I recently attended a seminar aimed at first-time real estate investors. The course included a segment on valuation. Hand-out, after hand-out, was passed around. Each photocopy laid out various real estate valuation models and formulas, including ROI, Cap Rate, GRM, and ConC – all intended to assist investors in making sound financial decisions. As the stack of mathematical formulas grew, the seminar participants sank in their chairs.
Initially, these beginner-investors were animated and engaged as the course covered the benefits of passive income and the best strategies for property management. But when confronted by the endless mathematical valuation models (intended to help them), they exuded less confidence in their ability to successfully navigate a real estate investment deal. Not a single hand was raised in question after this part of the presentation. The participants were bummed. A bathroom break was in order.
You might believe that people who are initially intimidated by these formulas should not be investing in real estate, but I disagree.
New investors need a little mojo to dive into their first real estate investment. But by beginning their property search with numerous (sometimes contradictory) valuation models, new investors lose their enthusiasm in a sea of numbers and begin to doubt their ability to recognize a potentially successful investment. They get discouraged and sidetracked. They quit before they even begin.
Now, of course, successful investors will ultimately need to learn the mathematical basics of income and expense, and to determine how much cash flow is generated by an investment property. Investors get more adept over time at quickly digesting income statements and balance sheets and using that information to plug into valuation formulas to judge an investment’s performance or potential. Understanding the financials is part of the game, but as with everything, it becomes easier with experience.
So how can a new investor feel confident about selecting potential investments to begin gaining hands-on experience? Are there simple strategies that can be employed to quickly signal whether a real estate deal is poised for success? Yes, there are two simple steps, using two popular websites – no calculator necessary.
Two Step Evaluation for Real Estate Investing
Step #1: The Zillow Rental Zestimate
Search the prospective investment property on Zillow. Find the Rental Zestimate. Add two zeros. Don’t pay more for the property. (If Rental Zestimate = $1,500, Don’t pay more than $150,000)
Step #2: The GreatSchools Rating
Find the GreatSchools rating for the designated public high school of the prospective investment home. If it is a 6 or greater, BINGO!
You have located an investment opportunity that deserves your immediate attention and a much closer look.
Why These Simple Real Estate Investing Steps?
Step #1 provides a rule-of-thumb estimation to determine if you will be able to purchase a property, pay its expenses and maintenance costs, and generate enough income to have immediate cash flow (or at least break even). This rule of thumb is often called the One Percent Rule (meaning that gross rent should equal one percent of the amount you pay for the property).
Depending on the condition of the home, the amount you pay for the property is not necessarily the purchase price alone. The amount you pay is the purchase price PLUS any necessary repairs to bring the home to a rentable standard. Of course, many of the homes you find on Zillow that appear to meet the One Percent Rule will require repairs and rehab. In fact, these are the homes where investors often step in to “make their money in the mess,” finding homes that require work and adding value. So, when you see a foreclosure, REO, or “as-is” listing, you should know that you will need to view the property, get any available disclosures and get your contractor buddy to help you assess what type of money will go toward repair and rehab, before you start imagining your new tenant family playing ball in the backyard.
Now people can argue all day long about the accuracy of Zillow’s Zestimates. Sometimes they are totally off-base (especially in areas with unique homes with few for sale or rent). But, generally, I have found them to be relatively accurate over time and place. Again, the Zestimate is a quick estimation tool, not the final word on rental value. You can further research rents yourself by:
- looking at other rental home listing sites like Craigslist, Trulia, or Hotpads,
- looking at For Rent signs in the area, or
- calling local property managers and inquiring about listings.
If you are working with a broker or realtor, the realtor should be able to give you a market rental analysis based on MLS listings.
Just like Zillow’s Zestimates, GreatSchools Ratings are a bit controversial because they rank public schools on a number scale from 1 to 10. According to GreatSchools, the “ratings are based on a comparison of test results for all schools in the state.” You might wonder why as an investor you care very much about this rating? Well, you do, because many of the families that you want as tenants care about the rating. GreatSchools has become a litmus test for many parents – who only seek housing in locations with above-average (6 or better) on the GreatSchools scale. In fact, tenants looking for rental housing on Zillow can easily set search criteria to include only properties within the desired school boundaries. So if your rental property has a below average high school rating, you will likely have fewer rental applicant families.
This school rating system may seem silly or unfair to you. You know test scores aren’t everything and you hear great things about this or that local school. Even GreatSchools says the ratings are “designed to be a starting point to help parents make baseline comparisons, not the only factor in selecting the right school for your family.” Blah, blah, blah. Because while that all may be true, many parents simply follow the numbers. And, based on my experience, I have found that parents who seem to care about the school rating numbers, also seem to care about their credit scores. So, this leads to my GreatSchools Rating Theory of Investor Happiness:
Above-average school ratings = More qualified applicants = Fewer vacancies + Better tenants = More Happy Investors
Don’t be overwhelmed and discouraged by valuation models. Instead, use familiar websites and simple steps to weed through the thousands of possible residential real estate investments. Find one that meets the Rental Zestimate and GreatSchools Rating criteria, and then, with confidence that you are on the right track, let the games begin.
Role up your sleeves, and learn how to conduct proper diligence on the property you have identified. Dig deeper into the condition of the property and the surrounding neighborhood. Procure estimates for repairs, if necessary. Determine operating costs and anticipated expenses. Lock down your financing and estimate your closing costs. Now that you are knee-deep in the numbers, try your hand at the valuation formulas. You may now find them helpful and informative in the context of your immediate deal.
Armed with information, you must make final call on your rental home purchase. Will this be the beginning of your real estate investment journey? Only you can decide.