Today I’ll share one of the most important lessons you’ll add to your investor tool box as you get started on your journey… How to evaluate deals.
Ready? Let’s go!
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First, some ground work.
You need to be clear on 3 things before you evaluate a deal…
WHY invest in real estate?
What market are you investing in?
What types of properties will you focus on?
So why real estate?
You invest in real estate for 4 main reasons…
Cash flow - consistent income to cover expenses and help you achieve financial freedom.
Leverage - the ability to purchase something big without having all the money for it, have others pay for it.
Appreciation - acquiring assets that grow in value over time.
Tax benefits - simply put, take home more of what you earn from your W2 job.
Not all good real estate deals are strong on all 4 - there are many successful investors that invest for just 1 or 2 of these.
BUT, while you’re getting started and still maintaining a 9-5, it’s important to aim to get all of these in order to lay the foundation for accelerated growth.
What market are you investing in?
Knowing which market you’re in is critical to understanding whether a deal is good or not. Get very clear on what good looks like in your market.
Use my guide to picking a market to get started.
What properties will you focus on?
Different properties have different return structures. They also require vastly different amounts of attention. While you’re working full time, start simple with townhomes, single families, or small multi family (4 units and under).
These are the properties where you’ll most easily take advantage of all the reasons to invest in real estate above.
Okay, now that you know why, where, and what you’re investing in… Here’s my simple formula to evaluate a townhome/single family/small multi family property.
Step 1: Determine cash on cash return
Cash on cash return is simply how much money you expect to make in a year divided by how much you put into the deal.
Start by using the Zillow Mortgage Calculator to estimate your cash to close and expenses each month. Make sure to include the advanced criteria like taxes, insurance, and HOA dues. Cash to close can be estimated by downpayment plus 2% of the purchase price (to account for attorney fees, origination charges, and prepaid expenses).
Then look at what similar properties are renting for in that area on Zillow Rentals, Rentler, Trulia, and local rental sites. Average the top 3-5 comparable property rents for your estimated revenue.
Now put it all together…
Cash on Cash Return = ((Estimated Monthly Revenue x 12) - (Estimated Monthly Expenses x 12))/Cash to Close
Savvy investors that have mentored me look for at least 15-20% cash on cash return when they’re active in a deal and are comfortable with roughly 10-15% if they are completely passive. I follow these same rules of thumb.
Step 2: Estimate year 1 appreciation
The more your property appreciates, the sooner you can cash out and leverage your equity to buy more investments. There’s an art and science to estimating your appreciation for year 1 of your investment property.
The art is listing a few recently sold comparable properties in the area and making an educated guess on what yours could sell for, taking into account how fast or slow the area is growing. You’d know growth information from when you picked your market.
The science is simply entering the details of your property into an appreciation calculator and entering in the current inflation rate being reported in the news.
Average these two numbers and subtract the purchase price to see home much equity you could make.
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To bring this home, when you find a cash flowing property that is set to appreciate fast, you’ve got a great investment. You’ll use this cash flow and appreciation to get your next great investment!
There are other factors you’ll consider like tax benefits as you build your portfolio but the factors above will be more than enough for your first deals.
For now, it’s time to get out there and evaluate your first deal - good luck!