RE Finance...

I want to invest in RE but I just don't know where to find the deals! Where do I start? How do I even know if that great deal is actually a good deal? Easy...it's all in the numbers.

Whenever I evaluate a property for potential acquisition there are two distinct parts: the quantative and qualitative analysis. Quantatively speaking I just want to know how the numbers shake out. This is where I look at the various expenses and potential income and come to a final calculation for ROI and cash flow. I can do this without ever seeing the property (and usually do!).

Once it passes my criteria (for me I want to see a 20% or better ROI before I'll even consider it) for investment I'll move on to step 2. Qualitative analysis is just my assessment on how it looks. It's my gut feeling based on the condition of the property. I ask myself things like, "would I live here?", "what are the potential maintenance expenses beyond what I forecasted in my initial analysis?", "how's the neighborhood?". This is where you decide if you want to be a slum lord or not. Personally, if I wouldn't live in a property I wouldn't rent it out. That's not to say that I wouldn't buy it and make it right but I simply refuse to preside over a tenement.

I think it's worth mentioning at this point a RE maxim that I've stumbled upon. I didn't make this up but I have seen it in action...

Rule of thumb: Single family homes have excellent appreciation potential but lower cash flow. Multi-family units have depressed appreciation potential but excellent cash flow

Why is this? Well, if we look at the numbers we see that you simply get more for the buck with multi-family. Check out my previous post My First Time... for an example of why multi-family gets great cash flow.

Anyway, lets talk about the numbers since that is what this post is supposed to be about. When evaluating a potential acquisition the first thing you should do is get as much information as possible. The listing agent for your property should be able to provide rent rolls, maintenance reports, and other supporting documentation for you to base your calculations off of if you're looking at buying a property that is already someone else's investment. For this scenario I'm assuming that we're buying multi-family (because I want cash flow) so these are reasonable assumptions.

Engaging the listing agent (and their property managers) should give us a good idea of what the maintenance expenses are, tenant turnover rates, and rents. We should then determine what the taxes are per unit. Most municipalities have online tax records that make it easy to figure annual taxes. I like to figure in 5% of gross rents and 10% for maintenance as an expense for planning purposes because this isn't the time to lie to yourself. You know these are going to be expenses so account for them! If you end up spending less than that then you've just given yourself a bonus but failing to account for them could be costly.

I see CAP rate thrown around an awful lot but where's the value in it? It's useless to me because I'm going to get a loan and CAP rate numbers don't mean anything in that case. I use return on investment because I want to know how much money I'll make on the money I put down. So if I put 25% down on a property I want to know how much that 25% makes me.

So in order to get the last number for my calculations (mortgage; principal & interest) I just use an online amortization calculator. Just Google "amortization" and a bunch of really great calculators will pop up for you.

Lets do an example analysis of a property we're considering. This is a quad-plex in a decent neighborhood that the seller wants $225k for. Rents are $600/mo and it is 100% rented.

Step1: Quantive Analysis - By the Numbers

1. Taxes = $60/month per unit (from the tax assessor's website) = $240

2. Insurance = $30/month per unit (from my friendly insurance lady)= $120

3. Mortgage = $225k x .75 = $168,750. 20 yrs @ 6.5% = $1,258/mo for quad-plex

4. Vacancies = $600 x 4 = $2,800 (monthly gross rent) x .05 = $140

5. Maintenance = $2,800 x .1 = $280

Monthly Gross Rent = $2800

- Mortgage                  1258

- Insurance                   120

- Taxes                         240

- Maintenance               280

- Vacancies                   140

                                  $762

So I have monthly estimated cash flow at $762/mo or $9144/yr. But recall that I had to spend $56,250 for my down payment to get that $9,144 so what was my rate of return for year 1?

9,144/56,250 = 16%

Not bad, huh? Of course this assumes that your tenants will pay on time and that there are no major repairs to be made. This doesn't satisfy my 20% ROI criteria so I would keep looking around but 16% is still a pretty good return. I'll keep it in mind if I don't find anything else better. For argument's sake lets say that I'm interested so we need to move on to step 2.

Step 2: Qualitative Analysis - How's It Look/Feel?

Now I want to see the property so I schedule a time to walk through the units and get a feel for them. Is there anything that would indicate major repairs were on the way? Are the air conditioners 30 years old? How's the roof look? Is the water heater about to go? I love talking to the tenants too. In fact, this is one of your single best sources of information. Ask them how they like the place. How's the neighborhood? Are they planning on renewing their lease? Are there any leaks or other problems that aren't easily seen? Tenants will tell on a property so fast if given the opportunity! So talk to them, they're on your side. They secretly hope that you'll buy it and take better care of it (and them) so they're willing to open up. You want to know what's wrong so you can make it right so consider them part of your team.

That's essentially all there is to analyzing an RE investment. Sure, there are foreclosures, short sales, distressed properties, blah blah blah. But many of those require cash purchases or will require prohibitive amounts of work to get it rentable/sellable. For me, I want something that I can make money on starting from day 1. I don't mind paying a fair price for something because I know I'm going to make money on it if it satisfies my criteria and if I take care of my properties and tenants. Resist the urge to be a slum lord, don't treat your people like they're your paycheck, and do the right things. You'll make your money. Waiting on the sidelines for the perfect deal will ensure that you stay on the sidelines, a sort of paralysis by analysis.

So to sum it up, do your homework and above all else be honest with yourself when plugging numbers into your spreadsheets. The old accounting adage "garbage in, garbage out" is infinitely true here. Acknowledge the ugly baby in the room and you won't be surprised when you take a vacancy, maintanence, tax, or insurance hit (among other things). Don't be greedy, find a deal that will make you a fair return and lock in solid long term cash flow. By the way, I spend very little of my profit month to month because I like to use it once a year as a down payment for my next property. Doing it this way is an excellent way to accumulate properties and, over time, complete financial freedom!

What are your thoughts?