How to Analyze a Potential Deal
As discussed in the earlier article as a real estate investor looking to make short term profits your goal should be to find motivated sellers who are looking to sell under market value and sell quickly. Read our earlier article here – Determining Profit Before Buying a Property. When you do find a motivated seller your next step is to evaluate your plan for this property. Novice investors may assume, “Everything in this area has gone up in value so I should invest”. But before buying property you should make a viable plan that also includes an exit strategy. The key idea here is this:
Never go into a deal without knowing exactly how to exit it.
A Good Deal Can Vary
There is no cut and dry formula that can be applied to every market when it comes to figuring out what a “good deal” is. In some places you could be paying 90% of market value and still be able to make a substantial profit especially during times when demand is high. In other places, you may have to pay 70% of market value or less in order that you be able to make good money when you sell the property. This is where experience comes into play. Once you become familiar with a certain area and you have done a few deals in the area you get a feel of the market and you know exactly what kind of discount is necessary to consider buying the property and terming it a “good deal”.
Unfortunately for those starting out you will be less likely to spot a good deal. Therefore do realize that as a novice investor you will have to accept the fact that you miss out on a few good deals by taking a defensive posture. If you are too aggressive you may make some borderline deals – deals that do not give you much profit. Its better to be defensive in your early days of real estate investing and let a few deals slip by rather than take a risk on properties and get burned in the process.
Knowledge is Power
The best ways to analyze a good deal is Knowledge and Education. In the world of real estate investments, there is a strong link between knowledge and risk. The more knowledge you have about properties, markets, mortgages, neighbourhoods, financing, local rent figures, repair costs etc. the less risk you have on losing a deal.
The CLEAR system
This is a system I learned during my stint as a real estate agent in the US. The CLEAR system is one of the best ways I know to determine whether a deal is good. CLEAR stands for:
- Cash Flow
- Leverage
- Equity
- Appreciation
- Risk
Lets analyze each of these concepts in more detail:
Cash Flow
Cash flow is the most important consideration when you evaluate a potential deal. Your first priority should be to find out whether the property you are planning to invest in will reward you with positive cash flows. The cash flow depends on a number of factors such as the state of the local rental market, the amount of financing and the interest rate you will be paying. Also make sure you compare the cash flow potential of a particular property against that of other properties that you have shortlisted to buy.
Its important to do some “real math” on income properties. What do we mean by real math?! Well for starters lets look at “stupid maths” for income properties that may be done by some novice investors:
- Monthly rent – ₹ 1 lakh
- Monthly EMI – ₹ 80,000
- Monthly Profit – ₹ 20,000
When you apply for a loan when buying property, most lenders will discount the rental income on your properties by an average of 25 % because there are other costs involved in operating a rental property. A 25 % discount is usually a correct deduction because expenses include:
- Taxes
- Hazard insurance
- Vacancy
- Repairs
- Management (even if you live in a villa managing it yourself)
- Real estate agent fees
- Maintenance
- Utilities
- Advertising
In some cases the above costs can even climb upto 50% of the rental property’s income. Of course the rate varies depending on local vacancy rates, the type of neighbourhood, and the age and condition of the property when you buy it.
Leverage
Next point in the CLEAR system for determining a good deal (after cash flow) is leverage. We all know the effects of inflation which will cause the value of a rupee today to be worth less in the future. Thus while real estate values may increase in the future, an all-cash purchase (all monies put up by you) may not be the most economically wise thing to do because you could use your own money in more effective ways. More cash invested into a deal may not be able to maximize the return on your capital.
Understand the Concept of Leverage
Leverage is using borrowed money to make a return on investment. Lets say that you buy a house for ₹ 1 Cr. If the property value increases by 10 % over one year the house is now worth ₹ 110,000,000. As a result of that, your ROI is 10 % annually. Actually you would net less because you would incur costs when selling the property.
But if you purchase the property using only ₹ 10 lakhs of your own cash and ₹ 90 lakhs in borrowed money, a 10% increase in value would still result in ₹ 10 lakhs of increased equity but your return on cash is 100 % (₹ 10 lakhs investment yielding ₹ 20 lakhs in equity). Of course the borrowed amount is not cost-free as you incur loan costs and interest payments when you take on a loan. But you could also rent out the property in the meantime which can offset the interest amount of the loan.
Do note that ROI is not cash on cash. As you can observe in the example above, appreciation on the investment was considered in the equation. Cash on cash return is simply the amount of cash you receive every year vis-à-vis the amount of cash you have invested. The return on investment (ROI) calculation considers the total profit including appreciation.
If you take the concept of leverage even further you can see that you can purchase ten properties with 10 % down and 90 % financing. If you are able to rent these properties for breakeven cash flow i.e. expenses and EMI payments not exceeding income generated by the property then you would be able to build a nice nest egg in 20 years when you pay off the loan for the properties.
Contrast that with the kind of money that you could make by investing your entire monies on one property for 20 years. You would have maximum cash flows every year but your total portfolio would not increase as much.
Equity
Just to underline the whole purpose of this long article once again – Our goal with the CLEAR system is to find out whether buying a certain property is a good deal or not. For that you need to find out how much (if any) equity the property has. You can find equity in many forms such as foreclosures or other distress situations whereby the property has a lesser asking price, a property that needs lots of renovations offering good potential or a poorly managed property that gives good rents. You can also create equity by changing its use from residential to commercial or vice versa. For example buying a ground floor apartment facing the street may not be an appealing idea but if you can rezone the property and convert it into an office or a retail storefront space that would turn out to be a great investment.
When financing is involved, equity can take the form of paydown on debt. For e.g. a rental property that earns income can be used to pay down financing known as amortization. Every mortgage payment is part principle and part interest. As you collect rent and make mortgage payments, the principle payment increases your equity in the property even if the property value does not increase.
Appreciation
The fourth point in the CLEAR system is to find out the probable appreciation of the property in question. Buying property in the right neighbourhoods at just the right time can help in appreciation and subsequently profits. But as we all know this can be tricky to time it exactly right. You cannot depend completely on short term appreciation of your property for profit because it can get risky. Instead buying for long term appreciation such as over a period of 10 – 20 years is safer and easier. It would be a good idea to study the long term neighbourhood and city trends to select areas that will sustain their values and grow at an average of 5 – 7 % annual rate.
Risk
The final point in the CLEAR system of analyzing a good property deal consists of assessing the risk involved in buying a particular property. It’s a fact that many real estate investors do not properly asses and consider risk and do not spend enough time on this aspect. Its also true that pretty much every real estate deal involves atleast some amount of risk no matter how “safe” the deal may look on the outside. Since real estate deals involve debt, your money can turn into a liability if the investment turns bad. There are also potential legal liabilities that we will cover in another article.
I suggest that you should always have a Plan B in case your initial investment plan goes for a toss. Know the answer to this question:
If you are buying a property for short-term appreciation and it does not appreciate, can you rent the property for positive cash flow atleast until the market rebounds?
To properly consider risk you must also take financing into account. A lot of novice investors buy properties with adjustable rate loans thinking that they will sell the property before the loan payments increase. If you have done that think about this question:
If you buy a property with adjustable rate loan and the rates go up will this put severe strain on your finances? If you have a few months of vacancies in your property can you handle the negative cash flow or will it break your bank? The bottomline is this – Expect the best but prepare for the worst.
Balancing Your Business with Personal Goals
As a real estate investor looking at the long term picture is important. You must balance your goals using the CLEAR system by aligning your business and personal goals. For some investors cash flow is not so important as retirement income or equity growth. For another set of investors the immediate requirement is steady income from the properties that they invest in so that they can quit their job. But owning rental properties may not provide enough income in today’s world and especially in cities like Mumbai where rental income is vastly underpriced when compared to the price of property. In short you should use the CLEAR system to do your math and consider all the implications of your real estate investments.
Summary of Article
- As an investor you can never take profits for granted. Always analyze and go for the best deal right from the very beginning of a transaction.
- If you want profitable deals then you should locate and deal with only motivated sellers.
- The CLEAR system can be a very efficient and useful way to analyze a potential deal
There are many successful investors in real estate and there are of course many who struggle. The difference can be boiled down to one factor: The successful investors had a CLEAR plan and followed it though!
Do not miss a single article!
Submit your email id to get new articles directly into your email inbox!
- Paperwork and Pricing of a Property - April 4, 2024
- What type of Real Estate Investor Are You? - March 25, 2024
- Various Ways to Profit as a Real Estate Investor - March 22, 2024
