“What test should I use when evaluating whether real estate is a good deal or not?”
I get asked this question a lot. “Should I use the 2% rule? The 70% rule? The expense ratio? Someone might say, “I don’t accept anything with a cap rate that’s lower than 7″. The list is actually much larger. What it comes down to is desperately searching for a surefire way to predict whether a deal is good or not. They’re making a fundamental misunderstanding of the tests.
Tests and Tests
You might think in the ER that you come there looking to get told what is wrong with you. It makes sense when you have something that ails you and you want to know what it is. But that’s a fundamental misunderstanding of what the ER is for.
In the ER we’re in the business of ruling out disease, not ruling it in. Why? Consider the person who comes in with chest pain. Chest pain can come from a huge amount of different sources, including muscular pain, arthritis, indigestion, pneumonia, and even heart attacks. It might be nice to know exactly what is causing that chest pain, but to find that answer requires a great deal of cost and time. Those are things that come at a premium in the emergency department.
Because of this, we are in the business of ruling out disease. We want to make sure that that chest pain is not coming from a heart attack or a pneumonia or some other life-threatening condition. We care little whether it’s coming from a muscle strain or acid reflux. Those aren’t going to kill you today.
So 99% of the time we do whatever tests are necessary to rule out serious disease and then send patients on to their primary doctor to get a definitive answer. It’s unfortunate in a way, when the patient has to spend a few hours in the emergency department to not really get an answer. On the other hand, they usually get something much sweeter: Reassurance.
It’s much like that with all these tests you do for real estate You aren’t trying to figure out if the deal is a good one. You’re in the business of ruling out all the bad deals. If you’ve done your homework, what you’re left with must be a good deal. All of these tests are really just used to find the reason that the deal is bad. If your rental property doesn’t make the 1% rule it’s likely a bad deal and you should move on. Period. Don’t waste any more time evaluating it.
If it does make the 1% rule, that doesn’t mean automatically that it’s a good deal. For instance, you could buy a 1% rule house only to find later that the roof was bad and now you’re putting in $20,000 and suddenly you’re 1% rule is down to 0.8%. Doing an inspection similarly should never help you rule in a house, it should always help you rule it out though.
Once you’ve done all the tests that are important, what you’re left with is a house that doesn’t have any of those negatives. This is a house worth buying. You’ll have to evaluate many deals to find the right one, to be sure.
Right now you need to be taking the time to determine what tests you’re going to use to evaluate your deals. We need to make sure these are good tests. Remember to never use them to rule in a a deal but always use them to rule out deals. Once you’ve arrived at a deal that doesn’t get ruled out, as long as you are using good tests, you have yourself a good deal and need to take a stab at it.
Let me know how it goes.