If you ever hang around other real estate investors, you’ll hear a conversation that goes something like this, “Hey John, did you make an offer on that property we were talking about?”
“I did, but I didn’t get it. The guy who got it overpaid by at least $20,000. What a horrible deal!”
Did the buyer get a horrible deal?
But, maybe it was a great deal.
I’ve “overpaid” for property in the past, but looking back on those deals shows a different experience. In every single situation, I breathe a sigh of relief as I appreciate myself for not allowing a few thousand dollars to be the difference between owning that asset or not.
If I had passed over every deal I “overpaid” for, I’d have half as much property and be short 7 figures in net worth.
It took me a very long time to understand that just because someone else paid more didn’t mean that they overpaid for it. Granted, some deals truly are bad deals and people do make investment mistakes. But, a good portion of the time, people pay more because they have different goals or strategies.
I’ve ‘overpaid’ for a property because I owned 5 other properties on that street. I’ve overpaid for a property because I needed a place to park cash. I’ve overpaid for a property because I believed the area would gentrify in 5-10 years.
The people who lost against me when bidding on those deals most definitely think I overpaid. I could have made a mistake, but I knew the risks and upside potential. I mitigated the risks to limit the downside, and the upside took care of the rest.
But, to bring it back on topic – What is a Good Deal in Real Estate?
- Defining a “Good” Deal
- Putting Numbers Together to Determine What is a Good Deal in Real Estate.
- Keeping It Simple – Mortgage Replacement
- So, What is a Good Deal in Real Estate?
Defining a “Good” Deal
I’ll go out on a limb and say that a “good” deal is any real estate investment that accomplishes your long-term personal and financial goals.
I can picture many of your throwing your arms up in frustration, hoping I’d just define specific returns or hurdles that define a good return.
Unfortunately, it’s not that easy. Every investor has a different goal. Wealthy investors with a lot of capital to put to work may appreciate low volatility because they have future plans for the cash.
Younger investors tend to want higher growth rates even if there is massive volatility. They don’t need the cash for decades so can afford huge losses. This is why crypto investments such as Bitcoin, Ethereum, or Cardano bring in so much interest from younger investors.
So, what we need to do is identify some major considerations before investing, then work our way into defining a good deal, for YOU.
The most important consideration is your risk tolerance. You need to figure out how much risk you are willing to take before making any investment at all.
The old axiom is to never invest more than you’re willing to lose.
While this is accurate overall, it doesn’t tell the whole picture.
The fact is there is risk inherent to everything. The value of cash in your pocket will go to zero due to inflation if you give it enough time. Almost every company will fail, merge, or end eventually. Every country will fail, every person eventually dies.
As the famous economist, John Maynard Keynes once said, “In the long run we are all dead.”
Instead, it should say: “Never risk more than you’re willing to lose.“
That’s because you can mitigate risks and limit downside potential. With proper risk mitigations measures, it’s very difficult to make a good investment go to 0. It happens, but if it’s a good quality investment and not a speculative YOLO play, then the odds are near zero.
The only exception would be a “black swan” type event that is entirely unpredictable. Perhaps there’s a major oil spill. Maybe a trash dump moves in behind. There are a lot of ways the value of the property can go to zero.
An asteroid can also hit the earth and we can all die. We cannot plan for every risk.
How Much Can I Risk?
So, once you have figured how much you can risk, it’s time to think about how much risk a deal is taking.
Let’s say you $25,000 you are willing to risk. You realize you can put 25% down on a $100,000 property. Does that mean your total risk is $25,000?
In reality, your total risk is $100,000 because you are still on the hook for the $75,000 loan even if you try to walk away from the property.
But, you’re only at risk for $100,000 if the value of the property were to go to $0. In all feasible situations, the property will always maintain some sort of value. So your true risk should never be the full $100,000.
If you’re diligent and purchase good property in growing areas, then your actual risk should be very low. If you neglect your property and also purchase property in blighted areas with few growth prospects, then your potential risk is very high.
Risk Mitigation Measures
Banks have calculated that the odds of being paid back for a loan are well over 99% when the borrower puts 20% down. The risk of default rises as the downpayment drops.
So, the first risk banks identified was the actual borrower. They crunched the numbers are determined the risk drops dramatically as the downpayment increases. So, they require down payments to limit that risk.
Furthermore, banks know that housing prices rarely drop more than 20%. So, if you put 20% down and they are forced to foreclose on you, then they still own a property worth their original investment.
So, when you cannot put a large downpayment on your house, banks will insure the difference. If you put down 5%, they will make you pay for an insurance premium to cover an additional 15% of the value of the house. In this case, if you default they have the full 20% they need to break even.
If the borrower is very high risk and gets an FHA loan, then the entire loan will be insured because the risk is very high. That’s why FHA has the highest insurance premiums.
These are just examples of how an entity identifies risks then mitigates them until their business works. You need to do the same as an investor. For example:
Risk / Mitigation For Investors
- Hidden plumbing or electrical issues / Good inspections, drain scoping
- Bad tenants / good screening, purchase in good areas
- Market value dropping / create equity with improvements
- High vacancy / upgrade units to increase desirability
- Weather or natural disasters / good insurance, flood coverage etc
- Missing mortgage payment / capex budgets and emergency funds
- Overpaying for a property / plan to own for 10+ years
Another major consideration is the time horizon you’re looking to invest in. In general, time in the market beats timing the market.
Read that again – Time IN the market beats TIMING the market.
Even if you bought a property at the peak of the bubble if you hold the property long enough eventually you won’t lose money. Sure, if you waited and bought at the bottom you would have made more money, but the number 1 goal is always to avoid loss of principal.
So, a good investment is one that matches your time horizon. Flipping a house in a dying neighborhood may work, but buying rental property in a dying neighborhood won’t work. So, any rental property you plan to buy needs to have a long time horizon in order to smooth over any market-related risks there are.
There are so many reasons to invest in real estate. Some people are looking for stable retirement income while others are looking to increase their net worth 20 years from now. Others are looking to reduce the volatility of their investment portfolio by adding real estate to it.
The vast majority of investors that I have worked with are looking to do one of two things – 1) Earn stable income, or 2) Increase their net worth.
While there are other reasons to invest in real estate (such as tax benefits or reduction of volatility), I’m going to focus this information on the 95% of people who are looking for one of the two major reasons.
The investment you make should match your long-term goals. This will affect the type of investments you make and the markets you choose to invest in. If you’re looking for income for retirement then you’ll be happy to invest in smaller towns and cities where appreciation is low but rent is high compared to prices.
On the other hand, you may want to invest in major metros if you’re looking for long-term appreciation.
Putting it Together
We’ve identified 3 major considerations. You may have more considerations based on your personal situation, but this is a good start.
Out of these 3, start by considering your personal goals first. This will determine how you’re going to invest. Then use these goals to work yourself into a time horizon that fits those goals.
Lastly, estimate your risks and plan your risk mitigation measures.
Your plan might look like this:
I’m looking for income to supplement my retirement payments for the next 15 years or so. I cannot take on much risk to my income because I’ll need to live on it. As such, I’ll buy newer rent-ready single-family homes in middle-level stable cities such as Oklahoma City or Kansas City. I expect the values and rents to stay stable or grow slowly in popular suburbs in and around the cities. I’ll limit economic risk by having mortgages no higher than 50% LTV which will keep my mortgage payments low enough so I can deal with vacancies.
Putting Numbers Together to Determine What is a Good Deal in Real Estate.
This step is going to be a little challenging. Here, we want to find the best possible deals in the market you choose that fits your investment criteria. This step is difficult because just about every market has a deal that will earn 30 or 40% while another deal will earn 3%.
Looking at the returns will not allow you to find a “good” deal. It will allow you to find a deal with high returns. The high returns may be due to an extreme amount of risk. If that risk doesn’t fit your investment goals then we can’t say it’s “good” even if it has a high return.
In the real estate industry, we generally look at two numbers to estimate the returns of a deal – Cash on Cash Return and Return on Investment (ROI).
Cash on Cash Return
This is probably the most fundamental term used in real estate so we’ll cover it first. It is simply the total cash you get as a percentage of the total cash you invested.
It is super simple to calculate: Total Yearly Cashflow / Total Capital Invested.
If you invested $20,000 in a rental property and it paid you $4,000 cash this year, then your Cash-on-Cash return is 20% ($4,000 / $20,000).
It is entirely focused on your cash return based on the cash invested and does not include other sources of profit such as equity pay down.
What I mean by this is that some portion of your mortgage payment goes toward principal. In accounting, this is part of your profit because it went from equity in your bank account to equity in your property. So it’s neutral and shouldn’t count against your profits.
Cash flow is different than profit. It’s how much cash you put into your account, regardless of why. It also does not take into account the changes in property value, equity paydown, etc.
Return on Investment
Return on investment is the sum total of all profit or loss you made divided by the total capital invested. This includes all appreciation, rental income, costs, etc.
It tells a very different story than cash on cash return does. It’s possible to have negative cash on cash return each year but a positive ROI. It’s also positive to have positive cash flow but have a negative ROI.
What is a Good Return?
In general, when investing we don’t want either of these to be below zero. Both should have a healthy positive result. You don’t want to earn money each year then sell an asset and lose money. Similarly, it doesn’t matter how much money you’ll make upon sale, if you cannot generate positive cash flow then it’s just a matter of time until the bank gets your property.
While both should be positive, you’ll adjust each of these based on your criteria, market conditions, and more.
Let’s say you want a stable 6% cash on cash return to cover your retirement, and a modest 2% price appreciation to match long-term inflation. So, you start looking around your specified area and property types and crunching the numbers…
…and it seems that almost all of the rental property in your city is providing a 4% cash on cash return. You dig a little deeper and find the average appreciation has been 4.5% over the last 5 years.
Good Deal But Bad For You?
In this situation, you have a difficult decision to make. You can keep your goal of 6% and you will likely not find any properties at all. The ones you do find with higher returns will be riskier than your goals allow for.
So, you will need to decide to either adjust your criteria or find a new market to invest in that can hopefully achieve your criteria.
But, let’s say you do keep looking and after many months you find a nice property with an average cash on cash return of 5%.
Is this a good deal?
While it doesn’t meet your goal of 6%, it is actually the highest returning property in the entire market area you’re looking in. It far exceeds the returns on other deals and meets all of the other criteria.
For this market, this particular deal is very good. It is in the top percentile of deals in the area, which means it has higher risk-adjusted returns than other similar properties in that market. So, it may not be a good deal for you, but it is a great deal for the area.
Bad Deal But Good For You?
Let’s consider another situation where you are looking for properties with the same criteria, 6% cash on cash and 2% appreciation. You are looking in a particular market and quickly find a deal with an 8% cash on cash return and a historical appreciation of 2.5%. Killer deal right?
You quickly put it under contract and excitedly begin your due diligence. While putting together comparable sales and rent comparisons, you realize that there are a lot of properties with 8% returns. In fact, you find several with 9% return and even one for a 10% return!
Is this deal a good deal? It meets every one of your criteria.
The answer is no. While this deal does fit all your criteria, it is clearly an average or even below-average opportunity in this market.
While you do need to have your own personal criteria, you also need to adjust it so you are always searching for the best deals available at any given moment.
Keeping It Simple – Mortgage Replacement
If you are a new investor looking for your first income-producing property, you may want to look at a slightly different set of criteria.
I generally suggest that for new investors, the goal should be to live entirely for free. After all, rent or mortgage is usually the largest single expense for a US consumer, so it makes sense to target that first.
There are 2 basic ways to approach this.
Multifamily Mortgage Replacement
The easiest way to live for free is to buy a 2, 3, or 4 unit multifamily. I suggest 4 or fewer units because all mortgage programs allow for 1-4 unit multifamily to be financed. So, FHA, VA, and conventional all work. Anything 5 units or more requires a commercial loan.
The goal here is to have the extra units cover all of your bills. We don’t need to get into complicated math to figure out returns if we can just add up the rents from 2 or 3 units, and make sure that covers the principal, interest, taxes, and insurance payments.
In this situation, you will be living entirely for free which gives massive leeway for you to save for your next deal.
I highly recommend this strategy because this is exactly how I got started. I purchased my first 3-family property in 2009 and lived in one unit. I lived there for 3 years and moved into a townhouse.
The rent from 2 units covered the entire mortgage for my first property. Then, when I moved to the townhouse, the rent from my old unit covered all the bills for living in the townhouse.
Eventually, I moved to Texas and rented out the townhouse. The rent from the townhouse covered my bills in Texas.
As you can see, I kept living for free which allowed me to save tons of money and keep buying more property.
Single Family Monopoly
This strategy is a little bit slower but still works. You will have to use a technique we call house hacking, but that’s the only difference.
With this strategy, you move into a single-family home that needs work and improvements. You live here a couple of years and work to fix it up and improve the value.
Then you will move into another home after refinancing the first one. You refinance it so you can use the equity to make another purchase without having to dig into your savings.
It may not be the most tax-advantaged method, but you’ll rent your first property out. The profit on the rent should lower your overall payment on the new property.
You’ll keep doing this until eventually, you are living for free.
For example, let’s say you purchased the first property and it costs $1,500 per month for the mortgage. Now, you move into another property and the mortgage is $1,600. But, you’re renting the other property out and earning $400/month in profit.
That means you’re actually paying $1,200 for your new home. Following this math, if you owned 3 rental properties you’d be living entirely for free.
So, What is a Good Deal in Real Estate?
A good deal in real estate is one that meets a two-tiered screening process.
First, the deal needs to have lower risk and higher returns than other similar properties in a particular market. So, it must be in the top 10-20% of all available deals in the area.
Additionally, it is a deal that also meets your own criteria that you set based on your own personal and investment objectives.
When it meets both criteria, then yes, it is a good deal.