So often, beginning real estate investors focus on techniques that they lose sight of the important issue: Is this a good deal?Â Learning to recognize a good deal takes research, education and, above all, experience.
Here’s a good formula to determine whether a potential real estate purchase is a deal.Â It’s a simple acronym called C.L.E.A.R.
“Will this property cash flow?” Well, that depends on a lot of factors, such as the strength of the local rental market, the interest rate on the financing, and how much of a down payment you make.
It also depends on whether it is a single-family or multi-family dwelling. All of these factors considered, ask yourself, “Will this property provide income?”
Then ask the question, “How will this property cash flow compared to other potential properties?”Â For example, a $150,000 house that rents for $1,000/month has a better income potential than a $300,000 house that rents for $1,600/month.Â A four-unit building that costs $400,000 may bring in $3,000/month in the same neighborhood.
Now, of course, whether the property will provide income to you begs the question of whether income is important to you.Â Is it?Â Do you earn other income?Â Do you need more income now, or is future equity growth more important?
There’s no right answer to these questions, but are all factors to consider when looking at a potential purchase.
Leverage is important for investors because the less cash you put down on each property, the more properties you can buy.Â If the properties go up in value, your rate of return goes up exponentially.Â However, if the properties go down in value and you have a lot of debt on the property, this can result in negative cash flow (see above).
Since real estate is generally cyclical, negative cash flow is only a short-term problem and can be handled if you have other income or a cash reserve to handle the negative. “Nothing down” investing is very attractive for the high-leverage investor, but should be approached with caution.
If you are a long-term player, leverage will generally work in your favor if the markets in which you invest appreciate in the long run and your income from the properties can pay for most of the monthly debt service.
Does the property you are purchasing have equity? Equity can take a number of forms, such as:
- A discounted price
- A potential fixer upper
- A rezoning opportunity
- A poorly managed property
- A foreclosure
There are many ways to create equity, but buying into equity is your best bet.
Find a motivated seller who wants out of his property and is willing to give up his equity for less than full value.Â Or, buy a property that needs work that can be done for 50 cents on the dollar or less.
In other words, if the property needs $10,000 in work, make sure you get a $20,000 discount on the price or better.
Buying in the right neighborhoods in the right stage of a real estate cycle will result in appreciation and profit.Â However, timing a real estate cycle is difficult and is speculative.Â If you buy properties without equity or cash flow solely for short-term appreciation, you are engaging in a very risky investment.
Buying for moderate, long-term (10 to 20 years) appreciation is safer and easier. Â Look at long-term neighborhood and city-wide trends to pick areas that will hold their values and grow at an average 5% to 7% pace.Â Combine this tactic with reasonable cash flow and buying into equity, and you will be a smart investor.
Risk is a consideration that too few investors consider.Â Now ask yourself, “What if my assumptions are wrong?”Â In other words, do you have a “plan B”?
If you bought for appreciation and the property did not appreciate in value, can you rent for positive cash flow?
If you buy with an adjustable rate loan and the rates go up, will this put you out of business?Â If you have a few vacancies, can you handle the negative cash flow or will it break the bank for you?Â Expect the best, but prepare for the worst.
And remember, whenever you look at a property to purchase, think CLEAR: Cash flow, leverage, equity, appreciation, and risk.
— William Bronchick, J.D. is an author and attorney who regularly presents workshops and do-it-yourself seminars at real estate and landlord associations around the country.