How to Pencil Out a Real Estate Deal
When making an investment in real estate, you should look at it the same way you would look at a financial investment in a bond, stock, annuity, CD or any investment. You should analyze how much cash equity is being invested — just like you would if you bought a financial asset – and how much cash flow it produces. This is commonly called cash-on-cash return. A bond might pay a 5.0% interest coupon cash-on-cash return or a corporate stock might pay a 2.5% dividend in cash. You also need to compare those returns to what you could earn on an investment in real estate.
Of course, real estate has the added potential returns of long-term appreciation in value, similar to a stock investment. But as we’ve learned the past few years, real estate can also depreciate in value. So going forward, let’s stick with cash-on-cash return estimates and while we hope appreciation in value will come, it’s wise to expect that it will materialize. If it does materialize, it will be the icing on the cake on an already smart cash-on-cash positive return investment.
3 Issues to Calculate Returns on Real Estate:
1. Cash Flows and Investment Returns – How much equity do you invest, what are the cash flows off the property, and what is the projected rate of return? Remember that garbage numbers in will give garbage numbers out, so be conservative in your projections.
2. Compare investment returns – How do your cash-on-cash estimated returns on real estate compare to other types of investments? Bank CDs pay .5% to 1.5% these days, bonds pay 4-6%, and stocks can be all over the map and might average overall returns of negative (10.0%) to positive 8.0%. So how do your #1 cash flows and investment returns projections on your targeted real estate purchase compare to other types of investments? Do the returns seem to be worthwhile for the high risk of real estate?
3. Risk – This is one of the most important items. Will your #1 cash flows and investment returns that you projected come true, or were you overly optimistic on your rehabilitation costs, rents and expenses?
The mathematical portion of doing a projection on a real estate deal is actually pretty straightforward. The tough part is properly estimating the actual cash investment needed to get the property rental ready and the cash flows the property will generate. That is the typical difference between a good investment and a bad one – your ability to properly estimate all the costs, rents and expenses.
How to project investment cash flow analysis cannot be adequately explained in a one-page blog post, so if you’re interested in more information, a webinar on this topic will be conducted at ZillowAcademy.com today at 10 a.m.
Penciling out a deal is the first and one of the many important tasks a buyer should do in any real estate investment.
Leonard Baron, MBA, CPA, is a San Diego State University Lecturer, a Zillow Blogger, the author of several books including “Real Estate Ownership, Investment and Due Diligence 101” and loves kicking the tires of a good piece of dirt! See more at ProfessorBaron.com.