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 that are priced below the FMV, regardless of whether they are existing or a pre-construction project. The best way to determine the 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 average price increase AND 2) is the sales volume increase. If both move in your favor, then you have peace of mind knowing that the correct trend is in place for prices to continue to move. In stock market investing, there is a saying that the trend is your friend and traders often look at price and volume data to confirm the trend. If a high-priced real estate market shows signs of falling volume, be very careful.
Step 3 is learning about the offering, especially in the preconstruction market. In some areas, there are very few projects on the books and in others, more than 15,000 units are expected to come up within 1 zip code, in 1 year. The same is true for investing in houses. If you’re competing with a bunch of new houses coming online, then the rapid price escalation may be limited. For most smart investors, they like to see a lot of demand with very little supply, which is nothing more than common sense.
Step 4 is to make your OWN opinions of the macro conditions of the local and regional market. So, for example, if you strongly believe that real estate is overvalued in your target area, why would you consider investing? On the other hand, if you think market forces will continue to rise in the market, why wouldn’t you be actively looking? As an example, some people believe that the aging of the United States is only now beginning to drive people to warmer, more attractive climates. Although property values are high in these areas right now, will we see 20+ years of additional migration into them? You have to decide for yourself because we won’t know the answer for another 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, relative to the amount of principal, interest, taxes and insurance (PITI) you’ll need to pay, you’ll be able to understand how much cash flow 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 monthly if things don’t pan out.
Deferred maintenance then becomes our Step 6. For an existing property, how much maintenance has the previous owner neglected that will have to catch up? Be careful here, as this can be one of the main places for unpleasant surprises.
And now I’ve saved the best for last: Step 7 is determining 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. Why? They understand their risk, they understand how to limit their downside, and the gains are far greater than the risks they are taking. If you were to stand next to them and see what they saw, you too would gladly take a risk and quickly 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 and battle-tested veteran.
As part of a new website we just launched, http://www.GetPreconstructionDeals.com, I get repeated requests asking if a particular deal 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.