Income, Depreciation, Equity Build Up, Appreciation and Leverage in Deal Analysis
When I speak or write about real estate investing I often use the acronym IDEAL to remind people of the benefits of investing in real estate. Of course, the acronym IDEAL represents the five main benefits of real estate investing: income, depreciation, equity build up, appreciation and leverage.
However, today I am going to briefly discuss how I use IDEAL in my deal analysis when I am analyzing deals like I do on AnalyzedDeals.com.
Most people when they analyze a deal use income as their starting point for analyzing deal and I think that’s prudent to do so. Analyzing a deal based on how much rent you will have coming in versus what your expenses would be on a property gives you a great idea of how that asset will perform for you in a major area of importance: cash flow.
This is one area where the size of the discount you are getting on your purchase comes into play. If you are getting a big discount when purchasing, then your payments will be lower and your income on the property will be larger.
One of the rarely looked at benefits of investing in real estate at the deal analysis stage is depreciation. There are tax benefits to owning investment real estate and one of the things that I calculate out is how much extra cash in my pocket I will get back in tax breaks for depreciating the investment property. I can then use this number in my overall analysis of the deal.
Few people know how much you pay down on a typical loan in the first few years, so it would not surprise you to learn that I don’t know of anyone else that actually uses this in their analysis. That’s what equity build up is all about… having tenants paying down a loan over time. Even though, it is a small amount for each of the first 3 years–about 1% per year–I do take this into account on my deal analysis because over time this becomes significant. It is one of the things I track on my portfolio of houses and one of the things I get excited about because I look at it like a savings account.
To begin my discussion of appreciation, I need to point out that I do not buy houses based on appreciation. I think that is speculation and similar to gambling on the roll of a die. However, I do use it in my estimate to see how a conservative estimate of appreciation will impact my overall return on the property I am analyzing.
The final thing I do take into account is the affect of leverage–applying a small down payment to control a large asset with loans. I do this by analyzing the deal with both a 10% down loan and a 20% down loan. By doing this I can compare my return on investment for both and, based in conjunction with how much cash I have to invest, make a decision about purchasing the property or continuing to look.
So, I hope that helps you understand how I use the acronym IDEAL when analyzing my real estate deals.
Until my next post,
James