February 6, 2017 by Omar Passons
So far, I’ve laid out an overview, covered how to decide in which neighborhoods to purchase a property and some of the issues regarding rules for uses of land and building homes in San Diego. The current topic is really the last of the foundation pieces – negotiating the purchase. Once the purchase is made, the process changes dramatically to one about financing and timing and – hugely importantly – managing risk. I’ll get to all that. But first it is critical to the entire rest of the series that we get a working understanding of how those who buy and sell property decide what to pay or offer. Let’s get started.There are a couple basic points to be made before we can actually talk about setting a price range. These are just ideas that help the bigger picture make sense.
Imagine you were in a position to buy a home. If you have two homes to choose from, one that is relatively new and everything is under warranty and one that is older, needs lots of repairs, and maybe you don’t even know if it was built by a licensed builder. Even if these two houses were the exact same size and in the exact same neighborhood, most people would say that they wouldn’t pay the same amount for them because one house will cost more than the other to fix and has more risk of things breaking and you don’t know if it will keep its value. If the new house is worth $250,000, maybe you decide based on the specific repairs and risk that you would only pay $200,000 for the older home.
The above example is a story meant to show an important concept in real estate that applies to purchasing one home or a whole apartment building and even to deciding to buy land that you have to build on versus land that has a building on it already. We will pay more money for things like certainty and sturdiness and having a place that is “move-in ready” than a place that’s not. These things are called “market preferences” and they are different for different people, but the point is that when we make decisions about buying things we do so based on our values or what is important to us.
The Neighbor’s House (the “housing market”)
When a person or investor thinks about setting an asking price, they look at the other prices in the surrounding area. In real estate, these are comparable sales or “comps.” The idea is that the best predictor of what a house or land in an area is worth is what other homes or land in that same area have actually sold for. Sometimes, though, you find that people are willing to pay more than others have in the past because they believe some change in the area is going to make the house worth more very soon. An example of this is to think about what happens to the land around new trolley stops or even planned redevelopment. People are willing to pay more when they know planned redevelopment is coming because they think the land will be more desirable to others in the future.
The idea of the housing market gets a little skewed in places like San Diego because it can feel like building new homes only benefits a relatively wealthy part of the society. This is partially true, but the reasons might surprise you. There are a couple things going on that cause this situation. The first reason is that San Diego builds tens of thousands fewer houses than it actually needs for the people who live here. Just like the avocado shortage has led to an increase in the price of avocados, this same thing happens on a much broader scale with homes. The housing problem appears not to be influenced by increases in housing supply for two reasons. First, the only homes that are financially feasible to build right now tend to be relatively expensive ones. This has to change. Second, the problem is that we are more than 100,000 homes below what we need, so when 1,000 homes get built they don’t make the dent in pricing that we’d hope to see. That is, the level of supply is still WAY out of whack with the demand.
There are many reasons for our housing shortage, some of them relate to the rules I wrote about in the last section – discussed in detail in this study. We also haven’t committed to making it easier to build entry level homes that teachers and janitors and sales clerks could afford to rent or buy. As an aside, when I talk about being affordable, I mean a home that doesn’t require a household to pay more than roughly 30% of its income each month on rent and utilities/insurance. A balanced market will always require some subsidized affordable housing for people like my mom who are seniors on a fixed income and couldn’t pay enough in rent to cover the cost of constructing her apartment. Unless you take the position that seniors or people who are extremely poor or disabled just should not be able to have a clean, safe, and perhaps modest home, then we must address the subsidized affordable issue as well. But we also desperately need more homes that are market rate for people making modest wages.
Now that we have a basic market understanding, we can move to another key concept – other uses of money.
Considering the Other Use of Your Money
This is one of the most important aspects of the entire series, so I want to give it proper attention. First, here’s a quick story. I had these two friends when I was in college, Eddie and Monica. Eddie was one of those people that everything came easy for because he was really smart. He didn’t mind taking risks in school or in life and was always thinking up the next big business idea. Monica was just as smart as Eddie, but she was one of those people who always had her work done ahead of time, whose apartment even in college was immaculate and who you just knew if you needed something she would be there. Monica was that friend who was never going to do anything really risky in school or in life but really preferred a steady, predictable life.
My senior year we were sitting at a taco shop near campus with some friends and Eddie and Monica had both told us they had some news to share and wanted some help. Eddie tells us that he’s found this long-distance telephone company that’s really cheap and it’s going to totally change how we use the phone (this was the mid-90s). It is a new service that hasn’t fully been proven, he says, but he is sure based on projections that he can make a ton of money. Then Monica jumps in and tells the group that after graduation she has a chance to go work for a 100 year old company in L.A. that owns a bunch of real estate holdings and will pay her a great salary, but only after she’s been there for six months. Both of them wanted to borrow $5,000 to get started, and since none of us were rich, we had to really give this some thought. Faced with these two choices and knowing you could only support one of your friends, which one would you choose?
I told the above story because it highlights one of the most important points about money and real estate: choices. If you had two choices to make with your personal money, one was risky and one seemed safe, which would you choose? To make the riskier choice would you want to get more money back for your investment? These are the same types of decisions that lenders make when deciding who to lend money to and that large investors make when deciding whether to give their money to a large, new building versus giving for the more risky option of building on raw land.
I’ll get much more in detail down the road, but just know that whether it’s a $5,000 loan or a $5,000,000 one, the person doing the lending has choices about what to do with that money. As a result, that person can ask me to pay a higher interest rate if I am a risk than if I was not a risk because there are plenty of low-risk options that I have to compete with for that money.
We have covered three basics, so now let’s talk a bit about the actual price negotiation.
Negotiating the Price – Your budget and a little guessing
Once a person or investor has done the research on an area, checked to see how a property can be used and what can be built, and located another person willing to sell property, the process of negotiating a purchase price gets going. We have all seen for sale signs or listings online for homes or buildings. The same is true for land or property that will be demolished for new construction. The asking price is often the start of the negotiation. If the property is in an area with a great school, parks, and good transportation options, it is likely to be more desirable to a renter or later buyer, so the investor may have to pay closer to the current asking price. If there aren’t many amenities or the schools aren’t as good or a variety of other reasons, the buyer may be able to request a lower price because fewer buyers are fighting for the right to buy the property.
People who develop property for homes base their asking price on projections from a document they call a pro forma. This is just a fancy term for estimates about how much things will cost, how much money the final project will bring in from rents and some estimate about how much risk there is that the project won’t happen at all. There will be a whole post dedicated just to understanding these pro formas, but for now one example will help show how important they are. Imagine that you expect to get $1500/month in rent from each apartment at the time that you plan to buy the apartment building, but that is based on the rents in the area this calendar year and next year. Right before you make the offer a change in the local law means that a project that would take six months will now take twenty-four months and the rents at that time could be only $1,000/month. This changes how much you would be able to buy the property for because the money to build the project is going to come from a construction lender who is going to want their mortgage payment regardless of the changes in rental income.
The point of this whole section is that negotiating a purchase price is based on many things other than just what the property next door may have sold for. Creating meaningful solutions to having homes people can afford is a complex problem that requires careful solutions. The purpose of laying out some of the issues that go into negotiating a purchase price is to help you understand that solving this important affordability issue has many facets and we have to take them into account while thinking about the best options. Thanks for reading! Return to the overview page here. Continue to part four here.