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Imagine for a moment that you just orchestrated the most amazing real estate deal of all time. This deal is so impressive Scorsese will make a movie about it with Di Caprio playing your part. People who aspire to become successful real estate investors will hold week-long case studies of this deal for years to come.

All the elements are present. Through world-class negotiating skills during purchase, you locked in so much equity it should be illegal. Price to rent ratio is in the low single digits so your property throws off cash like an ATM machine. And finally, the return on investment might make people think you’ve entered the loan shark business. A thing of beauty, a work of art.

And yet, I’ve got news for you. The most amazing real estate deal of all time, will NOT change your life.

Let’s run through the numbers of one such hypothetical scenario.

Suppose you were able to purchase a $250,000 property for $150,000 and secured six figures of built-in equity. No repairs are needed. The first week on the market you find a great Tenant willing to pay $2200 per month for a two-year lease on the property. Total operating expenses plus mortgage payments add up to $1400 per month leaving you with positive cash flow of $800 per month. Assuming a 35,000 capital investment that’s a 27% cash on cash return with an internal rate of return in the triple digits.

If you zero in on the numbers of such an amazing real estate deal, it’s pretty impressive. But when you open up your focus and look at the big picture, things come into perspective a little clearer.

Let’s look at the end result. With all the amazing equity, cash flow and returns, at the end of the day, even the most amazing real estate deal produces just $800 per month in passive income. That’s a fantastic return on the capital invested but from the perspective of your complete financial picture, that cash flow will not change your life. It will not allow you to retire early or do the work you want to do instead of the one you have to do.

The main point I want you to take away is this: Real estate investing isn’t some form of Olympic sport where investors compete for the highest return or the largest amount of built-in equity record. Instead, it is a vehicle you use to create the passive income and net worth required so you can design and live the life you want.

Even when you pull off the most amazing real estate deal of all time, if the aggregate of your investing efforts fails to create the life-changing circumstances that set you financially free, it’s all for naught. Or put a different way – if all you do in a lifetime of investing efforts is pull off a couple of “most amazing deals” but fail to fundamentally alter your financial life then what good did it do?

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.

Closing Note

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.