The title says it all — we’ll just jump right in.
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.
7 Core Tenets of Investing Successful Wealth-Builders Know to Be True
Tenet #1: Investors never spend the principal.
Investors understand this fundamental concept to the core. It is the root of capitalism — and the great divide between the 1% and everyone else. If I could sum up the key to wealth preservation in one phrase it would be this.
Never, ever spend the principal.
If you abide by this rule, you, your children, and your children’s children will be taken care of financially until the end of time.
This is a concept that goes over a lot of newer investors’ heads. Let’s dive into what I mean by never spend the principal.
When you invest a dollar, you need to think of that dollar as gone. Out of your life. Forever. You never use it to buy coffee, a house, pay for Junior’s college, your retirement expenses, or anything else. That dollar is to be put to work generating returns for you, forever.
Let’s use this (too simplistic) example to demonstrate the part of the investment you never touch:
I have $100,000 and buy a rental property for the same amount. A year goes by, and the property generates $1,000 per month for 12 months, and the property is now worth $110,000, as it appreciated in value. I sell the property, collect my cash, and walk away.
My situation a year from now is this — I have $122,000 in the bank. Not accounting for tax, my return includes the $12,000 in rental income and the $10,000 in appreciation — a total gain of $22,000 or a 22% return on investment (ROI). The other $100,000 of that money in the bank is the principal I used to invest in the first place.
Here are the results boiled down:
Starting Dollar Amount: $100,000
Rental Net Income: $12,000
Ending Dollar Amount: $122,000
I can spend the $22,000 I generated from this property without depleting my wealth, but if I spend more than that, then I have less than I started with. I would not even for a second consider spending anything beyond that $22,000. The original $100,000 is not to be touched and instead should be reinvested in the next property. To spend that money would violate a core tenant of investing — and instead of building wealth, I’d destroy it.
True investors don’t get into that situation.
Tenet #2: Investors must reinvest most of the investment returns.
Investors also understand this fundamental concept to the core. It is the root of true wealth and the great divide between the 0.01% and everyone else. If I could sum up the key to becoming truly wealth in one phrase it would be this:
Reinvest both the principal AND the majority of your investment returns.
If you abide by this rule, you, your children, and your children’s children will not only be wealthy, but exponentially richer, more impactful, and more powerful until the end of time.
Let’s be real — we’re here to build wealth, not to break even.
If you want to build wealth, you can’t just spend all of the returns you get from your investments. Instead, you need to reinvest them.
Back to the example of the rental property above. If you’ve gone from $100,000 to $122,000 in wealth as a result of your investment, you can’t expect to get any richer by spending that $22K!
Instead, you need to reinvest that $22K and buy a $122,000 property. The larger, nicer house will generate more rent and perhaps more dollar gain in appreciation than the first one, and your wealth will grow faster and faster as you repeat this each and every year, buying more and more properties.
Every dollar that you spend on luxuries or life obviously cannot then be used to invest. The key to remember is that you can spend some of the return. In the case of the house in the example above, I could still get rich by spending $10,000 of the return and reinvesting the balance. I’ll just need to make sure that I never spend too much money generated by my investments such that I dip into the principal or initial amount invested.
The point of investing is to build wealth and improve the quality of your life or the lives of others, so make sure to enjoy the benefits. But, be careful not to spend the principal and to reinvest the majority of the returns. If you do this right, your principal should produce wealth for you and your heirs to enjoy forever and ever.
Tenet #3: To invest, one must have capital.
You cannot invest capital unless you have it. And you cannot get capital without earning/inheriting it and keeping it.
This is why there is such a great divide in wealth in America. In spite of the fact that America has a relatively low cost of living and that we have one of the highest median incomes in the world, just about everyone in the country fails to accumulate significant capital in their lifetimes.
Want to get into investing, building wealth, or achieving financial freedom? Keep they money you earn. Don’t spend it.
This is also a hard pill to swallow for a lot of people who take pride in calling themselves “investors” but don’t actually have any of their own money to put into deals, businesses, or other ventures.
If you are one of those people who invests Other People’s Money (OPM), then you are not an investor in that enterprise. You may be a businessman, you may be wealthy, and you may be successful, but make no mistake about it — you are being paid for your skills, business acumen, and your efforts in managing the investment for your investors.
Sometimes, this payment is in the form of equity in the business or investment opportunity. And sometimes that type of payment can be exponentially greater than a W2 salary. But never forget that so long as you are bound to serve the interests of the investors, you are a manager of the investment.
You are serving the investors, not that there is anything wrong with that. It can be great to do this to get started, as managing other people’s money can expose you to knowledge that will help you to serve yourself as an investor down the line.
But the only way to accumulate capital with which to then truly invest is to either earn or receive it as a gift — and subsequently not to spend it.
Tenet #4: Investment returns do not correlate with effort expended.
You know that guy at the office who spends all day talking about his stock picks and portfolio? The guy who meticulously studies the market, looking for undervalued stocks?
That guy puts in a lot of effort. And enthusiasm. And he’s got this righteous attitude about how he’s doing it better than you.
Unfortunately for him, he’s wasting his time.
His efforts picking stocks, one at a time, timing markets, and otherwise trying to outperform Wall Street are utterly wasted, as he could simply invest in an index fund and almost certainly earn better long-term returns. I find it interesting to write about this topic because many investors get riled up when they hear that something that they put a lot of time and effort into is statistically worthless.
Of course, keep in mind that any investment that at least outpaces inflation can make one wealthy. Even poor investors can become wealthy so long as they reinvest most of their returns. This fools some folks into thinking that their efforts are producing wealth for them, when they would really be better off doing nothing!
Luckily, you won’t be one of those guys because you recognize that unless you want to devote a career to Wall Street and learn to live and breathe the nuances of the public markets, or alternatively, spend a lifetime finding, managing, and systematically buying and improving excellent companies, you’d be better off investing in index funds.
Far too many amateur investors with net worth below $1M attempt to pick stocks and beat the experts in public markets. And there is simply no correlation between their efforts and their returns.
Tenet #5: Investment returns are impacted by knowledge.
Interestingly, one of the reasons why folks attempt to pick stocks is because they haven’t bothered to read dozens of books on investing. They are ignorant of the math and philosophy behind why successful investors suggest not picking stocks. Thus, it is their lack of knowledge that leads to worthless efforts.
This is sad news for those of us who have devoured countless amounts of material on the subject. We know that knowledge can be incredibly powerful to our long-term financial positions and investment returns — if applied correctly to businesses that we have some control over.
For example, my knowledge of the Denver real estate market and real estate investing fundamentals have produced excellent returns on my first few properties here. Similar knowledge could not have helped me earn higher returns in the stock market, as I do not have control over the companies one can publicly invest in.
Here in Denver, the returns I generated from real estate were fairly predictable, if my prediction from last year is at all credible. While I did put in some effort, most of my efforts involved becoming deeply familiar with as many fundamentals of real estate investing as humanly possible. Everything from how to analyze a property and market to how to screen tenants, protect the property, do due diligence, and read and study contracts.
That type of effort involved accumulating knowledge.
The physical exertions and time spent actually “working” on the investment — my efforts — were relatively small and can be almost entirely outsourced to property managers, handymen, and contractors for the most part. In fact, my time was probably more valuable than the time spent actually doing the labor on the project — or in other words, my efforts actually negatively impacted the return!
Without knowledge, so much can go wrong for those that seek to invest and build businesses. And the problems that can result won’t just reduce your return, but can destroy the principal that you’ve invested, too!
Tenet #6: Investors do not confuse volatility with risk.
“Aren’t stocks risky!?”
Whether or not an investment is risky depends on what you mean by “risk.” I’m here to tell you that stock investing (or at least the stock market in aggregate) is not risky. Folks who tell you that stocks are risky do not understand the definition of risk very well.
Now, stocks as a group ARE volatile. Bonds, as a group, are less volatile. This is an important distinction that many people who refer to themselves as investors (but lack fundamental knowledge of investing) fail to understand.
While we do see that stocks are more volatile than bonds, they are not more risky. It annoys me that financial advisors, major media outlets, and consequently, your average investor have it drilled into their heads that stocks are riskier than bonds.
Let’s pull out a graph to demonstrate this point.
This chart shows the total compounded value of an investment in treasury bonds versus an equivalent starting investment in stocks. You can get this data for yourself from NYU’s Stern School of Business.
Now, the very first thing we see in this graph is that the treasury bonds produced far less total return than stocks in this chart over the time period we are looking at. This same scenario plays out across virtually every 30-year period that we have data for.
But an adherent to the “stocks are riskier than bonds” school of thought would counter that observation with the second most noticeable characteristic of the graph — the Treasury bills also didn’t suffer any huge losses (the dips) in the graph above.
And they’re right!
But here’s the thing. We are investors, so we understand the core concept of investing, the one described right off the bat:
Never, ever spend the principal.
Folks, forever (think “never, ever”) is a long time. We as investors only live off of a minority of the cash flows and/or returns from our investments. Therefore, we care only about how investments will perform over the very long-term.
Thus, we only care about the first observation in the graph! The investment that will help us build the most wealth, relative to its alternative.
In the short-run, yes, you will likely suffer some big drops in the market value of your stocks. But since you are investing forever, you cannot avoid the inescapable fact that given the choice between stocks and bonds, stocks are clearly less risky over the long-run.
This is because we as investors sensibly define “risk” as “the probability of having less wealth over time.” With this correct definition, bonds are statistically more risky over the long run than stocks. Stocks will be more volatile in the short-run, but over virtually every 30-year period in history, equity markets outperform debt markets!
This advantage to equities increases as your time time horizon expands. Because I plan to live to be 100, my time horizon is 75 years. If you are 50, your time horizon should probably be at least 50 years. Probably, we should both plan to live forever, giving us a time horizon of infinity.
But even if you don’t agree on infinity, 50-75 years is such an extraordinarily long time horizon that there is virtually no chance that a bond investment outperforms equities.
And because you have such a long time horizon, there should be no reason that by the time you retire (everyone under 50, that is) you can’t live off of just the interest and just the cash flows from your investments, even if your assets lose half their value!
This type of thinking should be applied to every investment that you make.
Note: If you plan to spend the principal of an investment, then do NOT use this definition of risk. You aren’t investing in that case. You’re “saving up” and in violation of the very first tenet listed here.
Understand risk, folks — risk must be considered in relation to your time horizon. Volatility in the short-run is tolerable. A voluntary, statistically certain long-term reduction in wealth is not.
Tenant #7: The best investments are specific to the investor’s personal situation.
Most people, especially those with low net worth, fail to understand that great investment returns do not come from typical investments in the stock market, bond markets, or even in passive rental property investing.
Instead, the greatest investments I’ve made (financially speaking) have been in things that reduce my monthly personal expenses. Yes, reducing your monthly cash outflows counts as an increase in wealth and an investment return. If it allows you to accumulate more wealth faster than any other investment, then do it — and do it first!
My bicycle, which I now ride to work, cost me $250. My commute is 5 miles, and my cost of commuting is about $.50 per mile. Biking to work saves me $5 per day, or about $750 per year, assuming I bike 75% of the 200 workdays per year. That’s an annual return of 300%, not counting the added benefits to my health, and you had better believe this was a serious investment that I analyzed as such prior to thinking about real estate.
My home is filled with LED light bulbs, which burn far less energy than incandescent bulbs. I use a drying rack ($20) to save $1 per load and spend virtually no extra time folding laundry weekly. Also, instead of buying a true rental property “investment,” I bought a duplex to house-hack — enabling me to live for free.
These are investments, folks. You are killing your financial position if you refuse to believe that there are items you can purchase that will substantially reduce your monthly expenses at far greater returns (ROIs of 1000% plus) than stocks, bonds, and real estate.
It is foolish to even think about investing in any traditional sense if there is perfectly good money you are throwing away each month. Often, this money can be saved with far less sacrifice than the time spent working hard to earn it or the time spent acquiring the knowledge needed to be a successful investor.
Bonus: If It Doesn’t Produce Cash Flows, It’s Not an Investment
You ever heard anyone tell you to invest in gold?
*Snort of derision*
Gold is a rock (OK, it’s a metal, but come on). It sits there. It shines. It produces no value, saves no lives, and does nothing but look good. Even that part about “looking good” is debatable. Don’t take my word for it, though. Here’s Warren Buffet on gold:
“I will say this about gold. If you took all the gold in the world, it would roughly make a cube 67 feet on a side. […] Now for that same cube of gold, it would be worth at today’s market prices about $7 trillion — that’s probably about a third of the value of all the stocks in the United States. […] For $7 trillion… you could have all the farmland in the United States, you could have about seven Exxon Mobils, and you could have a trillion dollars of walking-around money. […] And if you offered me the choice of looking at some 67 foot cube of gold and looking at it all day, and you know me touching it and fondling it occasionally… Call me crazy, but I’ll take the farmland and the Exxon Mobils.”
Gold is not an investment. When you hoard gold, you produce no value. At best, you are gambling that its price will go up relative to the currency you traded for it.
This is called speculation. People can make money speculating, but do not fool yourself into thinking that you are investing. You might be a great businessman, a student of the market, or even quite wealthy as a speculator, but you are not investing. This is not a recipe for long-term wealth and financial success that will compound forever.
Investors understand that investments must produce cash flows. You can invest in a business, you can build a business, but you cannot buy something, let it rot for a couple of years, and then attempt to call it an investment.
To all the investors out there:
- Have you found the above tenets to be true?
- What would you add to this list?
- What single investing principal has served you best thus far?
Let me know your thoughts with a comment.