I was having a conversation with someone that had absolutely nothing to do with investing. The conversation was about a different business but he was talking about how difficult it was to work with people who were always trying to cut corners. People often think that they know better than the experts do, or that they can build a better mousetrap by doing things their way. Instead of using methods that were tried and true they were always trying to “trick the deal”. In the end it never worked but only served to make things more difficult.
I thought about what he said and how it applied to real estate. Real estate investing is very much a numbers game. We deal with situations and people and associated problems but, in the end, it comes down to the numbers. A property either has equity or it doesn’t, it either has positive cash flow or it doesn’t. No matter how you manipulate the numbers, at the end of the day your bank account will tell you the truth. As they say, a deal either “pencils out” or it doesn’t.
How to Analyze a Real Estate Deal
Deal analysis is one of the best ways to learn real estate investing and it comes down to fundamental comfort in estimating expenses, rents, and cash flow. This guide will give you the knowledge you need to begin analyzing properties with confidence.
Numbers Don’t Lie
While even veteran investors can sometimes fall prey to it, it is usually the novice investor who will fool himself into thinking that he has a deal by using the numbers improperly. He may see a property that he likes and play games to convince himself that he has a winner. He may do this by underestimating the cost involved to acquire the investment or by underestimating the amount of work that the house needs. It can also happen by being overly optimistic about the price that can be achieved when flipping, or how long it will take to complete a sale.
Perhaps the biggest cases of self-deception come with rental properties. Sellers and agents alike are quick to claim that a property provides a positive cash flow and the novice buyers are all too eager to believe it.
It is so easy to fudge the numbers on rental properties that it is imperative to dig as deep as possible to verify their accuracy. A vacancy factor of 5% is typically used, but is that appropriate? A factor of 5% means that a unit will be vacant for 30 days once every 20 months, do the tenants stay that long? How easy is it to get the unit cleaned and rented in only 30 days? Perhaps a 10% vacancy factor or even higher would be a better bet. Another number that is often overlooked is maintenance, can you really expect that no maintenance will be needed? Property management is often ignored because the investor intends to manage the property as well. Does that mean that the expense should be ignored? What if a manager is needed down the road? Should an investor really work for free by managing his own properties without getting paid? That’s what it amounts to if you ignore the fee. What about accounting, legal and other administrative expenses? These costs are real even if you choose to ignore them.
Novice investors tend to accept the numbers presented to them at face value. They will also look to real estate agents for advice. If the agent is a real estate investor as well and truly has the best interest of the investor at heart that may be fine. However most real estate agents have never owned an investment property and only know what they have been taught. Remember that an agent only gets paid if he makes a sale. For a property to have positive cash flow it must cover all of the expenses not just the mortgage.
What it comes down to is honesty. Not the honesty of the seller or the agent or the appraiser or home inspector or anyone else involved in the deal. It is all about the investor being honest with himself. Do not try to make the numbers work because you are eager to do a deal or because you’re frustrated with not being able to find something that works. If you do convince yourself to do a bad deal you will pay the price in the end. Although you “can’t trick the deal”, you can trick yourself.
“Trust, but verify.” – Ronald Reagan