios than newer ones as will ones with more tenants than fewer.

A six unit apartment building in Jackson Ward renovated in 1980 may have a ratio as high as 40% of gross rents while a 30 unit renovated property with new windows might be closer to 25%.

When is this useful?  The expense ratio is very useful when vetting seller financials.  We have seen on many occasions a seller representing a 25% expense ratio on a 1930’s era apartment building (grossly understated) and conversely, we have seen expense ratios as high as 45% on garden style apartments when an owner has (incorrectly) coded a capital improvement as a current expense to shelter income. Good investors know what it takes to run a building and can tell when books feel off.

Other Metrics to Know

Besides the rules of thumb mentioned above, there are certain metrics (or inputs) that all good agents keep their eyes on.  Each one of the metrics, when combined with the rules of thumb above, can give some surprisingly accurate valuations without a great deal of effort.  I have seen good and experienced agents spew out incredibly on-point analysis without the benefit of pencil, paper or calculator by simply understanding the rules above and the values below.  It is pretty fun to watch…

All good agents, investors and developers should know the following inputs (and the 2014 answers):

• Construction Cost per SF – It costs about $100/SF to build a home and generally speaking, if your builder is spending any more then $140-150/SF on materials and labor (NOT including land) then you need to step back, take a look at what you are building and ask a lot of questions.
• Current CAP (Capitalization) Rates – Cap Rates for institutional grade properties hovering around 6% with the basic apartment properties trading anywhere from 6.5% to 8%.  Apartments with higher instances of collections or properties in need of substantial renovation should trade at higher rates (9-13%)
• Current Mortgage Rates – Mortgage rates for 30 year money are below 5%.  ARMS can still be obtained in the 3’s. (May 2015)
• Residential Rental Rates per SF (quoted monthly) – Rental rates in the Fan and Museum District are anywhere from about $1.00-1.25 with Downtown properties receiving closer to $1.70-1.80 per foot in rents.  The counties run closer to $1.00/SF mostly die to the home size.
• Market Values per SF  (sometimes referred to as $/SF or ‘price per foot’) – Price per foot in Suburban Richmond can range from a new construction high of about $175/SF (Nuckols Road corridor) to about $160/SF for new homes along Robious Road.  A resale property built in the 1990s’ will trade at about $110-140/SF depending on locale and city properties in Fan, Museum and Near West End will trade between $170 and 230/SF.

Conclusion

While are rules of thumb are generalizations and therefore have a high degree of variance, if you keep your eye on the metrics and apply the rules of thumb, you will be right (or close) far more often than you are wrong.  Understand that a property whose ‘rule of thumb’ is outside of the generally accepted parameters does not mean it has no value…it just means ask some more questions.

Ultimately, these ‘rules’ are intended to be guides and to offer initial insight but not be a substitute for well-constructed in-depth analysis. Over time, as you become more comfortable with these rules and learn when and where to apply them, many mistakes can be avoided and much time saved.

For more articles about values, check out our blog/analytics