In today’s episode of Discount Property Investor Podcast David and Mike go back to basic and talk about MAO Formula. It is a formula most investors use to determine their maximum allowable offer. The MAO is basically what you’re going to allow yourself to negotiate to if you have to. Check this episode to connect with David and Mike and learn more about real estate.
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David: Alright guys, welcome back discount property investors. I am your host David Dodge with co-host Mike Slane and today we're going to get back to the basics. In fact, I want to talk about the MAO formula.
David: The MAO formula is a simple formula that we can do on a napkin, we can really even do it in our head and it is a formula that we use to determine a maximum allowable offer, and in fact that's what MAO is, it's an acronym for maximum allowable offer. Now, why would we want to calculate a maximum allowable offer anyway? Like what's the point of that?
Mike: Well, you don't want to offer more than that cuz it's the maximum, right? It's kind of like the speed limit, it's the slowest you're allowed to drive, right? Oh wait, no. It's the highest, it's the limit so again you don't want to go over that. Just like the speed limit, you don't want to go over it, we all do. Same thing with the MAO, you don't want to go over it, but maybe sometimes we end up going a little over. It's just the way the business is, especially in the current market, things are going bananas but we still have to come up with a formula. We still have to determine how much we want to pay for properties and the MAO has always been what we've used and what we've told other people to use and continue to teach and use, but it changes. It changes with one of the variables in it which is the discount rate and we will get to that once we kind of dive into the MAO. So Dave, how do we calculate the MAO? It is your ARV multiplied by your discount rate minus repairs minus the wholesale fee and that is the MAO. So what is ARV Dave and how do we find that?
David: Love it. So MAO guys, it stands for maximum allowable offer, just wanna recap on that and Mike said it exactly right. The MAO formula, so we're solving for MAO, right? And we do so by a couple-
Mike: Oh no, not math.
David: -a couple variables, right? So we use the ARV, we start with that and it's kind of weird because the properties that we're buying or making offers on, they're never worth the ARV today. So that's something that I think a lot of new investors you know, have to try to wrap their mind around or they may struggle with is it's not the value of it today, it's actually the future value of what it could be hence after repair value, not today's value, right? Now, before we even go into more of this equation, the ARV can change depending on the level of updates or repairs that you do to it. So if you go in and you're just trying to get up, you know, a rental grade type of property, the after repair value may be, I'm just going to throw a number out, you know, 120 whereas if you go in and you don't do a rental grade rehab and you do a gut rehab and you update everything and use nice finishes and nice fixtures and you know, you don't- you don't slack on anything or cut any corners on that same exact property, you're gonna have a higher ARV on that property, higher after repair value.
Mike: Dude this is a really complicated- you're right, a lot of people get hung up on it and it's kind of complicated and I think the key is when you're looking at comps, when you're looking at the properties that sold around it, there's usually one or two that are really high like they're 10 to 20 thousand more in this price range, the 120-ish area, so what is that? Probably 5 to 10 percent higher than the other properties?
Mike: And then you're going to see like a little cluster of properties usually if there's a lot of properties in the area, a cluster of them, they're all going to be around the same number so like you'll see maybe in this area of 140 thousand and 145, and then the rest of them are clustered around this 120, 125, somewhere around there.
David: That's exactly right.
Mike: And then you'll see some lower ones and some off market ones that are much lower. So that's really what Dave is describing is those full retail to the nines ones, what would it- what's the max this thing would sell for? That's not the comp you want to use when you're trying to buy this sucker. That is the best case of property will sell for.
David: Yeah, figure out what repairs you want to do and then calculate those into your after repair value so you know, it can vary. So the ARV you know, is not always the same number. One guy may look at a property as a flip and he's going to have a higher ARV because he doesn't tend to go do everything whereas another guy may look at the property as a good rental and he just doesn't- he doesn't do everything, he does just what's needed and they're going to get two different ARV's. So the ARV guys, simply is the after repair value. It's the first thing we start with and again, we're solving for maximum allowable offer, we're solving for MAO so the equation goes like this: MAO equals ARV times the discount rate that Mike mentioned earlier and we're going to come- we're going to talk about that next, minus repairs and if we're wholesaling it, minus your wholesale fee. So again, ARV times discount rate minus repairs and simply enough if you're wholesaling, add in the wholesale fee too or subtract that out. That's it, it's that simple. So MAO, we're solving for MAO, we're using an ARV that's going to vary depending on your level of repairs, times that by your discount rate. Let's talk about the discount rate.
Mike: Let's talk discount rate baby.
David: Discount rates baby. So discount rates are really how much you're going to discount the property, and this is where you- this is where the investor comes in, right? So you have to discount it at least 10% in order to break even because that's what it's going to cost to sell it typically.
Mike: In an ordinary market-
David: Usually it's 8 or 9 percent.
David: But just go to 10%, boom, minimum. So if you're only discounting your property 10%, so that would basically be like ARV times 0.9, you are going to be able to break even on that so don't ever go over that number. Don't ever go over a discount rate of at least 10. We shoot for discount rates of 30% or 0.7, so we multiply our ARV by 0.7. Then when we do that, we're not making 30% profit on the deal or we're not expecting to at 70% or you know 0.7, there's 30% left over, 10% of that's going to be the cost to sell guys so you're basically shooting to make about a 20% return on your investment at a 0.7 discount rate. Next would be subtract the repairs and we talked about this a little bit because depending on the ARV you choose or you go with, are you going with the middle of the line ARV? Are you going with the high you know, high-end ARV? That's going to affect the repair cost.
Mike: Let me talk about discount rate a little bit more too.
David: Please, please.
Mike: So one thing I wanted to add was Dave's absolutely correct, 70% is what we shoot for but it also kinda matters where you are in town, the quality of the area. So again, the location is going to affect this but also current market conditions so in really really not good areas, we'll call them like your D-class, your war zones, your discount rates going to be much much higher. You may do a 0.3 as a- also a 0.8 or a 0.7. So what does that do to the offer? Well when you're multiplying it by a 30%, you're basically cutting out so much of that ARV. You're cutting your offer down significantly so that is going to again just really decrease the offer. In a higher-end area like really nice areas, you can probably buy up to 0.8 pretty safely because the numbers are bigger too. If you have a higher value property, a $500,000 property for example, 20% a discount is a much bigger number so there's actually still a room for a spread in there, as well as- again, you're not going to see properties in that area are selling for significantly lower. So your discount rate is definitely affected a little bit but a good rule of thumb, start at that 0.7 or 70% and you're going to be in the ballpark.
David: Yes. Typically a 70% deal is a wholesaleable deal too.
David: Because investors will be okay making 12 to 15 percent, they don't need to make that full 20%. So if you can get at you know, a 0.7, take 10 off the top guys that's- you got to do that every time no matter what the percentage is. So at 70%, that's 30 left, take 10 of the top, that's 20 left, you can wholesale that and give it to somebody at 12 to 15 and make yourself you know, 5 to-
Mike: 5 to 10.
David: 5 to 10 percent.
Mike: The other thing that's cool though is that often times newer wholesalers, even us, we've been doing it lately, is we underestimate the repairs. So if you did a higher discount rate at that 0.7 as opposed to moving it up to 0..8 and then you underestimate your repairs, you've kind of made up for that and it still makes the deal work or it still allows you to wholesale a deal.
David: Love that man, great advice.
Mike: So 0.7, great place to start if you don't know where to start, it's an average area, definitely start there. Dave, you we're getting into repairs, let's talk about it.
David: No yeah, so back to discount rate just really quick though. Guys, this is a sliding scale so you'll notice that we don't have MAO equals ARV times 0.7 minus repairs minus wholesale fees. Instead we have MAO equals ARV times our discount rate minus repairs minus wholesale fee, and the reason that we don't have a number in there is because it's a sliding scale. 0.7 is a great place to start. Mike said earlier, if it's a war zone or a place that's not the best neighborhood, right? You're going to move that discount rate from 0.7 down to maybe 0.5 or 0.3 or 0.4, whatever it might be, it slides. Now, in the current market conditions, we've had to adjust our discount rate from 0.7 up a little bit and in today's market, and I say that you know, we're recording this early July 2021, and probably for the last I don't know 6 to 8 months, we've been having to come in closer to the 0.75 or even the 0.8. Now 0.75, still wholesaleable, it's going to be tight. 0.8 works when you're buying rentals, right? So it depends obviously also on your strategy, your goal, your plan, you know, all those things for where that discount rate may be, but your typical discount rate is going to typically be anywhere from 0.8 on the high end down to 0.3 or 0.4 on the low end give or take and it's gonna slide so just know that. Next is the repairs. Guys, we talked about this in terms of you know, what's the ARV? Are you going high? Are you going middle? Are you going low? That's going to be reflected in the repairs. Are the repairs going to be 20? are they gonna be 40? They're gonna be 60? That's all going to depend on what you're choosing with the ARV. And then last but not least, wholesale fee. Now you don't have to minus out or subtract out the wholesale fee if you don't plan to wholesale it, right? And really at 0.7, you typically are going to have some room in there already to wholesale it, but it's good rule of thumb to add in a wholesale fee of you know, 5, 10, 15 grand, it could- maybe even 30 grand depending on the deal, right? Typically your wholesale fee should be a small percentage, so if you're buying a million-dollar house, $30,000 is a very small percentage of that but if you're buying a $60,000 house, $30,000 wholesale fee is 50%, that's not going to work typically. So you know, obviously that's going to be a little bit of a sliding scale as well. So this formula, the MAO formula guys, that's what we're solving for. Very simple: ARV times our discount rate minus repairs minus a wholesale fee if you're wholesaling it, is going to give us what's referred to as our maximum allowable offer. So if we run this formula through and let's say that we get an MAO of 125 thousand, that's the maximum allowable offer. Mike, what would we typically offer somebody if we calculated an MAO at 125?
Mike: We would not offer 125.
David: That's what I'm looking for.
Mike: So like we talked about, it's that limit, it's that speed limit. You're not supposed to go over 125 because this is the maximum allowable offer so we're going to come in underneath that, maybe 115, 110, 115.
David: 110 to 115 and they may not like that.
Mike: But it's good because it gives you a little room to negotiate. One of things I hear Dave say a lot is nobody likes someone who can't negotiate a little bit on price. So again, being able to come up a little and still be under or at your maximum allowable offer is really, really huge.
Mike: So that's why never go in with the MAO upfront. It just- it doesn't allow you to be the likeable person who can be negotiated with.
David: I love it.
David: I'm going to repeat what Mike just said: never go in with the MAO upfront. The MAO is basically what you're going to allow yourself to negotiate to.
Mike: If you have to.
David: If you have to, that's such a great point. So let's say that our MAO, the maximum that we're willing to pay or that we are allowing ourselves to make an offer on in this example, we talked about 125, if we make the offer for 110 and they say okay, great we got it even cheaper than what we had calculated for, but if they say hey you know 110 is not going to work, I'm asking 150, well now I can say let's meet in the middle and where does that put me at? Roughly-
David: Yeah, I like the middle when it's closer to our number too, trust me, love that. But that's the whole point, and sometimes, getting to your MAO may take days, it may take weeks, guys it may take months, right? Sometimes sellers aren't going to be willing to sell you a deal because they think the property is worth more than your offer and they may not- they may be right, they may be wrong, but when they're wrong which is typically most of the time, not always but most of the time. They need time to learn I guess would be the right word that the property isn't valued at what they think and that's why you need some grounds to negotiate up a little bit, right? You never want to leave with the most you can pay because then you have no leeway. If they say well we're close, can you meet me in the middle? Well then you're over your maximum allowable offer but if you go in below it, you now have wiggle room to negotiate up, but the beautiful thing is and Mike, you had mentioned this a little bit earlier is that if you can get that for less, if you can make an offer lower than the MAO and they accepted the offer then boom, home run grand slam.
Mike: Yeah, love that, love that.
David: You're rocking and rolling.
Mike: Love that.
Mike: So that's it.
David: That's it guys.
Mike: That's MAO.
David: That's all there is to it, it's literally that simple. Close us out Mike.
Mike: Cool. Guys, thank you so much for listening to us, appreciate it. Please like and share. If you want to leave us a review, it helps us reach more people and that's what we're about is kind of giving back into the real estate community. We help a lot of people through our coaching and through our free courses we have out there. We've got the free wholesale course.
David: Oh yeah.
Mike: We've got the free landlord course. Check those out and again, thank you guys so much for listening. We'll talk to you guys next time.
David: Signing off.
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