We’re all familiar with the term “fixer-upper.” For many different reasons, properties can come on the market in less-than-par condition. The degree and cost to cure becomes an issue to buyers and sellers, and a challenge for appraisers. At some point it’s no longer “normal market value minus cost to cure equals as-is value.”
The terms “entrepreneurial incentive” and “entrepreneurial profit” are typically discussed in terms of investment property, but the principles involved can also be applied to the many fixer-uppers—whether the buyer is a “purely investor type” or an “owner occupied investor type.” Maybe a couple new terms should be discussed: “sweat equity incentive” and “sweat equity profit.”
Case in point
I know of a “for sale by owner” house that’s been vacant for about a decade, with no upkeep.
It was originally built as a boarding house back in 1910. It has been converted to a one-unit dwelling over the years, with the last significant work done by the current owner about 35 years ago. Unfortunately, the original floorplan skeleton remains, and therefore the property has serious functional issues as it needs walls removed/relocated. The kitchen and one bath require bare-to-the-wall start-overs, and the other bath needs reconfiguring.
Because the house is in a registered historic neighborhood, returning it to the character of its age is warranted rather than modernizing, which would add to the project cost.
The uniquely designed roof needs immediate replacement. The central H&A needs to be replaced. Extensive wood replacement is needed on the exterior and interior, with significant old but unrepaired termite damage in a number of areas, especially the unlevel wood floors. Virtually every surface needs work.
Based on some nearby sales, the owner is asking close to $150,000. Just for example purposes, let’s say that could be in the ballpark if the repairs and replacements were completed. There is virtually no way to get a mortgage on the property in its present condition, so it takes a cash buyer. In nine months of market exposure, in this very hot real estate market, there have been no offers.
What’s it going to take to fix it up?
I put on both my appraiser and remodeler hats, performed a detailed walk-thru, and priced out the cost to hire everything done, and the estimate is right at $90,000. So is the right price to pay $150,000 (market value after renovations) – $90,000 (estimated cost to cure) = $60,000?
Who might buy it?
Quoting text from a McKissock course, Appraising REO Properties: “An essential – yet often overlooked – part of being an appraiser is knowing who is the most likely purchaser for a property.” The four possible candidates for this one are:
A) Investor who wants to have it fixed up and flip it for a profit
It certainly wouldn’t make sense to pay $60,000 for it, spend another $90,000 to have it fixed up, and end up with a $150,000 property. Where’s the incentive for the investor? Where’s the reward for risking the money and time? Actually, considering holding and sale costs, this type of buyer would lose money.
B) Investor who wants to fix it up themself
I’m always looking to invest in rental houses. I have the tools, skills, and experience to do most of the work. I think I could do it all for around $35,000 out of pocket, doing almost everything myself, but it would take me about eight to nine months to complete.
If I paid $60,000 for it and spent $35,000 fixing it up, I’d have $95,000 invested in a $150,000-ish final product. That would return about a $55,000 entrepreneurial profit. That could be a sufficient incentive to a lot of folks.
C) Owner/occupant who wants to buy it to live in
How about an “owner occupant investor” prospect? Would someone want to pay $60,000 plus the $90,000 to have a $150,000 house? There could be such a buyer out there, but is that the market? This type of buyer could have purchased a house for that price that did not need the work or time to have it repaired and remodeled.
Then there is the do-it-yourself owner occupant buyer who might pay the $60,000, fix it up for the $35,000 I said I could do it for, and have $95,000 invested in a $150,000 home. That buyer would have the $55,000 “sweat equity incentive” to buy it. Such a buyer might be a prospect for this property, but most of those types of buyers are looking for far less work to do.
D) Historical property preservationist looking to restore it to its 1910 glory
Not very likely. Although the home is in a nationally registered historic neighborhood, and there are a few dozen homes from the late 1800s through 1920s, restoration to original grandeur is not happening, and it is doubtful that such a buyer would want to tackle this one.
CE Course: Learn about the differences between traditional mortgage appraisal assignments and foreclosure assignments in our course, Appraising REO Properties.
So who would buy this fixer-upper?
Certainly nobody would be willing to pay the asking price of $150,000, spend $90,000, and end up having invested $240,000 for a house that all fixed up is only worth about $150,000.
From the above discussion, it’s pretty obvious that an appraiser would want to identify the most probable market (purchaser) and determine a return amount/percentage that market would expect for the work and risk. Often expressed as a percentage, does the typical purchaser seek a profit of 10%, 20%, 30%, etc.? What would motivate a buyer to choose this property?
If it’s an investor, the entrepreneurial incentive drives the research, analysis, and conclusions. If it’s an owner occupant we need to account for a “sweat equity incentive.”
Determining the entrepreneurial or “sweat equity incentive” often takes extensive research (interviews and extraction from sales, etc.), which are critical factors in determining what the most probable purchaser would be willing to pay. Continuing education courses, such as McKissock’s Appraising REO Properties, provide specific guidance on determining incentive and profit demands, as well as reporting procedures.
As stated at the beginning of this blog post, in cases where the needed work is a small percentage of a property’s value, it can be simply “normal” market value minus the costs to cure. At some point though, as the work becomes more significant, that no longer is true, and it can become the formula: Anticipated Sale Price – Repair Costs – Holding/Sale Costs – Entrepreneurial (or Sweat Equity) Incentive = As-Is Value.
Written by Steven W. Vehmeier. Steve resides in Florida where he is a state-certified general real estate appraiser and a licensed real estate broker. He has taught appraisal qualifying and continuing education courses for multiple colleges, professional appraisal organizations, his own school, and McKissock Learning since the mid-90s, often spending over 100 days a year traveling and teaching. He has authored dozens of appraisal courses and textbooks, including several for McKissock, and has been a member or affiliate of eight national appraisal organizations, and national director of two.
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