Putting It All Together: Short Sale Discounts, Cap Rates & Your Investing
So, you've read this far. And perhaps grudgingly you may now be willing to consider the possibility that short sale investing is an unusual, historically unique opportunity you maybe should consider.
Common sense, though, means almost certainly that you've got a couple of concerns: First, how you can be sure you're actually getting the important short sale discount...and how you can be confident a particular real estate investment makes sense. Let me talk about both of these concerns a bit.
Verifying You Get the Discounted Short Sale Price
First of all, with regards to the short sale discount, I think it's actually pretty tough for you or I to know whether we're getting the discount we deserve, need, or want on a particular property. The seller may not care much about the price, but both the real estate agent (whose commission is a percentage of the sales price) and the bank want as high a price as possible. And neither the agent nor the bank, in my experience, is very sensitive to the point of view that you deserve a discount purely because you've got the extra cost, risk and hassle of a short sale. You absolutely do deserve the discount by the way. But these guys aren't likely to intuitively understand that.
What I can say about the short sale discount though is that you should be paying less than the appraised value. And probably a fair chunk less than the appraised value. You certainly should not need to pay the appraised value inasmuch as short sale burdens you in all sorts of ways that a traditional sale (the sort considered a "comparable" by an appraiser) isn't burdened.
Remember, too, that a short sale probably burdens you with a bunch of deferred maintenance costs and other expenses that a traditional sale doesn't burden you with.
By the way, people will sometimes say that in a market with lots of short sales, these other short sales will affect every property's appraised value. Following this logic, a few short sales in the market will "automatically" cause the appraised values in an area to adjust downward for the short sale discount. But I don't think this is true-and haven't seen such as adjustment in my own experiences. Short sale transactions in the areas that I've looked at closely often represent a small percentage of sales. In some areas, for example, short sales represent only five to ten percent of real estate sales. And even in the worst hit areas, short sale transactions may represent only thirty percent of real estate sales.
Verifying You Make a Smart Investment
As for the question about whether or not a particular property makes a good investment, let me say a couple of things, one negative and one practical.
Here's the negative comment first: If the economy gets worse over the next decade, any leveraged investment may turn out to do poorly. So that's something you should consider. No investment is risk-free. And leveraged investments, as noted earlier, amplify losses.
Personally, however, I think the short sale investment opportunity is good enough to merit the extra risk on two or three short sale properties. Sure, I may be wrong. My financial profile is different than yours. And just so we're clear on this point, I would never suggest to someone that they make short sale investments the largest share of their investment portfolio. But with short sale properties you're getting a big discount on your investment in a hugely depressed market and you're funding your investments with super-cheap money. That should mean you get greatly leveraged, positive returns.
Furthermore, you should be able to improve your odds of short sale investment success by being really diligent about doing your investment analysis. Make sure that you've got a good cap rate by carefully doing the numbers. Be sure you have good inputs for things like the rent, the vacancy rate and the expenses. Make sure you're using a reasonable appreciation rate and that you're getting good, positive financial leverage with a good set of reasonable calculations.
I would think, for example, that your overall property rate of return should be in the 6% to 8% range with possibly a 4% to 5% cap rate and then maybe a 2% to 3% inflation rate. I've already mentioned that I think a 2% inflation rate is reasonable and probably (hopefully?) slightly conservative.
If you do get a nice 6%, 7% or 8% overall property rate of return and you can finance some of the purchase price with inexpensive 4%-ish mortgage money, you should enjoy a very good, albeit leveraged return on your investment.
Using the discounted cash flow worksheet described in "Appendix A, Discounted Cash Flow Analysis of Real Estate Investments" in the ebook (available as a download for $10.95), one can construct realistic scenarios that show 16% to 18% rates of return on single family homes if one receives a nice short sale discount and gets a good cap rate going into the investment.
One final comment: I think that if you do get a property that generates a 16% annual rate of return when using a solid set of inputs, you probably are getting a good short sale discount. In other words, another way you can be more confident of getting a good short sale discount is by doing discounted cash flow analysis and then, with a solid set of numbers, confirming that you're getting a rich rate of return.
If you do your analysis and you don't calculate a solid 4% or 5% cap rate or you do a discounted cash flow analysis and can't show, say, a rich double-digit rate of return, the problem may be that you're not getting the discount you deserve.
Next Section: Short Sale Investing Tips
Additional Information for Shortsale Investors
If you want additional information about how tax laws work for a short sale investment or for an individual running a business based on short sale investing, you may also be interested in one of my downloadable e-books shown below:
Tax laws provide active real estate investors with giant tax planning loopholes. A little upfront planning on your part could save you thousands a year...Read More
One of the most powerful tactics for saving small business taxes is maximizing your deductions. You can literally save thousands in taxes each year.Read More
Using an S corp for your real estate investing? To maximize savings, you need to minimize the salary paid to shareholders. But this decision is tricky.Read More