So often beginning investors focus on real estate investing techniques that they lose sight of the important issue – is this a good deal? 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. It’s a simple acronym called “C.L.E.A.R.”…
CASH FLOW
Ask yourself, 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. Also, it depends on whether it is a single family or multi-family dwelling. With All of these factors considered, ask yourself, “will this provide income for me?”
Also, ask the question, “how will this property cash flow compared to other potential properties?” 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. 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. Is it? Do you earn other income? Do you need more income now, or is future equity growth more important? There’s no right answer to these questions, but they are all factors to consider when looking at a potential purchase.
LEVERAGE
Leverage is important in investing because the less cash you put down on each property, the more properties you can buy. If the properties go up in value, your rate of return goes up exponentially. “Nothing down” investing is very attractive for the high-leverage investor, but should be approached with caution.
If you are a long-term investor, 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 pay the monthly debt service.
EQUITY
Does the property you are purchasing have equity? Equity can take a number of forms:
- 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 that wants out of his property and is willing to give up his or equity for less than full value. 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.
APPRECIATION
Buying in the right neighborhoods and in the right stage of a real estate cycle will result in appreciation and profit. However, timing a real estate cycle is difficult and can be very speculative. 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. 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. Combining this tactic with reasonable cash-flow will make you a smart investor.
RISK
Risk is a consideration that too few investors consider. Ask yourself, “what if my assumptions are wrong?” 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? If you have a few vacancies, can you handle the negative cash flow, or will it break the bank for you? Expect the best, but prepare for the worst.
Remember, whenever you look at a investment property to purchase, think “C.L.E.A.R.”
