Step 1 is always to determine the fair market value (FMV). As a real estate investor, you can always buy properties on the FMV. My question is why would anyone want to do that? Through careful selection, you can always find properties priced below FMV, regardless of whether they are existing or a pre-construction project. The best way to determine FMV is to work with someone who is already familiar with the area or determine yourself through local websites that show recent sales histories.
Step 2 is to determine the market trend for the area for which there are two critical pieces: 1) is the increase in average price AND 2) is the increase in sales volume. If both move in your favor, then you have peace of mind knowing that the correct trend is in place for prices to continue moving forward. In stock market investing, there is a saying that the trend is your friend and traders frequently look at price and volume data to confirm the trend. If a high-priced housing market shows signs of declining volume, be very careful.
Step 3 is to learn about the supply, especially in the preconstruction market. In some areas, there are very few projects on the books and in others, over 15,000 units are expected to emerge within 1 zip code, in 1 year. The same is true for investing in houses. If you’re competing with a bunch of new homes coming online, then rapid price escalation may be limited. For most savvy investors, they like to see a lot of demand for very little supply, which is just common sense.
Step 4 is to make your OWN views of local and regional macro market conditions. So, for example, if you strongly believe that real estate is overpriced in your target area, why would you consider investing? On the other hand, if you think market forces will continue to increase in the market, why wouldn’t you be actively looking? By way of example, some people believe that the aging of the United States is only now beginning to drive people to warmer and more attractive climates. Although property values are high in these areas right now, will we see 20+ years of additional migration to them? You have to decide for yourself because we won’t know the answer for 20 years!
Step 5 is one of the most important risk management tools available to the real estate investor. Each property typically has an inherent fee at which it can be rented, even if that is not your intention. By looking at rental rates, in relation to the amount of principal, interest, taxes, and insurance (PITI) you’ll have to pay, you’ll be able to understand the amount of cash flow that may be required to support the property. If your goal is to produce cash flow, then you need to be cash flow positive very quickly. If your goal is capital gains and cash flow is negative, you now understand what you may have to support on a monthly basis if things don’t work out.
Deferred maintenance then becomes our Step 6. For an existing property, how much maintenance has the previous owner neglected that will need to be caught up? Be careful here, as this can be one of the main places for unpleasant surprises.
And now I saved the best for last: Step 7 is to determine your own personal risk tolerance. Some new investors look at a deal and only see the positive. This is a big mistake. EVERY REAL INVESTOR I KNOW HAS LOST MONEY ON A TRADE, but they will gladly do more. Because? They understand their risk, they understand how to limit their downside, and the gains far outweigh the risks they are taking. If you were standing next to them and saw what they saw, you too would gladly take a chance and be quick to ignore any small loss you experience.
We hope this has given you a good start in learning how to analyze a potential opportunity. Obviously, each of these steps requires additional work or training, but they are what separate the new investor from the seasoned, battle-tested veterans.
As part of a new website that we have just launched, http://www.GetPreconstructionDeals.com, I get repeated requests asking if a particular offer is good or not. While we can’t answer this for individual projects, we can certainly see what the investor HAS to do to dramatically increase the odds of a successful transaction.