Over the last decade, I have worked with many successful long term real estate investors. They have different personalities, different professions and often employ different strategies. But they all have one critical thing in common:
Successful long term real estate investors possess the ability to quickly and accurately “size up” a potential deal.
If someone were to call you on the phone to offer you a potential real estate deal, would you know how to evaluate it quickly and accurately within 5 minutes?
If not, the technique I will share with you today will change that. It will allow you to analyze any long term real estate deal in 5 easy steps that fit in the back of an envelope.
The technique was developed by world-renowned Italian physicist Enrico Fermi. He created the world’s first nuclear reactor, has been called the “architect of the atomic bomb” and had a substantial role on the Manhattan project. So, in a nutshell a brilliant fellow. Fermi was known to use his technique to get quick and accurate answers to very complex physics problems on the back of an envelope. Today, I’ll show you how to use the same methodology, to solve a much easier problem: How to analyze a real estate deal in under 5 minutes on the back of an envelope.
Let’s dive right in. Someone calls you and tells you about a potential investment opportunity.
It’s a single family home that would make a great investment property – according to the caller. Here’s how you can run a back of the envelope analysis within 5 minutes.
Collect Information and/or Make Assumptions
To get started with the analysis you need 5 numbers that you can easily get by asking or making simple assumptions: A) Purchase price B) Monthly Rent C) Down Payment D) Loan Amount and terms and E) Monthly Payment. Let’s say you determine that the property is being sold for $170,000, would rent for $1700, you’d put 20% down, borrow $136,000 at 4.5% for 30 years and pay $689/mo.
Calculate key data
• Step 1: Calculate the annual rent – Monthly Rent x 12
• Step 2: Calculate cashflow before financing – Annual rent from Step 1 multiplied by 0.54 (operating expenses typically run about 46%)
• Step 3: Calculate the annual cost of financing – Monthly payment x 12
• Step 4: Calculate cashflow after financing – Cashflow before financing (Step 2) less Cost of Financing (Step 3)
Final Step – calculate critical metrics
There are three critical metrics that will tell you everything you need to determine if this is a good deal: Return on Assets, Cost of Financing and Return on Equity.
Return on Assets is calculated as the cashflow before financing (Step 2) divided by the price of the property. Another term for this metric is Capitalization or Cap Rate. It simply tells you the rate of return the property would produce if you owned it free and clear.
Cost of Financing is calculated as the annual cost of financing (Step 3) divided by the loan amount (your Assumptions). You would calculate this metric so you can compare it to the return on assets figure. If your return on assets is higher than your cost of financing that means you have positive leverage. Put a different way, you using the bank’s money to generate higher returns than what it cost you to obtain that money. You should avoid the opposite at all costs.
Finally, Return on Equity is calculated as the cashflow after financing (Step 4) divided by your down payment (your Assumptions). This metric tells you what your invested capital is earning. When you achieve positive leverage, your return on equity will be higher than your return on assets. Or put a different way, you are earning a higher return by using the bank’s money to finance part of the purchase.
The first time you do this analysis, it will take a little longer to complete until you get used to it. Afterward, it becomes second nature and a powerful skill to make you a better investor.
The technique is especially powerful, after you’ve run the initial analysis because it allows you to quickly evaluate potential scenarios (i.e sensitivity analysis). What if you paid $160,000 for the property instead – how would that impact your returns? What if the property rented for just $1600 instead? What if you could secure financing at lower interest rates?
Run the Fermi Technique and within 5 minutes you have critical information to make better investing decisions and make more money in the long term.
The Fermi Technique is an approximation method that provides some insight whether you should pursue any further, deeper analysis. It is NOT a substitute for the full fledged analysis that we discuss in How to property calculate the return on a long term investment.