It’s crucial understanding the different markets within a certain area. It’s a good idea to breakdown your market into at least six different price levels. The “levels” shown below are the retail prices within a specific suburban area. These vary by geographical location but this gives you an idea about how to segregate local markets by price ranges:
- Price Level 1: under $100,000
- Price Level 2: $100,000 – 150,000
- Price Level 3: $150,000 – $225,000
- Price Level 4: $225,000 – $300,000
- Price Level 5: $300,00 – $450,000
- Price Level 6: $450,000 and up
Price levels vary depending on the market. Obviously, in Southern California and Manhattan, the price levels are much higher than most markets. It’s up to you to adjust the prices according to the market you invest in.
A level one area is what is considered a “low-income” area. Theses areas tend to be high rental areas due to the low prices (under $100,000). These are the least desirable areas for homeowners to live. A level one area tends to be very risky for a few reasons:
- Fewer Retail Buyers: Most retail buyers prefer to buy in a non-rental market or a mostly retail market. That’s not to say that owners aren’t living and buying in level one areas, it just means that there are fewer of them. As a result, there is not a large buyer pool to sell to in a level one area.
- Tough Appraisals: Since level one is lower income, these areas tend to have more distressed sales (REO/short sales) and fewer retail sales. The chances of low appraisal are much greater in a level one area. An appraiser must use REOs and short sales if they make up the majority of the comps.
Example: Don’t learn this the hard way! What is likely to happen in a level one area is you buy for $20,000, put $10,000 into the rehab, and contracted to sell it for $55,000 to a retail buyer (FHA). Unfortunately, your appraisal comes in at $32,000! When examining the comps, there are several REO sales at $30,000 and under and there are no retail comps above $32,000 that meet FHA requirements. (You end up putting a tenant in the property and selling it to an investor for $45,000).
An exception here is when you seller finance a sale. People typically prefer to own a home when the mortgage, insurance, and taxes total to the same cost to rent. You don’t need an appraisal when you seller finance.
Investor Mistake: Why do a lot of new investors try flipping houses in the price level one areas? They do it for one primary reason – low capital investment. They start out saying, “I have $50,000 from my IRA (or whatever) and I can buy a house for $30,000, put $20,000 into repairs, and then sell it for $80,000.” Although that sounds good on paper, when you understand the ramifications of a level one area, it becomes a very risky investment. It’s better to raise the capital and go into a higher level area to flip houses.
More successful flips are more likely in levels 2 through 4 with prices from $100,000 to $300,000. This is where the largest segment of buyers are found. Levels 2-4 include first time buyers as well as downsizing buyers. Typically, levels 2-4 are the ideal levels to flip houses. However, do to the price range, these levels are mostly FHA buyers so you must be prepared to deal with FHA flipping guidelines, appraisals, and all of the ins and outs of FHA. This is where you should do 90% of your flipping.
Levels five and six are the $300,000 and up priced homes. The challenges with flipping these homes is that these are typically bigger homes, longer rehabs, more capital intensive, longer time on the market, and fewer buyers. But, the tradeoff is you have a more qualified buyer now (conventional instead of FHA) and you have a higher profit potential. You can make a lot more money per deal at price levels 5-6.
Please leave a comment if this article was helpful or if you have a question.
Author bio: Brian Kline has been investing in real estate for more than 35 years and writing about real estate investing for seven years. He also draws upon 30 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest. In the Olympic Mountains with the Pacific Ocean a couple of miles in the opposite direction.