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Ask Dave

Real Estate Investing 101

Tim wants to know what measurements Dave considers before investing in residential real estate. Dave gives Tim his rules of thumb.

QUESTION: Tim in Nashville wants to know what measurements Dave considers before investing in residential real estate. Dave gives Tim his rules of thumb.

ANSWER: I think the first thing you need to remember about residential real estate is that beginning investors tend to pay too much. You get emotionally involved. You get excited about being an investor and owning a property, and you have a tendency to pay too much. Slow down and don’t pay too much. Old time real estate dogs will all tell you that in the real estate business, the money is made at the buy. In other words, steal it or don’t buy it. That’s rule number one in your primer for real estate investing.

Rule number two is you need to decide why you’re buying the property—what your mission statement for this is—and buy it based on that. I very seldom—almost never—sell a piece of property. I buy to hold. That changes how you would operate and the way you would look at things. Before I went broke years ago, I used to buy and sell for a living, so I was buying to flip. It does change things. For instance, I was looking at a piece of ground the other day that was in an area where it’s going to be a while before that’s a prime area, but I’m buying it thinking 15 or 20 years out. That was my analysis of the piece of ground, which makes you look at it differently. If I had to turn around and put it back on the market for sale today, I wouldn’t even be looking at that property. Rule number two is you need to decide what your hold period is and how long you’re looking at it.

As far as rates of return, basically real estate is beautiful in that it creates three types of rates of return. Obviously one is the cash flow, which is a cash-on-cash rate of return. How much cash does the property put in your pocket versus what it costs you? The second area of return is the beauty of real estate, and that is going up in value over time and the capital gains. The third rate of return is that where you’re dealing with an improved piece of property—you can depreciate the capital improvements on a depreciation schedule and shelter some or all of the income. In other words, you can make income and have a tax write-off against that income that could cover some or all of or even more than the income that it creates. So all three of those things are rates of return combined in there.

If you combine all three of those in a sophisticated analysis, that’s called an internal rate of return (IRR). If you’re going to go through all that trouble to calculate that—I typically don’t, honestly—you’re going to want a 17–20% rate of return on an IRR. With cash-on-cash return, I look for 10% if not 12%. But that’s very hard to do, just like finding a great deal is very hard to do, so I’m very patient. I’m just not in a hurry. I pay cash for everything. I don’t use debt at all. That changes the numbers dramatically since I don’t have any interest cost. My rate of return is fairly pure.

Another rule of thumb I use that’ll get you to those numbers I just talked about in most cases is if you’ll look at today’s appraised value, 70% of today’s appraised value minus repairs is a great buy on a piece of property. It’s very hard to find. I may cheat on the 70% up a little. Why? Because I’m in a great neighborhood; it’s going to rent easy; it’s going to be a piece of property I’m glad I own; and it’s not going to give me a lot of trouble. It’s fairly new. It doesn’t have a lot of repairs associated with it. The hassle factor is going to be lower. Pride of ownership is going to be there. So I might cheat up a little then where if I’m buying something a little bit further away from that, then I’m going to cheat down a little and might not even want to give $.70 on the dollar for that.

You absolutely need to steal the property, whatever your definition of that is. Take your time. That would be the number-one rule that you want to use in real estate investing. You know I don’t borrow money, so I’m always recommending you pay cash, which makes you take your time usually.

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