Investing in Real Estate: Use This Formula for Success

August 8, 2016

Investing in real estate can be a good way to earn income, but don't buy until you've done the math.

This article is an excerpt take from a recent podcast with Josh Mettle

What are the first few things dentists should consider before they invest in real estate?

Cash Flow. First and foremost, one ought to consider cash flow.

In the buildup to the 2007 real estate crash, there was a reigning sentiment that started with this phrase…

If only I can just…

If only I can just break even on this property…

If only I can get 10% appreciation…

If only I can make this swing for a few months…

The huge problem was that people forgot about cash flow! What they meant was that they wanted to break even with their mortgage payment and property taxes and repairs and maintenance.

Folks had this attitude that, “I can be negative with expenses, and I can sell in a year or two because appreciation will more than make up for it.”

Gambling.

That’s not investing in real estate. That is called gambling.

There is no difference between that type of thought process and putting $50,000 on black or red at the roulette table. It’s just not something that you can base a sustainable plan on without eventually getting burned.

When you’re evaluating a property, you want to make sure that you’ve really got your arms wrapped around what your payment is going to be. Make sure you know exactly your payments for your principal, interest, your taxes, and insurance.

You need to know exactly what you’re operating expenses are going to be.

DISCLAIMER

: If you have LITTLE to NO student debt, then real estate investing from scratch could be a great place to start, assuming that you have the cash flow to save and support real estate.

However, for those with a significant amount of student debt and a lack of time, make sure you think really hard about your ability to handle rental real estate.

Consider these questions…

How could you handle the cash flow of an empty rental when you owe a mortgage?

What will happen with the property if you move out of town?

Another major decision that affects cash flow can be management fees.

Self Management.

Are you going to self-manage?

This means you or your spouse are going to collect the rent every month.

If not, this fee is probably going to be about 20% of your monthly rent.

In addition, think about these questions…

How much cash am I going to have to put in up front for a down payment?

How much cash am I going to have to put in to cover any deferred maintenance issues?

Just think that through:

“Okay, with my down payment, and what it’s going to cost me to get his property in the right condition, to make it the next 10, 15 years, what kind of rate of return can I get on my rental income?”

The Formula for Success

Let’s boil this all down to a formula for success.

We want to aim for at least a 10% return on equity when investing in real estate.

Let’s take an example…

I’m going to buy a $250,000 property. The down payment will be 10% or $25,000.

That’s the first part of my equity.

Then, we’re also going to need to do some rehab on the interior and other deferred maintenance issues to get it up to snuff and make it presentable to potential renters and keep it there.

Let’s budget another $25,000 for rehab and deferred maintenance.

That’s a total of $50,000 of equity & investment.

I want to see a cash-on-cash return of at least $5,000 a year.

Let’s calculate what rent needs to be to hit our target.

Below are the estimated expenses:

Description

Amount

Mortgage Principal and Interest

$1,100/month

Property Taxes

$200/month

Insurance

$100/month

TOTAL

$1,500/month

In total, we would be looking for rent of $2,000/month in order to meet our 10% formula for success target.

If a manager is doing it for it, you would need rent of $2,400/month to hit the magic formula.

If you can’t get close to that target, make sure to re-evaluate the property you are looking at.

Perhaps, you need to find a better deal or… an area with higher rents… or look at a cheaper property that would require less of a downpayment.

The good news is with real estate is that even if you make a mistake, time can cure all wounds and crappy decisions!

After all, every month, you are building equity simply by paying down your mortgage.

However, cash flow is king!

Make sure you honor the king or else you might regret the consequences…

Dave Denniston, Chartered Financial Analyst (CFA), is an author and authority for healthcare professionals providing a voice and an advocate for all of the financial issues that doctors deal with. He also served on the Dentist's Money Digest Editorial Advisory Board. He is the author of

5 Steps to Get out of Debt for Physicians, The Insurance Guide for Doctors, The Tax Reduction Prescription, and his new book, The Freedom Formula for Physicians.

He’s glad to answer any questions about insurance policies or other financial matters. You can contact him at (800) 548-1820, at dave@daviddenniston.com, or visit his website at DoctorFreedomBook.com to get a copy of The Freedom Formula for Physicians. Make sure to check out more podcasts at DoctorFreedomPodcast.com.

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