What Makes a Good Real Estate Deal?
by William Bronchick, JD
from creonline.com
So often, beginning real estate investors focus on 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
"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?" 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 are all factors to consider
when looking at a potential purchase.
Leverage
Leverage is important for investors 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. 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.
Equity
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. 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 in the right stage of a
real estate cycle will result in appreciation and profit.
However, timing a real estate cycle is difficult and is 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. Combine this tactic with reasonable
cash flow and buying into equity, and you will be a smart
investor.
Risk
Risk is a consideration that too few investors consider.
Now 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.
And remember, whenever you look at a property to purchase,
think CLEAR: Cash flow, leverage, equity, appreciation, and
risk.
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