How Do You Know How Much You Should Pay?

To become wealthy over time, you need to own assets, preferably plenty of real assets like property. The process to buy a house or apartment is relatively simple on the face of it. Show up at a home open and make an offer or wave your arm around at an auction until the auctioneer smiles and bangs down the hammer at you.

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Overpaying for your property is a sure way to dramatically slow the growth of your wealth creation. If you pay $600,000 for something that will value up at $550,000, then you are already $50,000 plus transaction costs behind. That could take several years just to catch up to the price you paid.

Yet this happens every single day – particularly in markets where demand is strong and prices are rising.

I have been very active in the Melbourne market, seeking sites for townhouses and small scale land developments. It is one of the most challenging times that I have experienced in over 30 years of real estate investing. This is simply because there aren’t many well located sites available and so many developers and would be developers, particularly from overseas who are swooping in and paying what I can only say are ridiculous prices to secure sites. Overseas investors operate on lower margins than domestic developers – and they are looking to park money in to a safe jurisdiction. They are less concerned with value and sufficient project profit margins than they are with getting their money out of their home country. The challenge with this is that our local land prices are artificially inflated and real estate agents look overseas first.

I had a conversation with an agent who told me that he sold a $10.4M site for cash in 15 minutes when an overseas buyer wandered in to his office. The same agent has an identical site about to come on to the market and he is expecting a similar result. Only the site by my calculations is worth $7M at best, using the end selling prices, selling & building costs and deducting a profit margin to calculate the residual land value. So as much as I would like to play, I won’t be bidding on that one.

Another example – I was looking at a 2HA site, which would support about 36 lots when subdivided. The adjoining lot was 2.75HA and had just settled for $2.7M, so about $1M/HA. The agent then informed me that the asking price for the site I was looking at was $4.7 – $4.9M – which was about two and a half times what the adjoining block had just sold for. Clearly it was overpriced and massively so. I asked the agent why her clients land was worth 250% more than his neighbour’s land and she said – and I quote – “I really don’t know, it’s just how much the vendor wants.”

Giving that one a miss obviously.

So how can you figure out what you need to pay to get fair value?

One of the keys is preparation – that is, knowing your market, what has sold in the area, when and for how much. You can get this information from local real estate institute websites or more comprehensive information can be bought from providers like RP Data.  Ideally speaking you will have been able to inspect or drive-by some or all of these nearby sales and be able to work out what the value is compared to other homes that have sold.

This is the primary method by which valuers assign a dollar number to a property. The secondary method is a check method whereby a valuer will break down the value of a property by its components – that is the land and the building. To do this you need to know the sale price of the property, the size and age of the building and the value of a similar size block of land. If you can source land sales evidence you have one component. If you can calculate the size of a building, you can apply a price per sqm, and then depreciate that “new” price by 1% for each year of the buildings age.

For example, say a 500sqm block of land in the area has sold recently for $250,000. You have a 200sqm home (on a similar size lot as your comparable vacant land sale) that would cost $1,500/sqm new and is 10 years old the building component, would be 200 x $1,500 less (1% x 10yrs) = $270,000. The total component value would be $270,000 + $250,000 = $520,000. Ideally the component value will be within 5-10% of the comparable value.

The second major key to not overpaying is to without emotion calculate the maximum you will pay for your intended property before you enter in to a negotiation or bid at an auction. When you reach that price, you just “walkaway” – which is why I call it a “walkaway” price.

This can be really hard to do in a hot market like Melbourne or Sydney, so it might take many offers before you finally secure a property at the right price.

But when you do, you will quickly realize that all that effort will pay off.

This is where I find myself at the moment having made dozens of offers of development sites in the Melbourne market. This is the toughest part of the process, buying right to ensure a decent profit margin, since demand is so high it is relatively easy to sell your finished product.

I’ll have some more news soon on one or maybe more projects in which you might like to take part by investing some of your own funds.

And you can be sure that all of the effort and research to ensure that the right price has been paid has been diligently and unemotionally completed.

For the next property you buy, check the comparables, calculate the components and be very firm on your “walkaway” price. And give yourself the best chance to grow your real estate wealth.

Please note: I reserve the right to delete comments that are offensive or off-topic.