A few days ago, I had a telephone conversation with a colleague and a fellow BP-er. Among other topics, the conversation veered into a discussion of the basis upon which investors make decisions relative to what they buy and what they pass on. Upon explaining to him my perspective, which took exactly 1 sentence, he said to me “…your next article should be about this, because so many people miss this.”
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.
So, How Do I Decide What to Buy?
There are an enormous number of strategies within the realm of real estate investing. Indeed, it can be a difficult task to define criteria for action. A new investor looking into this world for the first time is akin to a kid entering a candy store – their eyes grow big and their mouth starts to water. However, while making the “wrong” decision in a candy store can result in a relatively painless sugar rush, making a wrong decision around real estate can, and often does, cause ULCERS – those nagging open wounds inside the digestive tract that can make life quite unbearable for a long time…
My Decision to Act is Teed by Two Simple Overriding Precepts:
Precept 1: Don’t lose money!
Precept 2: Only buy property that you will be happy holding forevermore!
In my experience, placing emphasis on these two precepts dramatically improves chances of long-term success. Let us discuss this a bit further and itemize some of the subheadings under both categories…
Don’t Lose Money
As I see it, Don’t Lose Money is a function of three elements – presence of multiple exists, time, and cash flow.
I will not get into any deal, no matter how sexy the numbers look on the up-side, if I can not clearly identify three exit strategies – period! This is why I don’t flip houses, since by design flipping is intended as a 1-exit strategy.
Neither am I enamored with assignment, subject to existing financing, or any other strategy which carries with it the possibility of triggering the acceleration and Due on Sale clauses in the underlying financing. Why? Because as a scrupulous investor, these strategies require that I put my capital at risk in that I must be prepared to satisfy the existing liens should the lender knock on my seller’s door. If I put it on the table – I could lose it; I will pass…
To me, all of the above represents danger – too much danger for me to handle. I don’t like to gamble. Making money begins with not losing money, and multiple exits are a must in this regard.
I will not get into a deal that does not allow for at least 3 years. In my market, this is just too dangerous. If contractually, or by design, the deal necessitates a 6-month time frame – I pass. Most trading activities, such as flipping, are like this, and I chose to stay away.
Day 1 Cash Flow
There is a difference between speculating and investing, and often this difference is reflected in the presence or lack of cash flow. Presence of cash flow guarantees that we get paid; may be not much, but we get paid. Cash flow can allow us the luxury of time – the greatest asset in the world of real estate investing; more valuable than money! As such, anything that puts money in thy pocket is an investment, while anything that looks like it might in the future but does not currently is a speculation.
I don’t speculate. I only buy deals which make money on day 1. This is why I don’t buy raw land, up and coming gulf course residential developments, high-rise building projects in Panama, and all the rest of it. I only buy if the deal makes money today and makes even more tomorrow! In saying this, however, it is important to understand that the deal does not have to make a profit on day 1 – just to break even with room to grow in the future.
I know what you are thinking – mismanaged properties with vacant units which need remodeled and re-rented can not possibly make money on day one. Very true, and with this we’ve arrived at the Creative Finance lesson for the day:
Most people are so focused on the income column, that they can not see the magic that happens in the expense column!
While it is true that there may not be enough income on day 1, isn’t it also true that we can achieve an income statement equilibrium by lowering expenses for a period of time long enough to fix the problems on the income side?
The answer is YES, although with this we venture into the world of creative finance. It takes a special deal with a special financing package attached to it. There aren’t many of them out there, and this, my friends, is why I average only 1 deal per year 🙂
Buy Only Those Properties That You Will be Happy Holding Forever More.
I don’t like the idea of being forced into a decision, and while everything I own is for sale at the right price (exorbitant), I will not do anything whereby in order for the investment to make sense, it needs to be sold on a certain timeline. I am afraid of the market – it is a healthy fear in my opinion. The deal has to make sense today, tomorrow, and forever!
We can and should get very creative in the world of investing, but we should not convolute the basic principals. At times, in the heat of chasing that bird we forget the simple things – this can be costly. Building wealth begins with not losing, which is a matter of basic principals – remember this!