How to Analyze a Real Estate Deal

Historically, investing in real estate has been a tried and true method of building wealth over the long run. If, of course, you have the right wherewithal and mentality to do it because, let's face it, it takes work. However, as with any type of investment, investing in real estate has its own set of risks. You can lose a lot of money even if you made a legitimately great deal at the start. You can also make a lot of money with income-producing property, or you might only make a little that could have been a lot if you were better prepared when analyzing your real estate deals.

[00:01:00]:
Welcome everyone to the Retired-ish podcast. I'm your host, Cameron Valadez, and today we are talking investing. Real estate investing, actually. I'm not talking about hardcore real estate investing like those people who put cardboard signs up near a freeway that say, “We buy real estate” written in Sharpie. No, I want to go over the basics of how to analyze real estate investments or deals, let's call them, for everyday people like you and me who are maybe looking to add some real estate to your overall investment portfolio to build wealth over time and pursue your life goals.

I'm not saying that you should or shouldn't invest in real estate in particular because that depends on the individual and how they want to dedicate their time. But if you're already down that road, or maybe you've inherited some property or are considering investing in some property, this episode is for you. Maybe you're just dipping your toes in the water with real estate for the first time, or you have some real estate, and you're maybe trying to figure out if what you currently own is a good investment compared to others that might be available out there.

[00:02:09]:
You could be looking to purchase your first investment property, your 15th investment property, or looking to switch the property you inherited for another. Either way, knowing the basics of how to analyze real estate deals can make the difference between a great investment and an absolutely terrible investment. Simply put, real estate investing is a numbers game. You're investing technically in a physical asset that you can see and touch. But when it comes to making money, it's about how the numbers work on paper at the end of the day. That's why I say it's a numbers game.

It is not, “Hey, let me find the prettiest property on the block, and that should be the best investment.” I want to show you how to look at the numbers so you can make your own decisions. I'm not going to sit here and tell you how you can make tons of money in real estate with little to no money of your own or some so called silver bullet strategy or method to making a quick buck in real estate overnight.

Investing in anything, including real estate, has risks. When it comes to real estate investing, some risks are completely out of your control. But many of the risks depend on you and your actions and wherewithal right from the get-go, and how you shop for your investment, how much you put into it, how you manage it, when you sell it, if you sell it, the list goes on. But for the purposes of this episode, let's get into the numbers game when you're looking for and analyzing potential investment properties or you're trying to analyze investing in some sort of real estate deal versus some other investment.

[00:03:50]:
I want to start by saying that there are tons of ways to look at investment property and analyze a deal. There are so many different metrics or ratios and methods you may have read in a real estate book or something like that. But I'm going to go through what I think are the four major components you'll want to have a good grasp on because these four things are going to make up 90% to 95% of a real estate deal.

So here are our four components, or quadrants, that we want to look at when analyzing a real estate deal. Number one is the potential appreciation of the property itself. Number two is mortgage reduction, and that is only if there is a mortgage. Number three is the potential tax benefits of purchasing the investment property, and number four is cash flow. These are going to be the numbers you want to know or have a reasonably good idea of. They are essentially different areas where you may be able to derive some sort of return. I'll go through each of these as we go, but first, I want you to know that when you analyze a deal or even fully commit to one, you may or may not get all four of these different components of return. You might only get one or two of them, depending on how you go about entering the deal.

So, let's set up a very basic and hypothetical example in order to run through these four quadrants. Let's say you go out and purchase a rental property for $100,000. I know you're already thinking, I live somewhere like California. There are no properties for $100,000. I'm choosing $100,000 to make the math easier. It's the concept I want you to know here. So bear with me.

[00:05:37]:
And let's say that on that property, we put down a 20% down payment, which is $20,000, and you are going to have a mortgage of $80,000. All right, easy peasy. Our first component of this potential deal is going to be the potential appreciation of the property over time. This just means that the value of the property can potentially increase over time. The real estate market as a whole can go up or down at any given time due to a wide variety of factors. This is very similar to, say, the stock market. Then you can also have individual pieces of real estate go up or down in value, depending on a wide variety of factors that relate to maybe just that property or its surroundings, similar to maybe investing in a single company in the stock market. The concepts are very similar. Different areas of the United States have different average rates of appreciation over time, such as the Bay Area in California versus the middle of North Dakota. No offense, North Dakotans.

In addition, what you do with your particular property might influence its rate of appreciation or whether or not it's located next to a highly regarded school district. So, the potential appreciation is very hard to know ahead of time. Almost impossible. It's sort of like an educated guess that you're going to have to make. For our example, I will just use a hypothetical 4% average annual rate of return for appreciation. Back to our example. In a year from now, you are hoping that your $100,000 property appreciates to be worth $104,000.

[00:07:28 ]:
If we take the $4,000 of appreciation and divide that by our out-of-pocket investment of $20,000 for the down payment, that's a hypothetical 20% rate of return just from the potential appreciation or component number one. Now, of course, I definitely want to mention I have not accounted for the other costs and fees that occur when purchasing a property, as well as the various fees you would incur when selling a property. But remember, we are going to use these metrics to analyze one deal versus another. We are not calculating the exact return we can expect from the one particular investment we decide to make. You could do that if you wanted, and you eventually should if you are going to invest in something. But there are many more factors that you're going to have to put into your calculations.

Okay, so back to our example. The cool thing about the appreciation component is that it also is what we call tax-deferred, meaning you won't pay taxes on any appreciation until you sell it. But there are also some other cool ways to deal with that appreciation without ever selling it. But we'll save that for another episode.

All right, onto component number two, which is mortgage reduction. First, you want to understand what we call PITI, which is principal interest taxes, property taxes, more specifically, and insurance. So, PITI, and you'll want to try to make sure that the rent you charge on your investment property exceeds PITI. You want that covered at a minimum. So, if the rent you charge at least covers PITI, that means that your tenant will be essentially paying your mortgage down for you or reducing it. And as you know, as time goes on, more of each monthly payment goes towards paying down the principal, and less goes to interest. But at first, it's mostly interest.

[00:09:30]:
In our example, in year one, let's say you have no vacancies, so you have a tenant all year long, and your tenant pays $900 total in principal towards your mortgage of $80,000. That means your mortgage is now around $79,000, and you have $900 in equity. Therefore, the hypothetical return in year one from component number two, in this case, the mortgage reduction, is the $900 divided by the $20,000 you came out of pocket for the down payment. And that number is four and a half percent.

Moving on to component number three, which is the potential tax benefits, this one can get a little iffy when it comes to the potential rate of return you can get from the tax benefits. Since everyone's individual tax situation is very different, you could have technically two different people looking at this exact same property, and they could get very different tax benefits. It's very important to understand that not everybody will get those same tax benefits depending on the property they're looking at.

Now, this largely depends on the amount of total income your household brings in, as well as whether or not you are a real estate professional in the eyes of the IRS. Remember, if we focus on using this metric in a more basic fashion, simply to compare the potential tax benefits to those of another property, rather than trying to calculate our exact personal rate of return after taxes, we can keep things apples to apples. Now, one of the unique characteristics of real estate is that it typically loses money on paper.

Why is that? Well, it's mainly because of something called depreciation. There's also a deduction for mortgage interest if there is a mortgage. And don't even get me started on the fact that if you have a great tax advisor, there are plenty of other write-offs to be had here as well. Again, we'll save that for another episode. Or better yet, you can schedule a consult with us at my firm, Planable Wealth, and we could teach you all about that.

[00:11:41]:
So anyways, even though a property might appreciate and you might have your mortgage interest being paid down, and maybe even a little cash flow, your property still might show that it's losing money on paper, which is a write-off. How much of a write-off depends on the rest of your specific and personal tax situation. But for our example, let me throw out a fairly realistic number in terms of a loss. Now, in your specific situation, you may not even have a loss, but I'm going to use a loss in our example because they are fairly common.

Let's say you have a $6,000 loss on the property, again mainly due to your expenses, your depreciation, and mortgage interest deductions. Let's also add to our framework here and say that you make $90,000 in income from a regular W2 job, and you pay around 30% in federal and state taxes. That $6,000 loss on your tax return can pull down the $90,000 you're bringing in from your day job so that now you are taxed on only $84,000 in income. So, having the rental property in this hypothetical scenario actually reduced your taxes. However, as I said, this won't happen for everyone. You definitely need to get with your tax advisor on your situation or to help you analyze some deals.

The cool thing here is that if you do make too much income and therefore you can't get a tax benefit today, like in this example, you can actually accrue those losses and place them in a bucket to use later to offset any potential gain you might have when selling the property in the future or to offset rental income that you're bringing in once you're no longer generating losses.

In other words, you can likely use those write-offs someday in the future. So, in the first year, if you get a $6,000 write-off, you'll save 30%, which is the hypothetical tax rate that we added in of that 6000, which is $1,800. That $1,800 divided by our out-of-pocket of $20,000 is a 9% return. And lastly, component number four, which is cash flow. Of all the four components, this is the most important in my opinion.

[00:14:05]:
This is the money you collect in rents above and beyond all of your expenses and taxes, etcetera. This is the money left on the table that you get to put into your rental bank account after all is said and done on a monthly or annual basis. However, if you want to measure that now, you may not have any money left on the table, which would mean that you have a negative cash flow, and you don't want that. If you have negative cash flow, that means that you will have to come out of pocket more money to keep your investment operating. Occasionally, you might run into short time periods where you have negative cash flow, such as during a vacancy. And that might be okay because you may still have some return from those other three components we just discussed until you get that remedied. Can you still make money with an investment property that maybe breaks even and isn't cash flow positive? Yeah, sure. But you're limited to returns that come from the other three components, which also may not happen depending on your situation, or it might be a very little return.

Back to our example again. If, let's say, you cash flowed so positive cash flow after expenses, $1,000 a year or only $83 a month on this hypothetical property, that would be a 5% rate of return on your initial $20,000 investment. So even though we aren't toning it every month in rent on this hypothetical property, we are still adding to our overall rate of return that we might be able to get. So if we ended up just crushing it out of the park and picking an absolutely killer investment property, and we were able to take advantage of all four of those quadrants, then we add the return of all four together based on our initial $20,000 down payment or our out of pocket. And when we do that, we have 20% of the potential appreciation. Again, this is just my hypothetical example. We have four and a half percent that came from mortgage reduction. We have 9% from potential tax benefits and 5% from the potential cash flow, and this gives us a total of 38.5%.

[00:16:19]:
You might be thinking, holy crap, there's no way you'll get that kind of return. Now, as I said, do not think for a second that this is the return you are going to get. If you did a deal that was similar to my example, it almost surely would not be. There are different costs that we haven't accounted for, and of course, we had to make some reasonable assumptions just to get the concept across. You will, of course, run into surprise costs and repairs, bad tenants, or maybe a high turnover with tenants. You might have a drastic change in income, and the current tax benefits go away. Or maybe your property doesn't appreciate as much as you thought. Maybe you're forced to sell it at a bad time for personal reasons. Whatever the case.

Remember, there are still plenty of risks present in investing in real estate. But what this number allows you to do is compare it with other real estate deals or investments you might be considering. And by the way, if you're going to invest in real estate, you absolutely should be comparing many deals before making a decision. If you're just going to go and buy the first thing that's available that you see that looks pretty and you can afford it, and maybe it's near where you live, that's not investing. You're more likely to get emotionally attached to it and make it look how you want it to look and pour tons of money into it and not make very much money on it at the end of the day. Remember, investing in real estate is a numbers game. It's not what property looks the most appealing or has the most amenities. Don't make that mistake.

[00:17:52]:
As I was saying, you will use this to compare to something else. A different deal may require you to put more or less of a down payment. Another may cash flow a lot more than the first one that you looked at or just break even. So one could be like an apple, and the other one could be like an orange. When we combine all four return components together, we can make them an apples-to-apples comparison when it comes to the numbers in order to make a decision. So, now that we know how to use this tool let's take it a step further to help illustrate how you might use this analysis to do an actual comparison. Bear with me. I'm going to try to keep this as real world as I possibly can without spending too much time on it. So, this is a totally made-up hypothetical example.

Let's say you just inherited an investment property from Mom and Dad that was paid off and worth, say $650,000. It's already got a long term renter in it. So you figure, hey, why fix what ain't broken, right? While it may be easy to keep things status quo, if you are keeping this property as an investment to make money, you'll definitely want to know if you could make more money elsewhere, right? Of course. And this is where our analysis comes in. So we have a property worth 650,000, no mortgage, and we can rent it for, let's say, 3500 a month. Let's imagine we're in California for a moment, where rents are terrible compared to home prices. We want to be smart about this, so we are going to make reasonable assumptions about our costs. And actually, when you're shopping for an investment, you might actually be able to find out what these costs actually are, and your assumptions aren't going to be pulled from the gray matter.

[00:19:45]:
In addition to using some of these assumed costs, we're going to set money aside in reserves in case we have an emergency or need to make a big cash outlay with our property after we get it. Now, let's say we allocate $280 a month for potential vacancies during the year, and we allocate $245 a month for potential maintenance costs, 10%, or $350 a month for our property manager, which is pretty much the going rate. $623 a month for property taxes, $244 a month for insurance, and $70 a month for, say, an HOA fee. That leaves us with $1,688 in positive monthly cash flow, or $20,260 a year. For emergency purposes, we're going to set aside three months' worth of rent, so that will be $10,500 set aside for that. Okay, so our total cash outlay is the 650,000, which is the value of our property, plus the 10,500 we put into the rental reserve account, giving us a total cash outlay, let's call it, of $660,500. Now, you might be thinking, wait, I didn't pay cash for the property. I inherited it.

What you have to remember is that you'll always have an opportunity cost. See, you could have sold it, pocketed the money, and used it or invested it in something else. But instead, by leaving it as is and continuing to rent it out, you are choosing to leave the money invested in this property. So it's still money you're investing in the deal, so to speak, even though that money didn't really exchange hands. Hopefully, that makes sense. So if we take the $20,260 a year, which is our net cash flow, and we divide that into our cash outlay of $660,500, we get a 3.1% rate of return on our cash flow component. So you might be thinking, wow, I have no mortgage to pay, and I'm just pulling in monthly cash flow. This is awesome. But when you break it down, it's actually a measly 3.1% rate of return on your money, so far, at least.

[00:22:16]:
Okay, so now what about mortgage reduction? Well, you have no mortgage in this example, so this doesn't exist, nor do you have a mortgage interest deduction. So scratch that out of the return picture. Now, we have to rely on cash flow appreciation and tax benefits, the other three remaining quadrants. Now, let's say you and your spouse make $160,000 per year combined, and neither one of you is a real estate professional, per the IRS guidelines and tests. Well, now, you aren't going to get any immediate tax benefits from the depreciation of the property because you make too much money. So there's another one we can scratch off.

Now, we are left with a potential return from cash flow and appreciation only. We're down to two quadrants so far. So now, the last one, we get to appreciation. While this is largely unknown, as we talked about before, and depends on so many different factors, we can make a reasonable assumption here. Or if you want to be really conservative, don't expect any appreciation at all. Make it zero. In fact, I would really caution you against banking on any significant amount of appreciation. Since my example here is in California, let's do a little bit of both.

[00:23:39]:
I'll say we get, again, a 4% average annual appreciation rate. Not extremely high, and not nothing. So 4% of 650,000 is 26,000. And that 26,000 divided by 660,500, which is our total cash outlay, is roughly 3.9%. Because, in this case, we can only rely on the potential appreciation plus the cash flow. Our expected return for investment comparison purposes would be around 7%. Again, this is because there's no mortgage and because we aren't getting a benefit today from any potential tax losses due to income being too high. So, do you see how helpful this can be when comparing it to maybe another real estate deal or a different investment altogether? As I said, you might feel like this is a phenomenal investment in this example, since you can just keep it rented and you have no mortgage to worry about, and you're just collecting almost $1,700 a month in income. But when you compare the return, you're likely to get on the money that you've invested or left invested. It may open your eyes to see that, hey, wait, maybe I can do better with that money.

[00:25:03]:
This was with an assumed 4% average annual appreciation, which we can't know for certain. In today's interest rate environment, you might be able to earn around four to 5% with little to no risk in things like government treasuries or CDs that require no work at all compared to real estate. So again, it's not just comparing a real estate deal to another real estate deal. There might be other investments out there where you can kind of look at the risks involved in the rates of return and decide what might be a better route to go down with your money. As you can see, a real estate deal can be a good deal or a bad deal for many different reasons, some in your control and others not. But, knowing how to do a basic analysis can help you make decisions easier and with much more confidence.

That's all I have for today's episode. Hey guys, if you find the information and the strategies that I share on the show actionable and useful, please do yourself a favor and do us a favor and subscribe to or follow the show on your podcast app and share it with a friend who you think might benefit from some of the things that we discuss.

And don't forget to sign up for the Retired-ish newsletter to get your free retirement planning quick guides for 2024. Plus, you get useful and easy-to-digest information on retirement planning, investing and taxes, estate planning, Medicare, Social Security, you name it, once a month, straight to your inbox. No spam.

And, of course, if you want to learn more about the topics I went over in the show today or you want to connect with us to help you with your investment decisions, you can find links to the resources we have provided in the show notes right there on your podcast app.

Or you can visit us at RetiredishPodcast.com/47. Thanks again for tuning in and following along. See you next time on Retired-ish.

Disclaimer

Securities and advisory services are offered through LPL Financial, a registered investment advisor, member FINRA, SIPC.

The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual.

To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.

Neither LPL Financial nor its registered representatives offer tax or legal advice. Always consult a qualified tax advisor for information as to how taxes may affect your particular situation.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Government bonds are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.

CDs are FDIC insured to specific limits and offer a fixed rate of return if held to maturity, whereas investing in securities is subject to market risk including loss of principal.