Normally, my posts are usually a monologue intended to educate and persuade my readers. Today’s article is more of a working session or journal of my thoughts. I have no experience in real estate, but I do have a sophisticated financial background. This is how I think about investing in real estate.
Getting started
My current job is to oversee acquisitions for my company and make sure that all diligence is being performed to the fullest extent necessary. I also run valuations on all potential acquisitions.
My brain works on processes and numbers.
After reading Rich Dad, Poor Dad, I started to develop an interest in real estate. The book is about much more than that, but the idea of owning a physical asset that can pay me money by renting it out struck a chord. Talk about passive income!
It also has a limited supply. If you buy in the right area, your land becomes more and more valuable. If nothing else, the land itself should at least keep pace with inflation. After all, they aren’t making any more land any time soon (Dubai doesn’t count).
Of course, investing in real estate also has its costs. If you end up in a Hell House, your property could actually lose you money every year. If you get the right deal, you could have yourself a cash cow that prints money.
That’s where my analytical brain takes over. Buying profitable real estate is a factor of two processes: diligence and valuation–now you’re speaking my language. That’s when I dug in deeper.
Valuation
For me, this is the easy part. It’s simply a math formula based on a set of assumptions. Some of these are well known (like property taxes and HOA fees) while others take some guesswork (maintenance and capex). And everything has risk. That’s what makes it so interesting to me–and that’s why I’ll require a significant expected return on my investment.
While reading How to Invest in Real Estate, I started to get interested in setting the value. Since I’m as lazy as they come, my preferred strategy would be to buy and hold this piece of property while renting it out.
Keeping that in mind, valuing a house is determined by two things: income and expenses. Here’s the sheet I came up with to start:
This house is one I found on Roofstock. Using some assumptions from their website and verified with Zillow, I input all of the income and expenses relevant to the property to come up with a yearly return.
I like to be conservative with my models. The rent is lower than the Zillow estimate and the vacancy rate is higher than the Roofstock estimate. I’d likely be able to get a loan lower than 4% as well, but that’s alright. A little built in buffer never hurt anyone.
I also would like to keep a reserve of extra cash if/when large expenses occur. I have this calculated as twice the expected spend in the first five years.
This also doesn’t include property price appreciation. If that occurs, it’s all gravy.
Even through all of this conservatism, the deal appears to be favorable. If everything goes exactly to this plan, I’d be making an average of 5% per year for the first ten years after purchase. That’s a pretty sweet deal.
Next is the weakest part of my real estate skills…
Diligence
When I’m managing the diligence process of acquiring a company, I’m really looking for red flags and pitfalls–things that might change the value or kill the deal altogether.
I think the same way when analyzing real estate. I want to know the dirty little secrets of this property, and I hope to find no skeletons in the closet.
This is where experience in real estate would really come in handy. Without doing it myself, all of the potential pitfalls and red flags are all theoretical.
That said, when looking at a property, I currently do three things:
- I look for the purchase history. If a house was foreclosed on, there’s a higher chance that the previous owners didn’t treat it very well.
- I Google Map it. This shows me what the neighborhood looks like and gives me an idea if I would want to live there.
- I look at the historical prices and rents for the area. Housing and rent prices aren’t guaranteed to go up. I want to invest in real estate that has a high likelihood of appreciating over time.
I’m sure there are hundreds of other ways to vet a deal, and I expect to learn more along the way. For now, I hope this will at least weed out the deals from hell.
Conclusion
Considering the prices of the housing market right now, it may be a long time before I’m able to buy a rental property. In the meantime, I will be looking and researching more about the art of real estate until I find an opportunity.
And if I wasn’t clear, I’m a complete novice in this field. If you have experience or insights into anything real estate related, I’m all ears. Now is the time for information accumulation. With enough time and information, I’ll be a real estate investor in no time.
Thanks for reading!
Featured photo source: Morning Brew on Unsplash
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