How I Use Finance to Evaluate Buying Rental Properties

Sep 3, 2011 by Rental Property    7 Comments    Posted under: How to buy rental property

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Let me begin this site by emphatically stating that I thoroughly enjoy the subject of finance, and in particular as it applies to real estate. Finance and real estate are the two greatest passions of my professional life. For as long as I can remember, I have always been fascinated with money. This fascination eventually helped shape my course in life as I later majored in finance in both my undergraduate and graduate studies.

After graduating, I had the opportunity to work as a financial analyst at one of the largest banks in Texas. As part of the mergers and acquisitions group, my work there centered around analyzing potential acquisition targets for the bank. One way companies grow is by acquiring smaller companies that do the same thing they do. This is especially true of banks. Big banks merge with other big banks, and they buy, or acquire, other banks that are usu- ally, but not always, smaller than they are. I believe our bank was at the time about $11 billion strong in total assets. It was my job to analyze banks which typically ranged in size from about $25 million up to as much as about $2 billion. I used a fairly complex and sophisticated model to properly assess the value of the banks. This expe- rience provided me with a comprehensive understanding of cash flow analysis which I later applied to real estate.

Like many of you, in my earlier years, I owned and managed rental properties and read just about every new real estate book that came out. They all seemed to be saying the same thing, with only slight variations in theme, some delving into nothing-down tech- niques while others focused on slowly accumulating a portfolio of properties, gradually building a level of cash flow sufficient to pro- vide a living, otherwise known as the buy-and-hold approach.

The more I read, the more I discovered that none of these books focused on what matters most in real estate, that being the accumula- tion of properties that are properly valued, as well as their subsequent disposition, with the difference being sufficient enough to allow investors the opportunity to profit. Proponents of the buy-and-hold strategy would argue that because the holding period extends over many years, price doesn’t matter as long as an investor can purchase real estate with favorable enough terms. Nothing could be further from the truth. It is precisely this kind of misinformation that led thousands, if not millions, of investors over the cliff in the collapse of the stock market in the three-year period that began in the year 2000.

Price didn’t matter as long as it was going up and the terms were good. Since value is a function of the price paid, and price didn’t matter, value didn’t matter, either. Investors overextended them- selves buying on margin and otherwise using borrowed funds with absolutely no regard for an asset’s value. Most of these investors probably had no conceptual basis for their purchase decisions to begin with. In the end, many of those same investors watched in hor- ror as their life savings evaporated right before their very eyes.

Although I had bought and sold real estate for a number of years prior to my experience at the bank, it wasn’t until I gained a more complete understanding of the principles of finance learned during my graduate studies and my tenure at the bank that I was able to sig- nificantly accelerate my investment goals. I developed my own pro- prietary financial models, which enabled me to more fully analyze an asset’s value based on its cash flows and price relationship to similar assets. The combination of these financial analysis tools and a sound understanding of valuation principles has allowed me to increase my personal real estate investment activities from a meager $25,000 a year in volume to a projected $8 to $10 million this year alone. Through duplication and expansion, which are part of a well- defined plan, I fully expect to increase these projections to buy and sell over $100 million in real estate annually within the next three to five years. This may be a bit aggressive for most investors, but I can see this level of activity in my mind’s eye just as clearly and vividly as the sun shining in all its glory on a midsummer’s day. The pieces are already being put into place to help me achieve this not-too- distant objective.

Achieving goals of this magnitude exemplifies the difference between the finance and accounting disciplines. The world of finance can unlock the doors of commerce in a way that most accounting pro- fessionals can only dream of. A working knowledge of the principles of cash flow analysis coupled with a comprehension of valuation analysis will allow investors to chart their own course in the real estate industry—or any other industry for that matter.

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