Investment Property: What Defines a Good Deal?

 It can be all too easy to get lost in the excitement of an investment opportunity or in the shuffle of the math involved—especially for novice investors.  Sometimes when this happens, the investor gets so wrapped up in these elements of the real estate industry that they forget to evaluate whether or not the investment opportunity is a good deal to begin with.  Here is a very simple approach, called CLEAR, to help the investor ensure that he has found a good deal before making a purchase.  CLEAR is an acronym representing the five factors that must be considered in advance of a purchase: cash flow, leverage, equity, appreciation, and risk.

      The first obvious consideration is the cash flow the property will generate.  This will depend on a multitude of factors, including current market conditions and interest rates.  It is not enough to simply predict the earning potential of the property; rather, when investigating leads and deals cash flow must be measured against other similar investment opportunities.  Because the rent is higher, it may seem at first glance that you can earn more from renting a $500,000 home at $4,000 per month, than a $250,000 home for $2,500 per month; in fact, in most financing cases, the potential cash flow of the less expensive home is most likely greater due to the financing on the less expensive home.  Know what a property can earn, and know how it compares to your other options.

      Leverage is the notion that making small down payments on homes allows an investor to fund several projects simultaneously.  High leverage is most advantageous in expanding housing markets, where appreciation in the value of many leveraged investments will result in exponential profit returns (as compared with having only invested in one appreciating property).  This is a double-edged sword however, since depreciation among multiple investments can put an investor into serious debt.

      Next, the investor must consider the equity of the deal in question.  Equity can take any form that reduces the price of the commodity below the market value.  For example, foreclosures, rehab properties, discounted properties—all drop well below whatever the market value would otherwise have been for that property.  Equity on an investment is never a bad thing, and should be recognized by the investor.

      Appreciation can be difficult to predict, and therefore should not be used as the sole or primary predictive factor in determining a good deal.  If a property with little cash flow and equity is purchased on the assumption that it will appreciate very quickly, then the investor is at risk of losing the value of his investment.  However, if the investor chooses neighborhoods responsibly and times the housing market cycle correctly, he can plan for moderate appreciation to add to the value of his investment.  Don’t assume a deal is good just because you think it will appreciate quickly—this is very risky.

      The final factor is risk, and it is often overlooked by investors.  Considering the risk of investment means visualizing the scenario where everything goes wrong.  In other words, does the property come with a contingency plan?  Sometimes, contingencies work (consider a property bought for quick appreciation, which instead depreciated, but can still be rented to generate positive cash flow).  In most cases, however, if an investment has too much chance of depreciation, and if the potential success of the contingencies do not outweigh the investment’s initial failure, then the investment is too risky (regardless of how good the deal may look). 

      Tell us what you think. J

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