My fellow Real Estate professionals are definitely not going to be in agreement with me, in fact they may dispute this information to the core.
One of the reasons this is so, is that we have not had a “normal” real estate market for over ten years, therefore a lot of the existing real estate professionals have never seen what a normal real estate market looks like, their only experience, even though it may span ten plus years, has been that prices are determined by what other people pay.
In fact, this may come as a surprise to you, that prices are not necessarily determined by the average of what other people pay. This sounds almost counter intuitive.
As a real estate professional you are trained to do a “comparables” analysis in order to help a property owner determine the price at which he/she should sell his/her property.
Conveying this information is very hard because no one, except buyers, want to hear this. If you are a potential seller chances are you are also not going to be in agreement with me. All I would like to ask you, is to please bear with me.
How can this information help you:
If you are a seller and you apply the guidelines I will describe below, it is my personal opinion that you will sell your house in under 30 days in a frenzy of multiple offers, some of which may have a substantial down payment in cash. (I have actually done this many times –that is why I decided to write this article)
If you are a buyer, you could use this information to determine what house is priced correctly and then be confident that you are buying at the right price.
If you are a real estate professional, this is a tool that you can use to educate your client as how to price his/her home.
There are three criteria used by appraisers on how to price a property:
1. The Comparables Approach: this is when you see what other homes in your particular area have sold for. For the last ten years, in residential real estate specially, this has been almost the only method used. This method is not working anymore and sellers and agents who use this method are in for a long ride, with multiple price reductions as a necessity to achieve a sale. This means more costs to the Seller and to the Agent who needs to spend more energy, time and money marketing the property.
2. The Replacement Value Approach or also known as The Cost Approach: this consists of determining who much it would cost to build a property like the one being sold. This makes sense when you are going to build a home on a plot of land and this criterion is used by hard money lenders to lend money. In our down economy, this method is not very practical because most of the real estate that is selling is going at BELOW its replacement cost.
3. The Income Approach is a method of pricing a property by the amount of money it produces or the income it produces through rentals. This method is usually used in commercial real estate where office, apartment and shopping structures tend to be priced based on the amount of money they generate.
How Can this be Applied To You:
Put yourself on the shoes of the Buyer, why would he/she buy your home? How is he going to pay for it?
If he/she is paying cash, all cash, then he/she is going to want a price much lower than whatever is advertised. Cash has the advantage that you could close in two weeks or less.
No matter how beautiful, well cared & maintained, ideal location, special features, etc… your property possess, a cash buyer will demand a premium which will always translate in a much lower price.
If he Buyer is getting a bank loan then the bank is going to lend him/her a portion of the appraised value!
This portion is now 20% and sometimes 10% for properties under $729,000 providing the buyer has at least a 720 credit score. (this information may change over time)
Appraisers are now under much more stricter guidelines than they were before. Today’s appraisals (2010) are going to put the value of your house closer to the LOWER end your local market area. Therefore if you price your home above that LOWER end, your buyer is going to have to come up with an ADDITIONAL down payment besides the 20% the bank wants from him.
Why would he do that? Buyer’s are financially savvy. Put yourself in the shoes of the Buyer.
Say the home is priced at $625,000 (an inexpensive property in Los Angeles, California –this is by the way a real example). In this example the appraiser concluded its value to be $590,000.
The bank is therefore going to lend 80% of the $590,000.
This means the buyer needs to come up with:
20% Down Payment: $118,000
Difference Between Price & Appraisal: $ 35,000
His monthly payment for the next 30 years, including taxes and insurance, at present interest rates (2010), would be around $3,300 per month.
Because the home in our example has been expensively redone and because the builder did not skimp on materials (I know the builder too), if this house were to be rented, it could fetch $3,300 per month in the current market.
The buyer would not be getting any return on investment on his $153,000 that he put for down payment. Cost of living has been increasing by at least 4% each year, accordingly, a savvy buyer would want to get at least 4% return on his money. 4% of $153,000 is equivalent to $6,120 per year or $512 per month.
Therefore, in this example, using the income approach, the correct price for this home should be:
Monthly Rental of Local Area for this House: $3,300
4% Return on Investment on down payment: ($ 512)
Total Payment Including Principal, Interest, Taxes & Insurance: $2,788
Working backwards, this means that the sales price should be $500,000.
If we use the income approach we can see that this home is over priced by $125,000.
Most homes tend to be overpriced, this is because Realtors price them high in order to have room for negotiation and also because, in general, Sellers have an over inflated perception of the value of their home (sorry Sellers, nothing personal, this is what I have observed over many years of experience).
Why is the Income Approach So Important in Today’s Market:
1. – Banks are now requiring proof & evidence that the borrower can AFFORD the property they are seeking to buy.
2. – Banks are now requiring that buyers have a down payment which in most cases is 20% (or more for multimillion properties)
3. – Banks are now requiring that Appraisers be ULTRA CONSERVATIVE in their valuations.
4. – Banks are not allowing buyers to spend more than 40% in housing –this including debts too! This means that for borrowers that have debts, (read the majority), their available housing allowance is going to be less than 40%!
As a rule of thumb you should not pay more than 25% of your income for housing. Banks expect you to not spend more than 40% on housing. I know that most of us spend close to and sometimes upwards of 50% in housing. Just know that as soon as you start going above 25% of your take home pay, you start opening the door for trouble.
In today’s market, the lower end of the market is going to be determined by how much people are paying to rent a similar property to yours in your local area.
Rentals are determining the real value of your home!
This is not surprising; this is the way real estate has traditionally behaved! This is what is referred to as “Classical Real Estate”.
We still have some momentum (in California) from the last boom cycle, this momentum is fading rapidly and will continue to do so until all markets stabilize around the value of the rentals for each local area.
Sell now while you can because this phenomenon may never come back WITHIN our lifetimes!
If your strategy is to wait for the next couple of years, since you may have read on the press that we are on a “recovery” you may be in for even a bigger loss!
There are still some buyers out there in “boom” mode, willing to mortgage their future income at unrealistic and unsustainable levels, take advantage of that while you STILL can.
Use the Income Approach to Price your Property and it is my experience you will receive multiple offers within a week, borrowers would be fighting to buy your place, at which point you would be in a position to inch your price up and sell it for above the reasonable Income Approach Value.
In short, work in reverse. Instead of pricing your home out of the top end of the market and then painfully and slowly (costing you more money) wasting time & energy working yourself down, price it below the lower end of the market and work yourself up in a matter of weeks, generating a frenzy of offers!
I have done this very successfully. Most Sellers & Agents don’t do this. This is why, when a property is soundly priced, YOU GET AN AVALANCHE of offers.
Sooner or later, as times goes by, more and more people are going to get used to doing things in real estate the way it has always been done, now you have a window of opportunity because no one does what used to be standard.
I hope this knowledge helps you as much as it has helped me.