What is a “Good Deal”? Here’s Some Simple Math
As a real estate investor you’ll need to be able to do some math to know if you’re making a good investment or not.
But don’t worry — you don’t have to be a whiz or create an Excel file. I’m talking about the kind of math that’s easy enough to do with your phone calculator.
Over the years I’ve come up with a fairly simple formula. Other investors have come up with it independently of me, so that tells you it’s a pretty solid one.
The formula involves 3 numbers, plus something called the 1% Rule.
The 3 numbers are…
- What you buy the property for
- What it costs to renovate it
- What you rent/sell the property for
This should be pretty straightforward. Of course you will need to sell the property for more than you paid, even after the cost of renovation.
If you plan to rent, this is where the 1% Rule comes in.
Here’s how the 1% rule works:
Monthly rent = 1% of total investment cost
For example: You buy a property for $100,000. Once you figure in purchasing and renovation costs as well, the total amount of your investment is $150,000. 1% of 150,000 is $1,500. Therefore, you need to be able to rent your property for at least $1,500 a month.
(Side note: always make sure you factor in renovations and other upfront costs, not just the price of the property itself).
Now, does a purchase prospect have to meet the 1% Rule? Not necessarily. But it’s definitely a good, conservative rule of thumb that will act as a guard rail.
The 1% Rule gained traction back when interest rates were higher than they are now. It may be possible for you to have a positive cash flow while pulling in less than 1% a month, but let’s put it this way: if you are able to earn 1% or more a month, you’ll have a positive cash flow and a safety cushion as well.
If the property is going to earn you less than 1% a month, it may or may not be worth pursuing. You will need to go back to the drawing board and do some “less simple” math at this point.
All good so far?
There’s actually one more step you need to add, once you’ve figured out your monthly rent payment.
The step looks like this:
Actual cash flow = ½ of your monthly rent
A lot of investors aren’t prepared for all the costs that come with owning a rental property. These costs include things like insurance and maintenance as well as vacancies.
To have a realistic estimate of what you will actually pull in each month, make sure that you halve the amount of your anticipated monthly rent.
Sticking with our earlier example, that means that your actual cash flow each month will be $750 (half of $1,500).
The other $750 is going towards those other expenses. In fact, it’s a good idea as a property owner to have a “maintenance reserve” fund for exactly these types of expenses. It’s very possible for you to have a cash flow that’s greater than half your monthly rent — just remember, that the smart thing to do is start out with an estimate that’s more conservative.
My final two cents:
Time is valuable, so don’t waste your time or efforts on a property if you’re not sure whether or not it will be worth it.
There are other properties out there (even in today’s crazy market) and good opportunities exist, if you look far enough. It may actually be wiser to sit out a certain prospect and spend your day at the beach than to rush in and buy something that doesn’t jibe with the simple math.
With both time and some good simple math calculations, you’ll find the opportunity that’s right for you.