3 Real Estate Deal Analysis Rules Investors MUST Know
Everything in real estate requires analysis, and it comes in all forms—from incredibly simple to extremely complex. Real estate deal analysis is about running thousands of potential properties through a funnel and getting to the one(s) that meet your criteria, in this case, best cash flow.
In this article, you’ll learn the stages of analysis for investing in real real estate, as well as some rules of thumb that investors can use to quickly scan through deals to decide whether to pursue them or not. These rules of thumb can come in handy in saving you from analyzing every single deal that you come across.
The Three Stages of Real Estate Deal Analysis
Before diving into the deal analysis details, consider the reasons you’re investing in real estate and outline your goals. You don’t want to throw everything into an “analysis funnel” you borrowed from someone and wait to see what comes out on the other end. Instead, carefully select the filters you’re going to install in your own funnel to make sure only the most important pieces make it through.
Stage 1: Immediate analysis
You will do two basic tests in this stage: the sniff test—not being literal here—and the math test.
The sniff test is the basic criteria you have for a property. For example, you’ve decided not to purchase any properties requiring full gut jobs. Then you spot one requiring just that. Therefore, it has failed the sniff test. The property doesn’t warrant a second look. Don’t even bother going forward with it.
Stage 2: Pre-offer analysis
In this stage you are mathematically determining if the property deserves an offer. Let’s break it down:
Repair costs: You can get this number by asking a contractor for estimates or you can look at properties yourself, but make sure to be courteous of your realtor’s time.
Rent: Compare comp rental properties—or properties similar to the one you’re looking to buy. You’ll examine properties within one mile of your subject with similar square footage and amenities offered.
Monthly expenses: In addition to the mortgage (commonly broken down as principal, interest, taxes, and insurance—or PITI), this also includes costs such as property managers. It should account for things such as vacancies and repairs, too.
Other expenses: Will you be paying utilities? Is there a lawn service? Is cable/internet included?
Take all of these and subtract them from rent, and you have your monthly cash flow!
Once you know what your cash flow looks like, you’ll need to determine the value of the property to know what you should pay for it. Compare the property to similar properties sold or currently for sale—and make sure you’re nixing properties that exceed your maximum allowable offer (MAO).
Stage 3: Post-offer analysis
When you reach this stage, you are under contract. Now, take your concrete numbers and plug them into the aforementioned equations. Is this deal profitable, or will it cost more than it’s worth? This is the decision-making stage.
Deal Analysis Rules of Thumb
Now that you understand the stages of analyzing a deal, let’s touch on the rules of thumb you can use before you reach the post-offer analysis stage. These quick-and-dirty rules provide an easy way to assess potential properties.
The 2 percent rule
Perhaps one of the most common rules of thumb used by rental property investors is commonly known as the 2 percent rule—or the 2 percent test. This divides the monthly rent by the purchase price. Most investors want this number to hover around one to two percent, which indicates it will provide positive cash flow. (This can also be called the 1 percent rule, depending on the market and the investor’s personal risk aversion.)
For example, if a property rents for $2,000 per month, and the purchase cost is $200,000, then:
$2,000 / $200,000 = 1%
The property does not pass the 2 percent test, but it does meet the 1 percent test exactly.
So, what does this mean? Since it’s just a rule of thumb, it isn’t always precise. But generally speaking, the higher the percentage, the better the cash flow.
For instance, most properties that fall short of one percent will likely never produce positive cash flow. If it’s between one and two percent, it probably will. And if it is above two percent—an incredibly difficult find in today’s market—it will almost certainly produce positive cash flow.
The 50 percent rule
While the 2 percent rule provides a quick go or no-go decision for potential rental properties, it doesn’t really predict cash flow. For that, investors often rely on the 50 percent rule.
This rule states that, on average and over time, half of the income a property generates is spent on operating expenses, which are all of the expenses involved with running a rental property—except the loan payment. It includes taxes, insurance, utilities, repairs, vacancy, and other metrics that leave the landlord’s checking account each month or year.
The 50 percent rule can help an investor quickly estimate the cash flow of a rental property because it combines all of the expenses, except the loan payment, into one easy number: half.
For example, let’s say a property rents for $2,000 per month. The 50 percent rule says that half of this ($1,000) will be spent on expenses. This means you’d be left with $1,000. But then you need to make a mortgage payment (unless you paid cash for the property).
With the $1,000 remaining, let’s say the mortgage payment was $600. How much do you have left? $400.
$2,000 x 50% = $1,000
$1,000 – $600 = $400
The remaining value, or $400, is your estimated cash flow.
Of course, that 50 percent estimate on operating expenses can vary wildly depending on the property. In some areas, taxes and insurance might be incredibly high, but in other areas, it might be much lower. And in some years, you’ll spend significantly less on expenses… and in other years, the furnace might fail.
When you are looking at a property that rents for $1,200 per month, and you know the mortgage payment would be around $1,000, you can almost guarantee that the property won’t produce a positive cash flow. Why? Because $200 is not a lot of room for all those expenses.
The 50 percent rule helps keep real estate investors in check and reminds them that there are numerous expenses that add up over time, and they tend to settle around 50 percent given a long enough time frame.
The 70 percent rule
What about house flippers or wholesalers? For them, the 70 percent rule help determine just how much to pay for a property.
The 70 percent rule states that the most you should pay for a potential flip is 70 percent of the after repair value (ARV), which is what it would sell for when it’s all fixed up, minus the repair costs. So if a home would sell for $300,000 all fixed up, and the property requires $50,000 worth of work to get it there, then:
$300,000 x 70% = $210,000
$210,000 – $50,000 = $160,000
According to the 70 percent rule, the most someone should pay for this property would be $160,000.
But there are problems with the 70 percent rule. This rule of thumb assumes that 30 percent of the ARV will be spent on holding costs, closing costs (on both the buyer’s and seller’s side, such as commissions, taxes, attorney fees, etc.), the flipper’s profit, and any other charges that come up during the deal. This works well in many markets, but it has some severe limitations.
For example, the 70 percent rule doesn’t work as well for a property where the ARV is low, such as $50,000. As mentioned earlier, the 30 percent deducted from the ARV includes the holding costs and closing costs, as well as the profit the investor or flipper wants to make.
30 percent of $50,000 is $15,000. So following the 70 percent rule, all the fees, costs, and profit add up to only $15,000. If the fees and holding costs were to total $10,000, that would leave just $5,000 in profit for the house flipper—and I don’t know any house flipper who will take on the risk of flipping for just $5,000.
Incorporate these rules of thumb into your deal analysis stages—primarily stage two to run the numbers, and then stage 3 to double-check. Don’t, however, just rely on the rules of thumb. When it comes to real estate investing, due diligence is necessary—especially early on.