James A. Rivera Blog: The Ultimate Beginner’s Guide To Wholesaling Real Estate (Part 3)

Welcome to part three of The Ultimate Guide to Wholesaling Real Estate.

If you haven't gone through parts one and two yet, I'd encourage you to glance over those before continuing here, as they'll provide a lot of useful context for what I'm going to explain here.

In the previous section, I highlighted the three primary ways to conduct business as a real estate wholesaler:

Through assignments
Through double closings
Through traditional closings

Regardless of which method a wholesaler chooses, there are three stages that make up the business model as a whole:

Acquisitions
Dispositions
Transactions

In this blog post, we're going to dive into the Acquisitions side of real estate wholesaling.

As the name implies, “Acquisitions” is the department responsible for acquiring inventory.

Understanding Motivated Sellers

The first and most vital step in any real estate wholesaling business is finding great deals.

In one form or another, great deals always come through a motivated seller: someone who is willing to sell their property at a major discount because they need access to cash, and they need it fast.

Motivated sellers can have any number of reasons for selling, for example…

They may be getting older and want to liquidate their assets for retirement.
They may have a property with a lot of issues and they just don't want to deal with it anymore.
They may have recently gone through a death, sickness, divorce and/or a new job transfer.

Regardless of the reason behind the motivation, the thing to remember is that we're not here to take advantage of people.

As a wholesaler, the benefit you offer to a motivated seller is very similar to a car dealership. Sure, if someone took the time to list their car in online ads online and sell directly to an end user, there's a high chance they'd make more than if they simply gave it to the dealership.

But guess what… people turn their cars into dealerships all the time, and they're 100% aware that they're not getting the full market value for their vehicle.

Why do they do it? For convenience! They're getting quick, easy money that they can take home or use as a down payment for a new vehicle.

When they understand this and are fully aware of what's going on – it's a win-win!

Real estate investors of all kinds have a unique opportunity to improve society on a “big-picture” level because they're taking something negative (like a property in complete disrepair) and adding value by improving the property and, in turn, raising the morale and overall value of the neighborhood.

I won't get into to details here, but just be aware that if we as real estate investors approach our business with the right perspective, we can do a lot of good in addition to making a lot of money.

One of the saddest things about the reputation of real estate wholesalers is that they're known as swindlers and “bottom-feeders,” always on the hunt for who they can take advantage of next.

There are always a few bad apples in the bunch that make it worse for the rest of us. Generally speaking, though, there is a lot of good we can add to society by buying distressed properties and contributing to their renovation.

Please, I beg of you! Don't be one of these bad apples. Conduct your business with the intent to add value to people and help make this world a better place. [End of rant]

How To Find Motivated Sellers

There are a lot of ways to find motivated seller leads. Everything from working with auctions and real estate agents to driving for dollars and developing online ad funnels, to billboards, to creating bandit signs and direct mail marketing campaigns.

Essentially, this just boils down to the need for a smart marketing strategy. In any business, you have to have at least some marketing skills and be able to put them to use to get the phones ringing.

We have a lot to cover in today's post, so instead of recreating the wheel, here are three of the best posts Seth has written regarding how to find motivated sellers:

Suggested Filter Criteria for Direct Mail Marketing

If you have the money to do it consistently, direct mail is arguably the best option for your marketing efforts as a real estate wholesaler. The ROI is consistent and reliable, making it relatively easy to scale and build a business around.

Seth goes into all the details about how to do a direct mail campaign in the above-mentioned post called How I Find Motivated Sellers (and Get Them Calling Me), so be sure to check that out.

When you're using direct mail as your marketing strategy, there's an important question you need to answer:

When pulling a direct mail list as a real estate wholesaler, what criteria do you use to filter your list?

Unfortunately, there is no one-size fits all approach. Going into niche lists, like the delinquent tax list or probates, is going to take a lot more effort to deal with, but they'll also (most likely) yield a better response rate.

Generally speaking, though, we used the following criteria as a baseline during my time at Simple Wholesaling:

50% or Higher Equity
Absentee/Out of State Ownership
Older than 65 Years Old

We'd target areas where we knew investors were buying, and we'd mail to owners who had at least half of their mortgage paid off, were older in age, and didn't live at the property.

This helped us target a demographic of people who were facing retirement and owned a secondary home or investment property, hopefully with some problems that they didn't want to deal with.

You definitely might try what we used, but I will warn you: You absolutely have to test.

Different markets yield different results, and different criteria may be overused by your competition.

The more niche you're willing to go (paying the price of inconvenience to do it), typically the higher results you'll get and the less competition you'll have.

How to Analyze Deals as a Real Estate Wholesaler

Now, once you have a motivated seller lead, how do you run your numbers and come up with your offer? How do you determine how much of a discount you need and how much you could ultimately end up selling the property for?

Well, it all depends on what the exit strategy is for the property. As a wholesaler, typically you'll have two different kinds of buyers: rehabbers (also known as fix-and-flippers) and buy-and-hold investors (or “landlords”).

Let's dive into how to approach each scenario.

Analyzing Flip Properties

When rehabbers run their numbers, they typically use a rule of thumb known as the 70% Rule.

Essentially the formula looks like this:

Maximum Available Offer = Market Value * 70% – Rehab Costs

Let’s say a property has a market value (the price it could sell with a realtor) of $100,000. You multiply it by 70% in order to ensure your profit margin and then subtract your estimated rehab costs (the amount of money needed to make the property as financially valuable as possible).

We’ll go in detail on estimating rehab costs in a moment, but for now, let’s just say the rehab costs are $50,000. Your analysis would look like:

$100,000 *.70 = $70,000 – $50,000 in rehab = $20,000 offer.

So as a house flipper the maximum you could spend on this property is $20,000…but what about wholesalers?

If we need to sell this property (at most) for $20,000 in order for it to work for our buyers, then obviously we need to get the property for even cheaper.

So wholesalers, use what’s known as the 65% Rule, which is the exact same formula above, only we take out an additional 5% for our profit.

$100,000 *.65 = $65,000 – $50,000 in rehab = $15,000 offer.

Now, $15,000 is your MAXIMUM available offer, so you should aim to get the property cheaper if you can.

The cheaper you can get a deal, the more profit there is for you and, most importantly, the more profit there is for your end buyer.

When it comes to running the 65% Rule, the two hardest metrics to determine are:

The Market Value of the Property
The Estimated Rehab Costs

So, let’s dive into those for a moment.

How to Determine the Market Value of A Property

Here is a quick video where I show you how to use Zillow.com to run comps -or comparables to determine your market value.

Want a copy of the ARV spreadsheet I used in the video? Enter your email address below and download it for free!

Here’s the thing: Every market has a different set of rehab costs, and even within the same market, different contractors can have different prices and different opinions on what amount of work they need to do.

It’s unfortunate, as this makes estimating rehab costs one of the hardest aspects of being a real estate wholesaler.

If we ever lost money on a deal at Simple Wholesaling, it was because we underestimated the rehab costs.

They’re just extremely subjective. It’s a fact of life.

One time, I walked two potential buyers through one property at the same time and, for one, the estimated rehab costs came out as $15,000, while for the other, they were $25,000.

So … what do you do?

Well, for one, when you advertise a property. I suggest not putting out “exact” numbers for rehab costs. I’d instead supply a range, like “Estimated Rehab Costs between $15,000 – $25,000,” for example.

In terms of running your numbers to determine your MAO, simply use the highest rehab number available. That way, your end buyer has a lot of room for error.

Let's revisit the example above: If our rehab costs were between $15,000 – $25,000, my formula would look like:

$100,000 *.65 = $65,000 – $25,000 in rehab = $40,000 MAO.

A Pro Tip

If you are not a contractor, or you invest somewhere that’s different than where you live, I have a pro tip on getting a gauge of the rehab costs for your market.

Here is what you do:

Hire 3-5 contractors to come and give you bids on a potential deal. It might costs you $100 per bid (sometimes they’ll do them for free..but because you’re never going to use them to do the work, I’d keep it classy and pay them for their time).
This $300-$500 investment will give you a huge insight into what estimated rehab costs are for your area.
If one guy comes back high and another comes back low, you can generate an average of the five, per each line item on the bid that they submit to you (like X amount for windows, X amount for new tiles in the bathroom, X amount for kitchen cabinets etc).
If you do this for 5-10 properties (I’d use the money you’re making from deals to pay for it), pretty soon, you’ll develop a feel for what rehab costs go for and you’ll be good to go.

On Potential Rental Properties

Now if the potential deal you’re looking at is a rental property, running your numbers can be a bit tricky because your end buyers may approach their analysis in different ways.

In a perfect world, you’d be able to provide hard-fact metrics like the NOI and cap rate per each property. The problem, though, is that operating expenses vary from person to person. So, again, these numbers are subjective.

I’ve found that the best approach is to simply use a handful of guidelines to ensure you actually have a deal and then leave the rest to the discretion of the buyer.

I cannot tell you how many times I had buyers tell me our asking price was completely off, only for another buyer to call in with an offer 15 minutes later.

People desire different things when it comes to investment property, so, as a wholesaler, you just need to make sure you have a deal and don't sweat the small stuff.

The following guidelines can be used separately on their own, or collectively for a multi-angled approach.

The First Guideline: The 1-2% Rule

The first guideline I suggest you use when analyzing a rental property is called the 1-2% Rule.

This is a pretty simple concept:

Price * 1-2% = Gross Monthly Rent Amount

When talking to a motivated seller, first try and get them to give you a price they want for the property. Normally, this initial asking price won’t be anywhere close to how much you’d be willing to pay, but it gives you a starting point.

Let’s say they’re asking $50,000 (we’ll use numbers typical for Indianapolis because that's where I worked when I was with Simple Wholesaling). The next thing you’ll need to determine is the monthly rent amount.

If the seller is another real estate investor and they already have it occupied, that makes things easier, as you can just use the rent that’s already in place (sometimes they may have lower or higher rents for the area, but it’s still a helpful starting point all the same).

If not, you’ll have to determine what other similar properties are renting for in the market.

Here is a video on exactly how to determine that:

Now, why it’s called the 1-2% rule is because depending on what market you’re in, you may be able to get 2% based on these calculations and, in others, you may only be able to get 1%.

I know out in the San Francisco Bay Area, people are happy to get 0.5%, so it all depends on where you invest.

For the sake of our example, we’ll use the 2% rule. Let’s say this property is able to rent for $850 per month.

Let’s run our calculation:

$50,000 * 0.02 = $1,000

Obviously, with the rental amount being $850, we’re close but not quite there yet. In order to determine what purchase price will give you the 2% Rule, simple divide the rent by 0.02:

$850 / 0.02 = $42,500

What this tells you is you need to get this property for at least $42,500 – repairs costs.

You’ll have to estimate your repair costs the same way as I mentioned previously, but rental properties are typically in better shape then flip properties.

In addition to repair costs, you also have to factor in closing costs and miscellaneous fees your buyer will face like inspections.

For the sake of our example, let’s say the repair costs are $20,000 and the miscellaneous fees are an additional $2,500.

$42,500 – $22,500 ($20,000 + $25,00) = $20,000.

Now, here is an insider trick: In my experience, when running numbers using the 2% rule, it’s helpful to give yourself an error buffer. So, if my MAO is looking like $20,000, immediately I drop it by 25%.

$20,000 * 0.25 = $5,000

$20,00 – $5,000 = $15,000 MAO

Again, I want to emphasize the importance of recognizing this as your MAXIMUM available offer: You should start your initial offer as low as possible and then try to seal the deal as far beneath this number as you can.

If it was me, my first offer would be around $5,000, and I’d see where it went from there.

The more conservative you can be as a wholesaler, the better.

The Second Guideline: Offer 25% of the Lowest Market Comps (Minus Repairs)

The second way you can approach determining your MAO for rental properties as a wholesaler is to simply pull an average of the lowest priced comparables (on rental properties) around your property and then make your offer based on a general 25% discount.

If you aren’t a licensed real estate agent with MLS access, this approach can be a little tough, as I don’t know of a good way to filter rented single-family homes from the others on sites like Zillow or Redfin.

But, if you are licensed Realtor (or befriend a real estate agent) and have MLS access, it’s not difficult at all. Alternatively, you might try to get some rental property comps from local property management companies.

Either way, let’s say out of a list of 10 recently sold rental properties within a 0.5-mile radius of the property I’m analyzing (with similar square footage and bed/bath ratio etc.), I select the four with the lowest prices.

Property One

Sold Price: $45,000
Square Footage: 965
Bed/Bath Ratio: 2/1

Property Two

Sold Price: $43,000
Square Footage: 925
Bed/Bath Ratio: 2/1

Property Three

Sold Price: $32,000
Square Footage: 750
Bed/Bath Ratio: 2/1

Property Four

Sold Price: $36,000
Square Footage: 875
Bed/Bath Ratio: 2/1

Then, I take the average prices of these four properties and then multiply them by 0.25 to get my discounted offer price:

$45,000 + $43,000 + $32,000 + $36,000 = $156,000/4 = $39,000

$39,000 * 0.25 = $9,750 MAO

What’s nice about this approach is that it's fast and easy to calculate and the estimated rehab costs are included already.

With this price, you're probably going to be starting around $5,000 and going up from there. If your seller doesn’t agree to this low offer at first, that’s perfectly normal.

At Simple Wholesaling, the majority of our deals came from months of follow-up, not the first conversation, so the key is to set yourself up to be able to offer more in the future if you have to.

The Third Guideline: A “Rough” Cash-on-Cash Return

The final option to running your numbers on a rental property as a real estate wholesaler is where you do your best to determine a cash-on-cash return, based on your own estimate rehab costs and expenses.

For a quick review on determining cash-on-cash returns, here’s the formula:

Cash on Cash Return = Net Operating Income/Total Cash Investment

Our friend Brandon Turner over at BiggerPockets did a great job highlighting how to determine a cash-on-cash return in this video:

Where you run into issues as a wholesaler on this approach is two-fold:

When Determining Your Expenses within Your Net Operating Income
When Determining Your Rehab Costs on Your Total Cash Investment

These numbers are going to be subjective to whoever is running them, so as a wholesaler, you always have to be ultra conservative.

Pulling from the example above, let's say there was a property for sale at $50,000 that is being rented out at $850 per month. Again, let’s say rehab is going to be $20,000 and additional closing and miscellaneous fees come out to $2,500.

To determine our total cash investment, we need to include all associated costs and fees needed to purchase the property, so it includes the purchase price as well as everything else.

With our example, our total cash investment would be:

$50,000 + $20,000 + $2,500 = $72,500

Since we already know our total monthly income is $850, our next step in determining the net operating income will be to figure out our total monthly expenses.

This is where, again, it becomes subjective.

Some people pay 10% of the rent amount to a property management company, while others manage the property themselves.

Some people set side more amount for CAPEX expenses (see the video above) while others are comfortable spending less because they have access to certain deals on labor costs. It all depends on each investor’s personal situation.

The 50% Rule

To determine expenses, there is a general rule of thumb called the 50% Rule that a lot of investors use: It states that roughly 50% of your monthly income will go to expenses after mortgage and insurance costs.

So, if our total monthly income is $850 and our buyer’s purchase the property for cash, the 50% rule would look like this:

$850 – $250 (taxes and insurance) = $600 * 0.50 = $300

Based on this, our monthly cash flow is $300 if the buyer pays cash for the property. To reiterate, though: We have to be extremely conservative as wholesalers!!

My suggestion would be to give yourself a $100 – $200 buffer at all times. In this situation, that means I’d run my further calculations based on a $200 net profit after expenses.

This way, the deal will work for almost any buyer.

Finally, to determine our cash-on-cash return, we take our annual cash flow ($200 * 12 months = $2,400) and divide it by our total cash investment of $72,500.

($2,400 / $72,500) * 100 (in order to make it a percentage) = 3.31 %

Obviously, this is a HORRIBLE return at a $50,000 asking price … but what exactly is a good return?

It really comes down to local knowledge of your specific market. If you’re investing in California, a cash-on-cash return could be as little as 5 – 8%, whereas in Indianapolis, out-of-state investors typically shot for 12% or higher. We used to sell to some local guys who wouldn’t look at anything under 14%.

If you’re new, I’d suggest gathering this information by talking to other local investors or asking your potential buyers directly, learning how they run their own numbers, and then simply running based on what they’re looking to make.

Based on our current example, if the goal is to have 12% as bare minimum cash-on-cash return, here is what we do:

$2,400 * 100 / 12 = $20,000

In order to provide a bare minimum of 12% for your buyers, you need to be able to sell it to them at $20,000.

If you want to make an average profit of $6,500, subtract $20,000 to determine your MAO:

$20,000 – $6,500 = $13,500 (MAO)

Wrap Up

So this concludes how to find motivated sellers and analyze deals as a real estate wholesaler. In our next post, we're going to cover everything related to the Dispositions department where we build buyer's lists, market properties for sale, negotiate prices and ultimately dispose of our inventory.

See you next time!

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James A. Rivera Blog

Monday, November 12, 2018

The Ultimate Beginner’s Guide To Wholesaling Real Estate (Part 3)