The Real Estate Wedge
Arbitrage in Real Estate
Let’s start with this — what the heck is arbitrage.
Basically — if I can buy something today for $20 and turn around and sell it immediately for $25, there is arbitrage in the marketplace.
Most commonly, people refer to the stock market when speaking about arbitrage. The problem is that arbitrage very rarely exists in the stock market as the opportunities are quickly swallowed up by the day traders of the world.
But what if there was a market where you could benefit from arbitrage?
Real Estate Arbitrage
While the stock market may not have any natural arbitrage left for the average investor, real estate does. This is why I focus about 90% of my portfolio on real estate. That plus I was never able to do ‘well enough’ in stock investing. In real estate, there is a natural gap because of an inefficient real estate market. Often times, this gap is what can be referred to as the real estate wedge.
Most of the players are local (you rarely have out of town or country individuals in your local real estate market). In addition, usually only about 10–20% of buyers are investors (in comparison to the stock market where everyone is an investor). The result, end users create arbitrage in a market where there are insufficient investors to close the arbitrage opportunity.
There are quite a few real estate arbitrage opportunities, but the most basic ones are: (1) Buying under market and (2) Lifting the value of your home
Buying under Market:
An entire wholesaling industry exists based on the premise that you can buy a home under what it is worth, tack on a wholesaling fee and sell it to an end user or investor. If this isn’t proof that it is possible to buy a house under market price, I don’t know what is. I know quite a few wholesalers that do well operating in this market, and I know even more investors who will tell you exactly how important ‘the buy’ is in an investment. This is essentially money you make on Day 0 of your purchase.
You can buy real estate under market because of a breadth of different reasons, such as:
- Inadequate marketing of properties
- Homes that are for sale by owners
- Distressed property sales — foreclosures, tax liens etc.
- Personal Emergencies — power of sale, estate sales etc.
- Owners lifestyle — hoarders, old age sellers etc.
Wholesalers enter into contracts with these sellers at advantageous prices while providing them with solutions to help solve their problems. They then add a fee for their time spent and resell these properties to (generally) investors.
In each of these scenarios, there is an investor or a wholesaler capitalizing on the natural arbitrage opportunity on Day 0 of buying their home.
Lifting the value of your home:
The reason flippers can generate income in today's market is because of a second form of natural arbitrage in real estate. The end consumer (renter or purchaser) values a fully renovated home much more than an outdated one (obvious, right). However, the spread between the price of a renovated home and the price of an outdated home, has created an entire industry for house flippers. Flippers can come in, renovate a property and sell it for much more than it cost them to buy the home and renovate it.
Here’s a quick example in one of my favorite areas: between Victoria Park and Pharmacy bordered by the 401 and Ellesmere — also known as a part of Wexford-Maryvale.
There are only two houses on the market here, at the time of writing this article. Its been on the market for a while so … there may be something wrong, but it works for the case of my example.
Check out the three-bedroom bungalow below, listed at $699K. Likely it will sell at around $740K ish.
A couple pictures of the inside, and you can quickly see — this house likely hasn’t been updated in about 20 years.
By the way — if you read my last article on How to Live in Toronto for free — that last picture (the ‘dining room’) is exactly what I would use to make my fourth bedroom.
The Renovation:
Let’s draft a quick renovation plan (bare minimum work, maximum prices):
- New flooring = $10K for the entire house.
- Nice Kitchen on the main floor = $15K
3. New Paint = $5K entire house
4. Take down some walls (assume) = $5K
5. Two new Washrooms = $10K
6. Buffer: $10K
Your total renovation will cost around $55K.
Your Total Purchase Price: $745K + $55K = $800K
The Comparable:
Lets compare this to a house in the same area that is turnkey on the market (there is a lot more of this on the market — thank you flippers).
Based on this home, you can reasonably assume your house is worth around $915K. Being all conservative, let’s say $900K.
Lift in the value of your house: $900k — $800K = $100K
The result? You have lifted the value of your house by $100K in just a few months, not depending on any form of market appreciation. Imagine you did one every year? You would build your net worth by about $100K each year.
In real estate, if you can identify below market purchase opportunities and make strategic renovations you can continue to lift the value of your properties. This is the most common approach taken by a lot of new real estate investors to quickly grow their portfolio.
If you haven’t noticed yet — I am trying to do bi-weekly articles! My next article will be on exactly this, using the BRRRR to grow your portfolio, with a real-life example for you :)
