## About This Episode

**Episode #215** – If you could only use ONE formula, one analysis metric to tell if a real estate deal is a good deal or NOT a good deal – what formula would you use? That’s the question Coach tackles in this episode of Ask Coach.

## Episode Transcript

(00:00)

If I only had one formula, one analysis metric to tell if a real estate deal is a good deal or if it’s not a good deal, what formula would I use? That’s the question I want to tackle in today’s episode of Asked Coach, and we’re getting started right now.

(00:22)

Welcome to the Ask Coach edition of the podcast. If we haven’t met yet, I’m your host, Chad Carson. You can also call me Coach. And my mission here is to help you get out of the financial grind so you can do more of what matters in the Asked Coach podcast series is where I do my best to answer your burning questions about real estate and personal finance. Today’s question comes from Sean McKay.

(00:40)

Many of you might be familiar with him. He’s a past guest on the podcast episode, and he also works with American IRA, who is one of the sponsors of the show. I’ll put a link to American IRA and their self directed retirement account information in the show notes. Sean’s question came in by email, and it says, if you could pick one metric to evaluate a single family rental purchase, what would it be? For example, the 1% rule or a certain equity spread, et cetera?

(01:04)

So all of you know I love nerding out on running the numbers and doing deal announcements for real estate. So Sean hit me in a weak spot there, and I’m going to give you a short answer, and then I’m going to unpack it a little bit. My one metric, if I only could use one to buy a single family rental or really any investment property, is something called an internal rate of return. The abbreviation for that, if you’re using a spreadsheet, is also the IRR. And the reason internal rate of return is my one metric is because it encompasses and also uses all of the other metrics.

(01:35)

So, for example, it takes into account the cash flow you make on a rental property on a year to year basis. It takes into account the equity you pay down on the loan. And if you were to sell a property ten years from now, it’ll use that equity you pay down to tell you how that accounts for the return on the property. And also it takes into account any discount you bought on the property, any price appreciation. So it takes all of that and it puts it together into one formula and that return number.

(02:01)

So it gives you a return. For example, it might say this deal and these assumptions in this income and this cash flow and this price you would sell it for ten years from now will give you a 10% internal rate of return. And so you can use that as a goal. So for me, if I’m using leverage and buying a rental property and it’s in a solid location with a very low risk, I might say if I can get a 15% internal rate of return. That might be a good cut off for me.

(02:27)

I might try to shoot for 20, 30% or higher, but having an internal rate of return gives you sort of a threshold where you can say this is a deal that works for me or it doesn’t. And the other thing I like about internal rate of return is that it also takes time into account. So just to give you a real simple example, if you bought a rental property for $100,000 and just paid cash for it and you got a $10,000 per year cash flow for the next ten years, you would say, well, that’s a 10% return, right? Because $10,000 divided by $100,000 is 10%. And you’d be right in year one.

(03:00)

But in year ten, if you got $10,000, $10,000.10 years from now is not the same as $10,000 now, it wouldn’t buy the same amount. You have to take into account the time value of money. One of the most important concepts in finance and investing, internal rate of return does take that into account. And there’s more that I’m going to cover in this Ask Coach episode about how that works. Have a video where I go in depth and actually share a spreadsheet on internal rate of return.

(03:25)

If you want to get into it. I’ll put a link to my YouTube video in the video description and also in the podcast description. But I also want to use this conversation around internal rate of return to kind of jump off into a bigger conversation. So what are the most important whatever formula you use? One of the most important questions you should ask yourself is what is driving this return?

(03:48)

It shouldn’t just be, hey, I want to get a 10% return. It should be, what assumptions am I making about how I’m going to get that 10% return? And what I mean by that is where is it coming from? Is it coming from the cash flow on the property? Is it coming from the growth of the price of the property?

(04:03)

Is it coming from the debt pay down? There’s different sources of profit or sources of your return on the property. And the metrics are only helpful if you can understand those assumptions and look at them. Because sometimes you might say, wow, I’m getting 95% of my return on this property from the appreciation of the property only a little bit from the cash flow. Is that a good assumption?

(04:26)

Is it a good assumption that this property is going to keep on growing? And maybe it is, maybe it isn’t. That’s the kind of fuzzy space where you as an investor, have to make a call. You have to make a guess. Basically, based on the data, based on the teamwork input you’ve received from your realtor, from other people in the market, that’s where the guest work comes in.

(04:44)

Formula is only as good as your knowledge and your studying of the market. Let me give you an example. Just to try to make this real, I’m risking talking about numbers and maths, math on a podcast and on the Ask Coach podcast, even on YouTube. I’m not drawing it out of my normal whiteboard, so maybe I can do that in a future episode if you all like this concept. But let’s just say on one extreme, you buy a house or a rental property for $100,000.

(05:07)

And I know that’s a low number in a lot of places, but these are round numbers that make it easier for me to do math. And let’s say you pay cash for that property and you rent it out and you get $6,000 per year in net rent. This is after you pay all your expenses, management, taxes, insurance, maintenance, anything on the property. What’s left over $6,000 per year. So you would have a 6% rental yield or a return from the cash flow in the property.

(05:34)

$6,000 divided by $100,000 is 6%. So that is one driver of your return, 6% return, but you also have another return on the property. Let’s say that property goes up by $3,000 per year, or at least in year one. There’s an appreciation of the price. You bought it for $100,000, but after one year it’s worth $103,000.

(05:55)

That’s called an appreciation of the property. And so your total return actually, let me take a step back. You make about a 3% return from the appreciation. $3,000 divided by 100,000 is 3%. So your total return in this example is 9%.

(06:10)

In that first year, we’re not doing the internal rate of return because that’s going to be too complicated to talk about here. But just in a one year return, 6% from cash flow, 3% from appreciation total of 9%. That makes sense, right. But what’s interesting to look at here’s, those assumptions, two thirds of your return in that case came from the cash flow. $6,000 out of the $9,000, $3,000, or 33% of your return came from depreciation.

(06:36)

So that’s important to know that’s saying, okay, most of my return, two thirds of my return is coming from the cash flow in the situation where I paid cash for a property and I’m making a total of about 9%. All right, that’s one example. Let’s go to a slightly different scenario that might be more real for a lot of you. Let’s say you buy that same $100,000 property, but you put 20% down and you’re still making $6,000 per year in net income, but you also have a mortgage on that property. Let’s say you pay 6%.

(07:05)

I’m going to keep it really simple here. You got a private lender who will let you pay 6%, and you just pay interest only. And so your payment on that is 4800 per year. I did the math for you. 6% times $80,000 is $4,800.

(07:18)

So you’re going to make a $2,200 per year cash flow. That’s 6000 in rent minus the 4800 in mortgage payment, interest payment, you’re making $2,200 per year in cash flow, and then you’re also making that same $3,000 in growth. All right, so you’re with me, still making cash flow, making less cash flow because you have a debt payment on the property, you’re making an appreciation the same because whether you have leverage or whether you don’t, you have the same amount of appreciation. But your total return on this property is 5200 per year. That’s the 2200 in cash flow and the 3000 appreciation, $5,200.

(07:53)

What’s your return on investment? You only invested $20,000 this time because that’s your down payment. You invested a lot less because you used leverage, use the bank or use the private lender. So your return is actually about 27.5%. That’s 5200 divided by 20,000.

(08:10)

So you’ve gotten back over a quarter of your money in one year from the returns on this property. But here’s my point and why I’m going through all this. What are the drivers there? What percentage of your return came from cash flow? What percentage came from appreciation?

(08:24)

And in this case, 42% of your return came from cash flow and 58% over half of your return came from appreciation. So you made less cash flow and you made the same amount of appreciation. But because you invested less of your own money, a larger portion of that came from appreciation. So when you use leverage, appreciation becomes a much bigger driver of your overall return, for better or for worse. You just need to know that I’m going to go through one more example to kind of drive this point home.

(08:56)

Let’s say that appreciation is not only 3%, it’s actually a 6% appreciation because in the last year or two or in 2022, we’ve had ten to 20% appreciation rates on some properties. This is where people build a lot of wealth, especially when you have a lot of leverage. So let me show you how that works. All the numbers are the same the same amount of cash flow, $2,200 per month. But instead of 3000 depreciation, we are going to get a $6,000 appreciation in year one.

(09:24)

That’s a total of $8,200 in return for that year, 2200 in cash flow and $6,000 in appreciation. So what kind of return are you making? You still invested $20,000 and you got an $8,200 return. That’s a 41% total return. But what percentage came from appreciation?

(09:44)

What percentage came from cash flow? About a quarter. 27% of your appreciation of your return came from cash flow and about 73% came from appreciation. So I want to step back. This would be easier if I was drawing a picture for you, but I hope it all makes sense.

(10:00)

The more leverage you use, the driver of your return flips from cash flow to appreciation. And that’s just important to know that if you’re in a highly appreciated market, one of your most important things to pay attention to, and this is where you as an investor make your money. You want to find locations where you can have a lot of demand. So increase in demand. You want to have a location where population is increasing.

(10:28)

You want to have a location where jobs are increasing, where people are getting paid more, because that is what drives the demand for real estate. At the same time, you also want to find locations where supply is limited. This is why I love infill neighborhoods. I don’t want to buy a new construction house right on the edge of the Metro market. I want to find a nice older neighborhood, but it could be like a 1980s neighborhood.

(10:50)

It could be a 1950s neighborhood. I’m a sucker for older neighborhoods with the big trees and they’re walkable. We built the best neighborhoods in the 1915 2030 before the cars really took over. That is my opinion at least. But those older neighborhoods, it’s hard to build new construction in those neighborhoods.

(11:08)

So if you have an existing house there, the supply is limited. And if that’s a high demand area, that’s a recipe for a lot of price growth on a property if the overall market is really doing well. So that’s how you make investment decisions. I’ve gone through all these numbers and the nerdy math behind it. But for investment decisions, if you’re going to use leverage and if you’re going to have a driver of your growth, be appreciation growth.

(11:31)

Your formula is to look for locations like I just explained, and to get low interest long term mortgages, because the biggest way you can go out of business and real estate is having debt. That is dangerous, like the Dave Ramsey model, where he had to pay off a bunch of debt in 90 days during a banking crisis because he had balloon notes on his loans. That’s what you want to avoid, because if you can hold on over the long run in a good location with low interest, long term debt, you might have a little bit of negative cash flow, but you’re not going to have any big disasters. That’s how you make money in a growth market. On the other extreme, going back to my original example, if you’re just going to pay cash flow and I know Sean, you let me go off on this question.

(12:08)

If you’re buying a single family house, you’re going to make a decision based on what type of market you’re in. If you’re in more of a cash flow market where you’re going to pay cash for properties, then most of your return is coming from the cash flow on the property, and you want to pay most attention to that. I like to find a balance. My personal preference is I want to have both. I don’t want to have a property that has a tiny, tiny or no cash flow or negative cash flow, but a ton of growth.

(12:32)

That’s too speculative for me. But I don’t want to have a property that only makes cash flow and the property goes down in value over time. That would be like a single wide mobile home that I’ve owned. Some of the property itself deteriorates, but the land underneath it. If I buy a single wide mobile home in a great location, then over the next 20 years I’ll make a lot of cash flow.

(12:50)

Maybe I’ll throw the mobile home away 20 years from now and then I’ll redevelop that land into something else so that’s a little behind the scenes of how I think about it. I want cash flow and growth. I want to pay attention to the location of the neighborhood and then I try to measure that by an internal rate of return with some reasonable assumptions and that’s how I make a decision. I hope that detail and that kind of in depth look at it was helpful, Sean. And for everybody else who listened to that, I appreciate you listening.

(13:17)

If you like the show, I’d like to invite you to subscribe to my free email newsletter at coachcarson.com/reitoolkit. In addition to weekly updates, articles and behind the scenes tips from me, my email newsletter subscribers get my real estate investing toolkit, which includes a property closing checklist that I actually use when I buy properties, a real estate deal worksheet, a tenant screening criteria checklist and other spreadsheets and goodies that will help you on your journey to financial independence using real estate. You can get it all for free at coachcarson.com/reitoolkit.

(13:49)

I also want to take this time to thank some people behind the scenes who make this podcast possible each and every week. This includes my podcast editor extraordinaire, Michael Win, my amazing virtual assistant Megan Thomson, my wife Kari, who helps me behind the scenes and is my partner here at Coach Carson. And of course, thank you to all of you, the listeners of the show who make everything possible. This show exists for you. It exists because of you and I really appreciate you being here for another episode.

(14:12)

Everything I’ve shared with you in this episode has been for general education purposes. I have not considered your specific situation or risk before buying your own investments, be sure to consult a financial realtor estate and or a legal professional until next time. I’m Chad Carson. You can also call me Coach and this is a show all about helping you get out of the financial grind so you can do more of what matters. See you next time.

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## Links & Resources

- Real Estate Deal School – https://coachcarson.com/reds
- Internal Rate of Return video: https://youtu.be/HJnnpXoR6y0
- Self-directed retirement accounts – American IRA: https://www.coachcarson.com/americanIRA

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