A common thread I have seen in many failed real estate transactions is the failure to start with market value and work backwards. I will give you two examples and explain to you how most people approach them contrasted with how I, as an appraiser, believe they should be approached. Many people are familiar with the process of buying a house and flipping it for a profit. Many times this is done successfully, other times not so much. Some investors do this successfully while others fail because of their flawed understanding of cost and value.
Some investors begin by looking at what they paid for the property then add the cost of improvements to arrive at a list price for the property. The problem with this scenario is that cost does not always equal value, meaning that just because you paid $50,000 for a property, invest $25,000, and require a 15% profit, does not mean that you can ask and get $86,000. The market may not support that value for the house in the current economic climate. A better way to approach this is by determining what sales price the market will support and working backwards from this number. This will help you determine how much you should pay for a property and how much in improvements you should invest, as well as covering your desired profit. I have seen many investors attempt to do it the first way I described and resort to dropping the asking price because the market will not support their original price. The bottom line is that the price is lowered, which reduces the profit from the investment.
The second scenario involves homeowners attempting to sell their home. Many owners arrive at a list price by looking at what they owe on the house and then adding in the cost of improvements they have made over the years. While this may sound like the logical thing to do the price may not be supported by the market. Some homeowners may have put too much money into their home, either by over paying for home improvements or by over improving the home for the neighborhood. It is always a good idea to find out if the value added is more than the cost of the improvements. It would not make sense to invest $25,000 in a swimming pool if the market (ie potential buyers) will only pay an extra $15,000 for that amenity. I use the pool as an example because that is one of the most common improvements that does not give you a good return on your investment. Have you experienced what I have described here? What was your outcome? I would be interested in hearing your story.