Anatomy of a Real Estate Deal

520 Barron is a charming 3 bedroom place that wears its age on its sleeve. It is located in the Barron Park Area of Palo Alto. It has been put together in bits and pieces and the heritage shows. It was originally a small 1 bedroom place with a small kitchen. Since then the kitchen has been expanded out into a large kitchen+dining leading into a family area, 2 more bedrooms have been added behind the existing one. The layout is odd, two of the bedrooms are inter-connected without a real way to get to the master bedroom without going through the other. It’s not a great deal, there is a way to spend some money and fix it up so that it all makes sense. The house has a converted garage that is a small studio apartment with its own kitchen and bathroom. This cottage is interesting in that it represents the tantalizing opportunity for some additional help with the mortgage. Being clearly separate from the house, it can be rented out with very little trouble. Stanford is close enough to supply a large population of single graduate students who would love the cheap rent and short commute. An additional storage cottage in the back is useful as a workperson’s shed/additional storage etc. As we were to learn later, trees aren’t all good. Their roots get under your foundation. Plants cozy up to the wood exterior and exhale water into the walls. Wood wicks up the water into the whole house. Before you know it, the house is crumbling around you and you’ve still got all this furniture that feels damp to the touch.The landscaping and yard are mostly harmless. Nothing out of the ordinary: a lemon and orange tree each, a couple other large trees, some flowering plants, gravel driveway, some paving in the backyard which could use some upkeep or better yet removal.

520 Barron was put on the market in June of 2009. At the time it was listed at $995,000. We had seen it at the time, but not being in the market but merely curious we had filed it away as what a million dollars could buy you in Palo Alto. It is quite enjoyable to walk around that part of Barron Park. It’s close enough to El Camino to be walkable, and yet rather quiet. The houses vary from old and decrepit to spanking new McMansions. The road is tree-lined, windy and mostly reminiscent of a tiny village road. The schools, that ultimate arbiter of Bay Area housing prices, are at both ends of the spectrum. The elementary school, Barron Park Elementary, ranks at the bottom of Palo Alto schools by API score, the middle and high school rank at the top by API. Being on the leeward side of El Camino means that all three schools are walkable from the house.A starter home is the cornerstone of bubblicious thinking. You buy a starter home by extending your finances just that much more. You move in, and then fix it up a little at a time as you go along. Five years later, the market has boomed along and you sell and you get a lot more for the house and the magic of leverage means that you almost doubled your investment. But don’t think there’s something wrong with making so much money so soon. It’s called, sweat equity. Once you put it that way it almost feels like you worked for every penny of that money, you didn’t just sit in that house and enjoy your tax-free mortgage-interest payments. And so you sell the house to the new sucker family who needs a starter home and move in to a higher level now that you have twice the down payment available and with any luck you’re earning a little more. Of course you aren’t saving much, but saving is for suckers and the Chinese government. The entire area exudes character and is a great place for a family. For a “starter home” (we love realtor-speak, we do), it’s a good bet in a good area.

We started looking for a house in earnest about a month ago. Lined up a great agent, hooked up the RSS feeds from Redfin, and away we went. One day, I decided to look up Craigslist and what should I see but a house in Palo Alto, Barron Park even, listed on there for $985,000. The house was not on Redfin and indeed did not have an address listed. We were intrigued, and decided to reach out to the listing agent to find out more. That started an incredible ride on the real estate roller coaster.

First off, the agent, we’ll call her C, said she couldn’t tell us more about the house until we told her more about ourselves. Apparently the owners of the home were interested in keeping things private and didn’t want their lives too far disrupted. We were quite open about ourselves and told her a bit about us. Next, C asked us for our lender’s contact information. I thought it was a bit much to ask for all about us without so much as a glimpse from their end, and so I instructed our lender’s agent to reveal as little as possible while giving C enough confidence to proceed.

Then C went silent for a while, leaving us to wonder what was going on. A couple prods later, she was back and promised us we were first in the line for a series of private showings of the home, and could we come by the next Thursday. We took our agent, D, along and saw the home on March 25th. The location of the home was not revealed to us until the last moment. Picture our surprise when we discovered that it was, drumroll, 520 Barron. Apparently the earlier innings on the market had not gone too well, and it had been brought back on the market now by a different agent. One assumes the seller waited just long enough for the tail on the previous contract to expire before re-engaging with a new agent. This time, they were willing to settle for about $10k less, which was nice.

The house clearly needed a bit of maintenance, it appeared that the roof needed to be replaced, and C gave us a huge stack of paper for the disclosures. We went home and went through the disclosures. In addition to the roof, the disclosures revealed that there was some “deferred maintenance” pending on the house, and throwing in the work that we would do to pretty up the house a tad, we thought we were looking at expenses of about 50k on the house, all told not a bad buy at 985k. And so we went in with the offer. We agreed to pay the asking 985k, and threw in an incentive for an immediate acceptance. We also wrote a personal letter to the owners indicating our fortuitous find of the same home we had seen once before and how we looked forward to living there. Our offer was accepted, and as we went into overdrive to get our funding arranged, we also brought in our inspector on the following Tuesday. Inspection highlights

  • Almost none of the 3-pin sockets is grounded.
  • There’s a random car jack lying under the foundation, almost as if the house was held up at one point by a car jack among other things.
  • Very close inspection reveals that the cottage rear wall is missing siding.
  • Significant wood-rot in the foundation

As the inspector started walking us through the house, it turned out that the deferred maintenance on the home was more than just the few superficial items that the disclosures had hinted at. In particular the foundation was apparently in much worse repair than we had imagined. Of course, C told D, you knew about that. D professed that no, he had no idea that was the case. When we got home that evening to chew over what we had just learned, D forwarded us some new disclosures that C had just sent him. This included a foundation inspection indicating that it was in really poor shape and would take almost $90k in repairs to fix up. That really got us riled. Had we just been had? What was going on here? Was this a bait and switch? D advised us that we had best talk to our contractor first, look at what other potential gotchas there might be before we moved forward with a renegotiation of the price.

The contractor wasn’t much help and so we got back to C a week later and cut our price to $900k. Given everything, this was a reasonable price for the house. It looked now that the house needed about $150k of repairs to it to get it up to a reasonable level, and with all that done it had a good chance of being worth around $1.05M. If we got lucky a little more than that but not much more. The sellers weren’t so amenable though. A little digging around revealed why. It turns out that they bought the house right at the peak of the bubble for $950k. They put down less than 20% (as was the practice at the time) and financed the rest, presumably on comparatively (compared to 2009-2010, that is) high interest loans. It was unlikely the sellers had much equity accumulated in the house in such a short time, and they presumably had by now paid up about $180k in mortgage and tax payments. An exit at $985k would give them about $110k back after settlement costs and broker’s fees. Adjusting for the mortgage interest deduction, they were looking at a rent equivalent of $150k spent to live in a Palo Alto house over 3 years, mostly breaking even. Unfortunately, every drop in the price affects that number quite severely. A $25k drop in the price raises the 3-year cost to $175k, getting it to unacceptable levels. And here we were asking for a $85k drop in price. For $235k I would want to have lived a lavish downtown lifestyle in Palo Alto, not turn of the century (last century!) house in Barron Park!

But they had no case to hold on to 950k. And so, they offered to have the foundation re-inspected by Mark Garrison, apparently a pre-eminent foundation expert in the Bay Area. Mark met with us a week later to tell us what he saw under there.Mark Garrison highlights

  • [T]here’s been some subsequent work that was done [by the current owners]…a lot of it superfluous…waste of time and effort
  • [Y]our termite report, I’m sure the guy had a field day
  • I would expect a discount…I’m buying somebody else’s issues.

It was just as bad as the first report had made it out to be. You could live here, Mark said, but eventually the deferred maintenance would catch up with you. You would have to spend about $90k to make it code-compliant or about $50k-$60k to reinforce it and install enough belts and suspenders that the foundation would pass muster. In short, $900k was a fair price and $925k should be as high as you go.

The sellers got back to us. They offered, surprise surprise, $950k. On what theory? This made no sense to us. It was the seller’s theory apparently that other people would buy the property for a demolish and rebuild and still expect to come out ahead. We don’t know about that. A demolish and rebuild is between $200k and $250k. The opportunity cost to owning this space for that time is another $60k. In other words, the rebuilt house has to sell for at least $1.2M, potentially $1.25M. I just don’t see that happening. At $900k there’s a fighting chance of making the economics work. Across the street, 3765 La Selva, with a similar lot size sold for $800k. Next door to it sold for $700k (slightly larger lot). There’s a reason those deals got done at sub-900k levels.

The only way to make the economics work is to sell it to people who will live there for a while and then figure out what to do with the house, thus amortizing some of the sunk cost across a few years of living there to make up for the additional $100k-$200k compared to across the street. But people who live there eventually have to pay the piper, and he already has his hand out for $85k+.

It’s not clear that relisting makes perfect economic sense. An expected value calculation would indicate limited upside, and given that every additional week in the house represents an additional investment of over $1k to the sellers, marginal returns are rapidly diminishing.The sellers decided that if we didn’t agree to $950k, they would put the house on the market at $899,000 and let the market bid it up to where they want it to be. It’s a risky move, what if the market decides not to offer $950k? Now they have not one, but two foundation reports setting an approximately $90k tag on deferred maintenance. Throw in the roof, the myriad other things wrong with the house, it’s a gutsy move. Given our investment in the house so far, we upped our offer to $925k. This would get us to the foundation expert’s lower number on the maintenance. No dice! They rejected that outright.

That’s that I suppose. We don’t get the rationale, putting it on the market seems like a rather large risk given that we’re 50% of the way between the listing price and their desired price. But that’s their call, and so be it.

We’ve moved on to looking at other homes.

A final meditation on the agent’s role in all of this. One way or another, the agent got us the disclosures really late in the process. There is no question that this cost both us and the seller some money, the sellers more than us. In our case, our loss was the $500 or so we spent on the inspection. In the sellers’ case, there was a loss of time while were in contract, time that could have been spent showing other prospects. And this bit about listing the house, that’s weird too. For all this work, she’s going to make around $200 more than if they had accepted our final offer. We’re almost certainly missing something, a bubbly attitude perhaps.

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