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No. of Recommendations: 4
This reminds me of a story. An engineer was wandering through the desert and stumbled across a chasm. She started thinking how nice it would be to have a bridge across the chasm rather than walking around it. Next she starts thinking about what it would take to build the bridge and pulls out her slide rule, thinking to herself the chasm is about 60 yards across...

And comes up with:
- 45013.4234 cubic yards of concrete
- 450.623 tons of re-bar
- 5240.31 linear feet of framing lumber

Then it strikes her, all of these figures are based on an estimate of 60 yards, it may be 50 to 70 yards across, there's no way she can calculate material down to three decimal places...

How does this apply? I've analyzed a few dozen properties and have learned not to take my estimates to seriously. In reality a couple of simple calculations and an experienced gut feeling is sufficient. Here's my first calculation:

GRM (Gross Rent Multiplier) = cost/annual rent, <9 = profitable, > 13 unprofitable (you're buying future equity)

120000/ 14400 = 8.3 GRM, very profitable, you may be outbid
140000/ 14400 = 9.7 GRM, depends upon your locale

Next is CapRate = 0.65 * gross income / price (0.65 is the expected operating profit, i.e. doesn't include mortgage interest payment)

14400 * .65 / 120000 = 7.8%
14400 * .85 / 140000 = 6.7%

So you're earning between 6.7 and 7.8% on your capital, how does that compare to your other investments? Also, if you are earning 7.8% on your capital, and borrowing at 6% (mortgage) is that good? Am I comfortable with the increased risk due to leverage?

Now every professional in the real estate business knows these numbers and every investment opportunity (real estate/stocks/commodities/...) gets analyzed on a risk/return basis and people make a decision.

In Southern CA, GRM runs in the 13-18 range because you're buying future appreciation. In the Midwest, where appreciation isn't as much, you're buying cash flow and I understand GRM runs in the 8's or so.

Lastly, calculate how much mortgage the property will carry. Use the GRM #'s. Operating profit = 0.65 * income, then use calculate the mortgage principle based on the monthly payment (0.65 * income / 12) and voila, you know how much to pay where the building is break even. If the price is higher you need to put in cash. If the price is lower, you have immediate profit. You most likely have to put money in to lower the mortgage and because you probably can't get a 0% down investment property loan.

Just remember, you can't tell if the chasm is 55 or 70 yards.

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When Life Gives You Lemons
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