Analyzing real estate deals

When analyzing real estate
deals, my biggest problem is self deception. I fall in love with a bad
property because I like the trees in the backyard. Then I run away from great
deals because the bathroom smells funny. I’ve learned I can’t trust my
emotional brain when investing. For me, the only way I’ve found to avoid
self-deception is via financial analysis.

I’ve
read dozens of books on analyzing real estate deals, and taken real estate
investing courses including Rich Dad Poor Dad/Tigrent Learning courses as well
as Bruce Firestone’s Ninja Real Estate course. The method of analysis Rich Dad
focuses on is Market Capitalization Rate and Cash Flow. The problem is, this
method helps you quickly identify a bad deal but doesn’t give you any reliable
means to compare one deal to another, in my opinion.

L-R, Robin Chahal, Bruce Firestone, Armin Eshtabi, Ninja Real Estate graduates

For
example, if you have an opportunity to buy a 3-bedroom, 2-bath rental property in
Orleans (an eastern suburb of Ottawa) with an expected Market Cap of 7% pa and
positive Cash Flow of $100/month, and an opportunity to buy a 3-bedroom, 2-bath
rental house in downtown Ottawa with an expected Market Cap of 7% and positive
Cash Flow of $100/month, your analysis indicates that these two deals are
equivalent. They are not. The latter may have much greater annual appreciation in property value as well as a lower long term vacancy rate and thus a higher overall rate of return. 

Moreover, if you want to compare real estate investment with a different kind of investment, you have no way
to do it.

For example, how does a real estate investment compare with putting the same
money in a high interest savings account, or putting money in an S&P
(Standard and Poor’s) 500 Index Fund?

The
metric that is much more useful than Market Capitalization or Cash Flow is IRR
(Internal Rate of Return). It’s harder to calculate, but is a much more
meaningful number since it includes capital appreciation as well as wealth effect (from pay down of mortgage principal) in addition to cash flow (which is the only thing cap rates actually measure).

A high interest savings account
will have an IRR of 0.8% (February 2016). An S&P 500 Index Fund will
return a 6% IRR over the long therm. I’ve seen real estate deals in Ottawa with a 20%+ IRR, and I’ve seen real estate deals in
Ottawa with
negative IRR.

IRR isn’t perfect either—it
doesn’t take taxation into account, but it’s the most accurate measurement I’ve
seen.

Robin Chahal IT specialist Real estate investor

postscript: Bruce Firestone covers how to calculate IRR on real estate deals in detail in his Real Estate Investing Made Easy course on Spirepoint.ca as well as here, https://profbruce.tumblr.com/post/140496724994/determining-the-internal-rate-of-return-irr. Prof Bruce summed up different ways you can value property here, https://profbruce.tumblr.com/post/116460775824/how-to-value-property. More about cap rates here, https://profbruce.tumblr.com/post/140496812164/how-to-calculate-the-capitalization-rate.

More from Robin Chahal, https://profbruce.tumblr.com/post/140496999144/benjamin-graham-warren-buffett-method-of