13. The Importance and Uses of the Value Formula

Now we must get down to figures. Assuming that the property has passed your three tests of eligibility, and you feel that it is a good property for your purposes, we now learn what you should pay for it. There is no necessity to em­phasize the importance of this process. Even if you never read this book, you would certainly know that if you pay too much for a property, you are entering a deal in which you can make little or no profit. Conversely, you should be ready to pay a certain price! In no other way can you spot the good buys. That means the property for which the owner wants less (and some­times FAR less) than it is worth. Obviously you proceed to buy these with a minimum of dickering and delay. And, mark you, there WILL be such buys from time to time.

The importance of a thorough understanding of the Value Formula cannot be exaggerated. It is as much your means of measurement as if you were a buyer of yard goods and were setting out to buy some cloth. Would you let it be measured off by guesswork? In the same light, a property is worth a certain amount. And when you say it is worth that much you are saying many more things, between the lines.

You are saying that if a buyer pays the Value Formula amount for it, he can safely depend upon it that he will make a fine return on his investment.

You are saying that at this price, with a fair finance plan arranged, he will have a nice net profit in hand each year that will give him back his investment in a comparatively short time.

You are saying that if he has any of the usual setbacks, he will not be seriously hurt. That means if, after a time, a new roof is required, there will be a fat accumulation of profits out of which to pay for it.

The use of the Value Formula becomes even more important when we consider that it will establish a price. That price will be the one which you will feel for years in the payments that you will saddle yourself with for twenty or twenty-five years.

Then there is the matter of confidence. You will have a sense of sureness that you know what you are doing. If the Formula says—"Give him $12,433" (with a leeway of 5% either way) you know that when you refuse to pay him $14,000, you are making no mistake, even if you like the building and want it. You know that you are doing the right thing, and you reiterate the offer and withdraw and wait. Your conscience need feel no qualms. You've made no mistake.

THE USES OF THE VALUE FORMULA

There are four major uses of the Value Formula. The first use will often be of help to you. In most sales, there is the tradi­tional Alphonse-and-Gaston wrangle and haggle about price, with each side repeating again and again that it is worth so much, only to have the other side repeat that it is worth SO much. And you get nowhere. Both sides are expressing opinions. And opinions, of themselves, are worth little, unless substan­tiated by some evidence. The Value Formula gives you that evidence. You have an authoritative form with which you can sit down with an owner and demonstrate the true market value of the property—by the printed word. That often carries great weight. It gives you something more than just your opinion against the seller's. Often I have seen it convince the seller.

The second (and third) use of the Value Formula apply only to the real estate brokers. If you are a broker, interested only in making a commission, you will use the formula to convince buyers that the property is worth what the seller wants. Again, the printed authority will help you when you need something more than your opinion against the buyer's. With the Value Formula, you can demonstrate and prove authoritatively the market value of the building. In this regard, as brokers, you will use the Formula to help convince sellers, too, that they are asking too much, thus getting them to offer the property for a reasonable figure so that you can more easily sell it and make your commission.

The third use of the Formula is for making official ap­praisals. Brokers and appraisers are often called upon to make an appraisal for an estate, for a bank, for a tax assessment pur­pose, and for many other requirements. You will have a formal­ized, substantiated, neat and orderly method of arriving at an exact figure. Also, when you are up on the witness stand being cross-examined by the attorney for the taxpayer, you will be sure of yourself. He demands, "This figure you have given in your appraisal is just your opinion, is it not?"

You answer quietly, "No, it is not."

Usually you will get as the next question, "Then what is it?"

You reply, "It is an exact appraisal, fully and properly made."

Now, (and I've never seen it fail) he comes back with, "Just how did you arrive at this figure?"

That question is what ruins his case. Your answer is going to take between fifteen minutes and one hour, but he, having asked it, must listen (and so must the court or tax appeal board) to the whole answer to it! Now you proceed to spell out each step in the Value Formula as you did it on this prop­erty, and come out at the end with the exact answer. True, you will usually find that most of those in the courtroom haven't the faintest idea what you've been talking about, but you have driven home your point.

Your fee for making an appraisal will vary with the custom in your area, but in general your charge, without going to court or any other type of hearing, will be $200 to $10,000, plus $100 to $200 per day for going to court. Going to court includes any days that you are asked to appear, whether the case is called or not, and any day on which you go to court, even if you do not testify because the case is settled in the lobby. Even if you spend 10 minutes in court, you are entitled to be paid for the day. And all you need to know is what you will learn in this book.

The fourth, and by far the most important use of the Value Formula, will be in setting prices and values for your own use in selecting the properties you will buy or reject. In those cases where the buyer asks too much, but wants a counter-offer, you will know exactly how much to offer. Where he has asked a price within the Formula figure, you use your judgment as to whether to offer a little less so as to avoid appearing over­anxious, but you have determined that if the financing can be arranged—you will buy this one. To understand this fourth use we should know a little of the history and customs of Real Estate values.

THE FIFTEEN PER CENT RULE

For hundreds of years there has obtained a custom in our business as to what an investor is entitled to make on his in­vestment. Let us take a simple example.

Suppose X Chain Stores wants to have a store in a certain location. The owner of the land is approached with a proposi­tion. Will he erect a store, 100 feet by 200 feet, and pave a parking lot for 200 cars? If so, how much rent will X Chain have to pay for it?

In figuring out the return on his investment, Mr. Owner must take into account the fact that the building will depre­ciate as the years pass. That is some loss. Then the money that is invested here cannot be invested elsewhere, and the interest on it is another loss or cost. If the return on his money in the real estate investment is to be only the same or a little more than he would receive as dividends on blue-chip stocks, he is better off buying stocks.

For these reasons the fifteen per cent rule gradually became almost universally standard. Here is how it works.

The owner gets quotations from the builder as to the cost of the proposed building. To this he adds the cost of the land. Any other cost, such as the architect's fee, insurance, etc. is added in for a total cost to the owner of the finished store, ready for oc­cupancy. Now the rent per year is fixed by finding a figure that is exactly 15% of the total cost. In this plan, the owner usually pays real estate taxes and has a provision in the lease that any increase will be paid by the tenant, thus leaving the owner, in effect, a guaranteed income. From this, we evolve the general principle:

A piece of Real Estate should earn as annual gross rent, fifteen per cent of its cost or value.

Now the Value Formula takes that rule as sound and proven by years of application and experience. It has been the basis for thousands of leases and rentals for generations. The changing value of the dollar has never affected it, of course, because it was a proportionate rule. Thus having established the pro­portion between the value and the rent, we put the rule to a new use.

Whereas we used to determine the rent to be charged by taking fifteen per cent of the value, we now reverse the process. For it is obvious that if one is true, so is the other. If we accept the principle that a building that cost $100,000 is worth a rental of $15,000 per year, then it is not fair to say that if a building fetches a rental of $15,000 per year, it is worth $100,000? Of course!

But it's not as simple as that. If that were all there were to it, we would not have the advantage that we do over the run-of-the-mill investor. In general, the real estate investor stops right there. That's all he knows about figuring the value and he goes by this rule-of-thumb. It was the way he was taught, and he knows no other. What's more, it seems to him quite adequate. As he sees it, this method has proved itself thoroughly. He has been buying property for 19 years with that rule and guide and he has almost always turned a nice profit. What he does NOT realize is that he has been making a nice profit on this or that property these past 19 years, but not for the reason that the rule-of-thumb is sound. His profits were made because of the constant rise in prices in the past 19 years! He just about couldn't lose!

You, who will understand the Value Formula will have an enormous advantage over the rule-of-thumb investor. And you will be safe from losses due to inflation or depression. Your guide will have its method founded in facts. That is, ALL the facts, not just the gross rent. To understand this, let us con­sider an example.

Suppose you set out to buy a grocery store. You found two available. One was the Brown Store in Brownsville. The other was the Black Store in Blackstone. You learned the gross in­come of each. Brown Store took in $5,000 per week. Black Store, likewise, took in $5,000 per week. If you were a rule-of-thumb investor, you would stop right there. That would be all you would need to know. If grocery stores were generally worth six times their gross sales amount, you would place the value of Brown Store at $30,000. You would then compute the value of Black Store the same way and come up with a value of $30,000, too. And, in the natural course of your method, you would fix upon this as the value, so that if the owner of Black Store wanted $35,000, you would refuse to buy it. But if Brown offered you his store for $25,000, you would grab it as a bar­gain—yes, you would not!

The most rudimentary understanding of business would make you examine the facts about each store much more deeply than that. You would want to know what part of the $5,000 that came in each week was profit. What part was used to replace the merchandise sold? How much of the profit went for rent? For help? For other expenses? In other words, you would consider it childishly foolish to place the same value on both stores, simply because the gross sales amount or income was the same. Well, believe it or not, that is nevertheless exactly what thousands of real estate investors do! And that is how mil­lions of dollars worth of real estate is bought and sold every day—by experienced members of this field. That's what they've been doing for years and that's what they will most likely con­tinue to do for generations to come. And that's where you come into the picture with an enormous advantage over them.

When you compute the value of a building you start with the amount of gross income—but you only start there. Then you take into account all the other factors that will affect your profit and loss picture. For instance, the interest rate on mortgage that you will have to bear will affect your profit and loss figure for decades. We accept as a norm, for purposes of our formula, a rate of 6%, which is the general rate throughout the country in 1960.

But there are many areas where 8 and even 10% mortgages are common. That does not mean these properties are not good buys. But it does mean that the profit you will net will be lower. And that, in turn, means that the price you can afford to pay for the property must be lower if you are to clear a good profit.

Hence the Value Formula takes into account any amount you must pay out each year over 6% in mortgage interest as an excess expense—over and above the amount we "forgive" as normal. If your interest bill is 8% of $50,000 or $4,000 per year instead of $3,000, as it would be at 6%, you will be paying $1,000 more per year in interest than we forgive.

The formula, in these cases, deducts that $1,000 from the gross income, and says, in effect, "You are not receiving a true gross income of (let us say) $10,000. You are, for our purposes, receiving a true gross income, before regular and normal ex­penses, of $9,000!"

You now do the same process with other facts about this property. You may find that the janitor cost factor is higher than the Formula forgives. If so, you adjust the income for that overcharge. And so on. That is, in effect, the same method that any person with common sense would use in deciding which grocery store is the best buy. He would study the expense fig­ures, compare them with the income and these would often lead him to a conclusion he would never have reached other­wise. He might cheerfully pay $35,000 for the Black Store, even though the gross income was the same as Brown Store, and Brown could be bought for $25,000. And he would be doing the right thing.

Let us apply the facts of the grocery example to a true case in real estate. There are two apartment buildings not far from my office. They were built on a piece of land that is one-half in Brookline and one-half in Boston, Mass. The same builder built both at the same time. He built them precisely alike. As a re­sult, they both earn the same income, approximately $40,000 per year each. Now the rule-of-thumb investor or speculator stops right there. He takes that income figure of $40,000 and multiplies it by six and two thirds. That is the same as multiply­ing 15% as income to bring it to 100% as value. And the specu­lator buys either building at that price, or for as much less as he can. You will not stop there.

Both buildings being exactly the same, they are assessed for tax purposes for $120,000 each, by their respective cities. But the tax rate per $1000 of assessed value in Brookline happens to be $55. That of Boston well over $100. Please fix these facts firmly in your mind and remember that the annual tax bill for the Brookline building is some $6600. That leaves $33,400 of the income after taxes. The Boston building must pay $13,000 each year as its tax bill, leaving $27,000 of the income for other purposes. Now I ask you the big question. Would you pay the same amount for either building? Of course not! Yet, the specu­lators do! Because their way of figuring does not take these things into account. Yours does.

The far reaching effects of this method will vitally affect your fortunes. Here is how.

Let us say there is a building for sale for $15,000. The quickie rule-of-thumb method indicates that it is worth $17,000. The untrained speculator gobbles it up, thinking he has found a bargain. Now he starts to feel the effect of the extraordinarily large expenses that this particular building carries. He soon finds that he has made a bad buy. He tries to unload it, but, unless he finds another untutored rule-of-thumb user, he must take a loss. Nobody wants to invest in a building and receive NET on his investment, 5 or 6% per year.

The Value Formula, as you apply it to this building, shows a fair buying price of $12,000. When you found you could not buy it at or near this figure, you passed it up. You knew better. Thus you will find the Formula protects you against bad investments. The speculator buys it because he does not know the proper and thorough way to determine what IS a good or bad investment. All he knows is, "multiply the annual income by six and two-thirds and that's what it's worth." So he gets stuck with some real lemons.

It works the other way, too. Let us say the speculator is offered a six-family double Toby for $22,000. The income is only $3,000. He does some quick figuring. He multiplies $3,000 by six and two-thirds. That makes $20,000. So he offers $18,000 or $19,000. You come along and apply the Value Formula. It shows a value of $26,000! You haggle a little and buy it at $21,000. In these cases, the speculator has missed out on some topnotch investments because he used his rule-of-thumb. The Freeman case bears this out.

A speculator whom we will call Jack, offered me the Freeman group of Aunt Tobys. There were four-family and three-family buildings in the lot, fourteen apartments in all. The income in 1946 was about $5,880, with very low-rent-controlled ceilings. The woman who sold them to Jack had been peddling them about for some time and all who came offered her between $23,000 and $25,000, to permit a resale at six and two-third times the annual income with a good profit. Finally Jack had bought it for about $25,000 and set out to sell it at a profit.

He offered it to me. You may be amused to hear what my wife said about the deal when I told her I was considering buy­ing. "Bob, how can you? After all, Jack is a sharpshooter! Don't tell me you expect to get a good buy from him! It doesn't make sense. He's been dealing in properties for years and you'll never convince me that he'd sell it to you at any price that would make it profitable to you." I grinned and reminded her that her roast was smoking.

I bought the parcel for $30,000 with $3,000 down. There was a first mortgage of $24,000 and Jack took a second for $3,000. Application of the Value Formula showed that this property had exceptionally low expense factors. The tenants supplied their own heat and janitor service. Even the hall lights were on the meters of the tenants. Most had occupied the same flat for 25 years or more (shades of Aunt Toby!). They never expected, nor got, any service or attention other than the repair of a leaky roof, a leaky pipe, or an electric fixture. They did their own decorating. In other words, they let the landlord alone and he let them alone and everyone was happy, for years and years. And, most important of all, although these buildings were in neglected condition, the location was tops. Thus any improvement was justified and would pay off handsomely. And I would never lack applications from prospective tenants. To this day, I have never seen the inside of half the apartments nor even met those tenants. Each tenant mailed me his rent punctually.

As a result of the fact that I had to pay out so little of the income there was an average of $3,000 per year left in my hands for the nine years I held it. That makes $27,000. Then I sold it, using the selling methods you will learn here, for $60,000.1 was able to prove to a very canny investor that he could buy it at that price and make money, and he did. If I had wanted to sell it a year after buying it, I am certain I could have got $50,000. But at that time I was concentrating on buying—not selling. In the nine years I owned Freeman, I really had a dream investment. The rents came to my office regularly and dependably. I never went to collect a rent in my life. I might drive by the buildings occasionally, say, once a month or even less often, but I wouldn't even slow down. They required a minimum of attention. It was precisely the type of ownership that I had first learned about at Aunt Toby's. But now I was in the Landlord's position. It was just as pleasant as I had dreamed, and more.

In 1955, I sold Freeman and most of my other holdings in a manner and for reasons we shall discuss later. The buyer of Freeman, a Mr. N., paid me $6000 down and gave me a new first mortgage for $54,000 at 4K per cent on a 22 year basis. In 1955 4/2 per cent was a standard interest rate in this area.

Let us total up the whole deal.

I put in, at the purchase                                                 $3,000.
I took out between 1946 and 1955                               $ 27,000.00
I got as down payment from Mr. N                               6,000.00
My wife and I received payments per month
including interest and principal on $54,000  at 4%% for 22 years $322.60, which will give us in the 22 years                                                85,166.40
that means we will have taken out of
Freeman a total of                                                         $118,166.40
less what we put in                                                        3,000.00
thus we will clear in the 31 years                                    $115,166.40

The one thing that made this possible was simply this: I knew the Value Formula and Jack did not.
Isn't it obvious that if Jack (and his many counterparts) knew the Value Formula, he would have sold Freeman on the basis that I did? We can certainly see from these facts that there must have been many and many a buy that Jack has re­fused because he uses the old rule-of-thumb, and the price seemed too high for him. Instead, he stuck to a figure that the rule-of-thumb gave him, and, since all the other prospective buyers of Freeman were guided by the same rule, nobody offered the seller more—and the seller took it. But you can see what an advantage it gave me—and will give you.

So we can say that the fourth and most important use of the Value Formula will be to enable you to see good buys that the average speculator does not see, and you will buy them and make the profit that he will pass up. On the other hand, he will grab many a "bargain" that you will pass up. After that, unless he is lucky enough to find another as untutored as he himself is, he must take a loss.

That is the importance of the Value Formula and its four main uses.

Are You Ready To Move Onto The Next Lesson? Click Here….