Step One: Evaluate the asset.
Evaluating the asset is a whole lot like what you do in a renovation (see above). This focuses on a financial analysis, which is like a desktop analysis that answers the question, "Does this asset produce sufficient income to meet my investment goals and requirements?” For my asset evaluation system, all I use is a spreadsheet on Google Sheets. I use a sheet to find the income capitalization rate (aka, CAP rate). This can also include looking at the internal rate of return on your investment and your debt cover ratio (aka, DCR).
The three most important things in real estate are location, location, location.
So the rule of thumb is If you haven’t seen the dirt, you’re wasting your time.
To do this I look at the financials first, even if it’s just for 15 or 20 minutes. This will save you hours and hours in the long run. By doing this quick check, I can see if the property is somewhat feasible given my goals and finances, then I'll physically take a look at the property.
On the other hand, if a quick look at high-level financials doesn't make sense to me, then I will likely waste my time by going to look at it. Crunching the numbers up front could keep you from wasting an entire day of going out to the property.
Step Two: Assess the value of the real estate
Your top two approaches for evaluating the value of an asset are standard.
- The income approach: analyzing the income generated by investment
- The sales comparison approach: (what appraiser and investors often use to evaluate a property)
The income approach
Use the spreadsheet that I've created to determine what the income is worth purchasing. This spreadsheet helps you know your absolute maximum bid on a property. My assumption is that 90 percent of decisions are emotional, and you don’t want to make buying real estate emotional. You want to use ice cold logic. Doing that will save you many mistakes wrought by emotion.
If you are smitten with a particular property, you just might make a major mistake. Let’s say your competitor wants to buy it, and you want to outdo that person. If you’re not careful and you let your pride get the best of you, brokers will prey on you. Leave your decision to a strict application of your evaluation.
For my decisions, I pick a maximum offer price based on my valuation, along with my intellectual intuition on what the asset is really worth. Then, I stick to my opinion on the worth of this asset regardless of what emotions fly my way. It works—I’ve learned the hard way.
The sales comparison approach
You can also do a sales comparison approach, which means taking the most recent three to five transactions that have sold in the last 24 months (or less). See how much these sold for, and use that data to compare the opportunity in front of you by using a spreadsheet. This is called a sales comparison approach. Using this approach is intended to be done in addition to the "income approach”.