3 Questions to Ask Before Investing
Is this a good deal?
This is one of the questions every investor is trying to answer when evaluating real estate. There are calculators and rules of thumb to help people answer this question. However, the answer for one investor may be completely different for another. Many investors like to use key metrics like IRR, cash on cash, or equity multiple to determine if a deal is good, but we’ve already talked about why you need to stop using return projections for these decisions.
Let’s illustrate this with a quick example. Say you are evaluating an opportunity to invest in a multifamily property that was built in 2010 in a growing market. It is 94% occupied and has projected returns of 15% IRR, 8% annual cash on cash, and a 1.9 equity multiple.
Is this property a good deal?
Before you answer, understand that the question should be: Is the property a good deal for me?
Just because others think an investment is a good deal doesn’t mean it’s a good deal for you. Whether you make decisions based on a formula or your gut, you need to answer key questions first. Once you answer these, you will be able to decide if a deal is good for you.
1. Why am I investing?
Yes, I know you’re investing to make money, but you need to dig deeper if you want to be able to evaluate opportunities. What are you trying to solve? Are you looking to live off of monthly cash flow? Or is your primary goal to build long-term wealth? Maybe you just want extra income to pay for vacations, tuition, and other expenses.
If you want passive income, you may be disappointed with an investment that requires you to be actively involved, no matter what returns you are getting. Too many investors get into real estate for financial freedom and wind up with a second job instead. The clearer you are on the problem you want to solve, the easier it will be to find good deals.
2. What’s the business plan?
Once you are clear on your goals, determine the business plan for the properties you want to explore. Are you looking to buy and hold rentals? Are you looking for value-add properties? Or are you looking for a flip or distressed property to rehabilitate?
Each strategy has its pros and cons and should align with your investing goals. The business plan to carry out this strategy is critical to each deal. This is what separates a good deal from a bad deal. Good deals have a clear business plan and proof of concept for execution.
Let’s use our example property here. If the business plan is to perform cosmetic upgrades when residents move out, we can keep occupancy high, while bumping rents on the unit turns. We may be confident because three comp properties have similar finishes and amenities and are achieving the projected rents.
3. What could derail the business plan?
The last of these questions requires understanding the risk involved in the business plan. You need to understand what can derail the plan, how these risks can be mitigated, and your comfort level with the risk. If you’re doing a buy-and-hold investment, the biggest risk may be incurring a major repair. The best way to mitigate this is to have proper insurance and cash reserves set aside.
Going back to our example property, what if we’re not able to get the rent increases we hoped for? First, the ability to achieve these rents should have been confirmed in the business plan, but if something was missed or changes, you want to make sure you have a Plan B or other ways to mitigate the risk. You may decide to focus on the most important upgrades and only perform those instead.
Identifying the risk in the business plan allows you to proactively address it, making it easier to sleep at night. There isn’t a metric or formula that can calculate the importance of peace of mind. Maybe we should call it the new IRR for Inner Rest and Relaxation. When deciding if a deal is good for you, this IRR may actually be the most important metric.
About the Author:
John Casmon has helped families invest passively in over $90 million worth of apartments. He is also the host of the #1 rated multifamily podcast, Target Market Insights: Multifamily + Marketing. Prior to multifamily, John was a marketing executive overseeing campaigns for Buick, Nike, Coors Light, and Mtn Dew: casmoncapital.com
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.