The Most Important Thing An Investor Looks For
Many people think that real estate investing is difficult and filled with risk.
There are, of course, whole industries that thrive on making simple topics complicated. I prefer to make things as simple as possible. I learned that from my rich dad. And he had a simple formula for real estate success.
Rich dad would always ask two questions:
- What is the cash-on-cash return for a real estate deal?
- Have you done your due diligence for a real estate property?
For rich dad, these were two sides of the coin that were essential for moving forward on any deal.
Return On Investment
Your return on investment is exactly that: the amount of cash the money you invested is paying or returning to you. In other words, how hard is the money you invest working for you?
Here are a couple of examples of how to calculate ROI so your results are returned in percentage-format (which is intuitively easier to understand):
- If you invested $1,000 in a stock that pays an annual dividend of $40, your return on investment would be 4%. ($40 / $1,000 = 0.04 = 4%)
- If you put $10,000 cash as a down payment to purchase a $50,000 rental property with an annual positive cash flow of $1,500, your ROI would be 15%. ($1,500 / $10,000 = 0.15 = 15%)
When it comes to real estate transactions, this is also called a cash-on-cash return because it calculates the cash income earned on the cash invested in a particular property.
To me, the cash-on-cash return is the most important number because it tells you exactly what your invested money is earning. In other words, it tells you how hard your money is working for you.
These two examples of stock dividends and rental property are cash-flow investments.
But ROI also applies to capital-gains investments, too.
For example, if you purchase a share of stock for $20 per share and the stock price goes to $30 after fees and expenses are deducted, your profit or yield would be $5. Your ROI in that case would be $5 / $20 = 0.25 = 25%.
What Is A Good Return On Investment?
I get asked quite often what a good return on investment is, but that answer depends on a few things. Depending upon whom you talk to, ROI will vary.
For example, if you talk to a banker, he or she may say, “We pay 3 percent interest on your money.” For many people, this may sound good.
If you talk to a financial planner, they may say, “You can expect a return on your investment of 10 percent per year.” To many people, a 10 percent return is exciting.
Ultimately, a good ROI depends upon the type of investment. It depends upon the economy. And it depends upon your financial intelligence.
Back in the late 1970s, I remember my parents talking about the rate of return they were getting on their bank’s certificates of deposit (CDs). It seemed normal at the time, but their rate was 18%. Who wouldn’t like an 18% return on a CD today? What I found really interesting though was when the savings-and-loan crisis hit in the 1980s. The bank retracted the 18% interest rate and basically canceled the outstanding CDs. If an individual had done that, lawsuits would have followed!
With little financial intelligence, you can typically expect a low return on your investments. Why? Because you won’t know what to look for in investments that generate higher returns and will probably end up in investments or savings plans that offer low yields.
This is why financial planners recommend mutual funds, CDs, and savings to people with little money know-how.
This is also why so many people get taken in when they are promised too-good-to-be-true returns on investments they know nothing about.
Obtaining and sustaining a high rate of return takes financial education and experience. There is no secret sauce, no magic pill. It takes putting in the time and effort to study, research, and then take action.
As an investor, you need to get as much information as you can upfront so that you’re making as few financial assumptions as possible.
In my opinion, the words “due diligence” are some of the most important words in the world of financial literacy. It is through the process of due diligence that a sophisticated investor sees the other side of the coin.
When people ask me how I find good investments, I simply reply, “I find them through the process of due diligence.” Rich dad said, “The faster you are able to do your due diligence on any investment, regardless of whether it is a business, real estate, a stock, or bond, the better able you will be to find the safest investments with the greatest possibility for cash flow or capital gains.”
Due diligence is the process of looking under every nook and cranny of a potential investment—this is when you roll up your sleeves and become a detective. It’s not glamorous. And it takes time and effort to do it properly.
Don’t worry, however, there will always enough time for you to do this part properly because as part of any contract to purchase, you must include a due diligence period in the contract—plus, include a clause that requires the seller to provide any and all materials and access requested in a set turnaround time (to ensure they don’t hold you up from meeting your deadline). This includes looking over financials, inspections, rent roll evaluations, and more.
So what kinds of things are you looking for when doing your due diligence on a rental property?
Here are just a few examples—it’s really only the tip of the iceberg (which is why you need to allow yourself enough time to gather all of this information):
- Current rent roster with paid to dates
- List of security deposits
- Mortgage payment information
- Utility bills
- Tax bills and property tax statements
- Termite inspection
- Income and expense statements going back two years
- Market surveys
- Rental agreements
- Physically walk and inspect the property, including each unit if it’s an apartment building (taking note of all damages, so you can use that as leverage during the negotiation)
Often during a due diligence period, you’ll discover hidden costs that require you to adjust your financial models for cash-on-cash return.
This means you can go back to the seller and renegotiate the purchase price to make your models work. If you had skipped this crucial step and found out these hidden costs after the fact, you would quickly go from a positive gain to a really bad deal.
Bottom line: The quicker you do your due diligence on a potential investment (without cutting corners), the more likely you are to find the safest investments with the greatest possibility for cash flow.
Editor, Rich Dad Poor Dad Daily