Being a good investor is all about having a vision for where you want to be, taking a view on the market, and running the numbers. When these three elements don’t line up then smart investors stay on the sidelines.  But when they do line up then it’s time to act.

Having a vision, taking a view, and running the numbers: the three pillars upon which you’ll build your ability to make sustainable decisions which will, over the long run, help you to achieve your financial goals. Well forming the vision is the fun part; we all enjoy thinking about where we want to end up in life. And you’ll have lots of help in taking a view; everyone and there dog is out there making predictions about what’s next for the real estate market – your task is separating the wheat from the chaff.

But what about running the numbers? How many of us get really excited about running economic models? Well in my view looking before you leap is the best way to keep your momentum as an investor, and that means having an idea about what to expect from an investment in terms of rate of return, cashflow and net present value.

But analysis is like aspirin, or fine wine, or just about anything, for that matter. A bit of it can make a big difference – but that doesn’t mean that a massive dose is a good idea. More isn’t necessarily better.

So how do you strike the right balance? Well watch out for two traps – 1) becoming infatuated with the analysis and forgetting about the underlying uncertainties (no analysis is perfect) and 2) becoming infatuated with perfecting the analysis to the extent that you never get a deal done. In other words: don't get paralyzed.

Both of these problems happen, probably more than you’d think.

So - how to avoid these issues? Again, it depends on your goals as an investor and your personality type, but I’d suggest a few rules of thumb:

• Remember: your analysis is based on your assumptions. Unless you have a working crystal ball you’re never going to get it all right. Your analysis will give you your base case. When you get your results ask yourself “is this target a good result? Does the potential reward justify the risks?” if the answer is “yes” then drive on and figure out how to make the deal work – don’t spend too much time fine tuning. 
• Analysis is a process: I worked for a while in strategic planning with a major corporation. We spit out huge, detailed plans. And we never followed them. Is this a bad result? Well, not necessarily, because the planning process in itself is hugely valuable. It forces executives to examine their assumptions, communicate their goals, and crystallize their thinking. The planning process helps organizations to articulate their vision and set their course, even if they don’t follow the resulting plans to the letter. Real estate analysis is similar: running the numbers will force you to consider the big questions around vacancies, rental rates, repairs, and other risks that you might not consider before jumping into the investment. 
• Evaluate the sensitivities: Don’t just look at the final “answer” – look at the sensitivities to understand how much risk you’re taking. Ok, you’re forecasting a 5% appreciation rate...but what if it’s -5%? Or 10%? Most investors who bought in 2006 didn't predict today's market - but there are a handfull who at least evaluated the risk of a downturn.  Investors who consider future risks are investors who are prepared to take action when things don't go right. 
• Be honest with yourself: There are two camps that you want to stay out of – the overly conservative camp that kills every deal that comes along by handicapping them with excess costs, and the rose-colored-glasses camp that tweaks all the variables up until they get the result they want. Nervous Nellies do no deals, and Pollyannas do bad ones. 
• Remember that once you’ve made your bed you’re going to have to lie in it: A single fortuitous event (a new rail line) or misfortune (a mold infestation or a disastrous tenant) will radically impact the performance of your investment. You’re still going to have a lot of uncertainty to manage once you make your investment; the purpose of the analysis is simply to ensure you’re pointed in the right direction before you pull the trigger.

Real estate investing software is what EquityScout is all about. Ironically, it's not something that I talk about a lot in this blog. There's a reason for that. In my view real estate investment software is a tool - one of many - that can help investors to reach their goals. Much more important that the tool is the thought process that it supports. That's what I write about - the though process - and readers who identify with the thought process and the philosophy end up check out the tool.

So that said, what are real estate evaluation tools useful for?  Here's a few thoughts:

• Real estate investment software adds discipline to the investment process. Buying real estate, by its very nature, can be an emotional process. And that's ok; gut feel and intuition are qualities that are crucial to successful investing. But discipline is equally important. Software can bring some structure to your decision making process.
• Real estate investment software forces investors to explicitly state their assumptions. GIGO :: garbage-in-garbage-out. You can punch in assumptions to make any investment look like a barn burner - but if you're buying a starter duplex in Los Angeles for $500k that rents for $2,500 per month then you're actually going to have to assume a 20% appreciation rate for the investment to break even. And you're actually going to have to type those numbers - "20%" -  into the model. Being forced to explicitly articulate your assumptions in this way can be a good gut check - and sometimes can be just the wake-up call you need to get you to take off those rose colored glasses.
• Software helps investors to compare dissimilar investment opportunities. Should I buy a fourplex, that duplex around the corner, or a couple of single family homes? I have a different view on each, how do they stack up?
• Real estate investment software helps geeks to pull the trigger. This, for me, is the big enchilada. I'm an engineer by training, which means that sometimes I can't spell too good (as some of you will have noticed from the occasional typo on this blog) and that I need to see some numbers before I can get off of the fence and take action.

Read here to see more pros and cons of the real estate software approach.

• Look before you Leap
• Five Things to Remember when Running Economic Analysis
• Is a Real Estate Investment Software package right for you?

A common staple of finance websites and literature is a comparison between different investing options. Stocks? Bonds? Real Estate? Where should you put your money?

The answer, of course, will depend on your resources, your risk appetite, and your goals. But for investors who still have a fair amount of runway ahead of them before they hit retirement, most comparisons fail to highlight the true benefits of investing in real estate. 

The bottom line:

Over the long run, the stock market has yielded great returns. From 1987 to the present the S&P 500 has appreciated at an average rate of almost 10% per annum, and the NASDAQ has averaged over 11%. Over the same period the average home price in America has increased at around 5.6 percent. 

This is the comparison upon which many analysts focus. One dollar invested in real estate in 1987 would be worth around $2.84 today. That same dollar would be worth $5.74 or $7.31 were it invested in the S&P 500 or the NASDAQ, respectively. But this is the whole picture

Volatility: Real Estate Bubbles vs. the Stock Market

We’ll get to leverage in a moment – that’s where these conversations inevitably lead. But the first thing to consider is volatility. 

Yeah - we know that stocks yielded an average of 10% to 11% over the past twenty years or so, but how did we get from point A to point B? Investors will remember the period from 1999 to 2002 which were rough years for the sock market. From its peak in August of 2000 to the bottom in September of 2002 the S&P 500 lost over 40 percent of its value. Over roughly the same period the NASDAQ declined by a whopping 75 percent. Eventually the market managed to shake off these doldrums, but this was a tough period for investors. 

Real estate has hit some hard road bumps too. It’s interesting to compare the severity of regional real estate downturns with the stock market collapses listed above. Global Insight periodically releases a study of market valuations in which they list, among other things, a summary of major past price corrections. The most severe being associated with the oil bust in the ’80s; fellow Texans will remember this period.

• Lafayette LA, declined by 35% over 15 quarters
• Odessa TX, declined by 28% over 18 quarters
• Abilene TX, declined by 28% over 11 quarters

All three of these markets were significantly overvalued before they fell. The lesson here being: what goes up must come down, and investors who live in regions characterized by overvalued markets have reason to be concerned. 

If you live in certain parts of Florida, California, and other overheated regions of the country, this means you.   But for the rest of you: note that the three historical cases above are the worst of the worst. There never in recent history has been a major national correction in real estate prices, and most regions have experienced continuous growth in property values for decades. Watch out for regional markets that have been spiked into a speculative frenzy - but overall, volatility in housing prices is low.

It doesn’t make sense to talk about leverage without first talking about volatility. You can use leverage to turbo-charge the returns on about any investment, but high volatility usually makes leverage prohibitively risky. 

Not so with real estate.

Aside from a handful of regional exceptions notwithstanding, real estate prices historically have marched steadily upwards at a steady 5.6 percent per annum. Factoring in leverage this return ratchets up to over 13% per annum; considerably better than stock market returns at lower volatility. 

What is leverage?

Simply put: a dollar invested in stocks buys you one dollar’s worth of stock. But that’s not the way we buy real estate. A typical investor might put $20,000 down to buy a $100,000 home. So instead of getting one dollar’s worth of house for your one dollar investment you’re getting control over five dollars worth of house. 

That’s 5:1 leverage. One buck from you, and four bucks from the bank. 

That $5 invested in the housing market in 1987 would be worth around $14.18 today. Assuming that you hadn’t paid down any of the mortgage your $1 investment would be worth $10.18. Compare that against the $5.74 that your S&P 500 investment would be worth or the $7.31 that your NASDAQ would have netted. 

The upside...

I’ve made some simplifications, but overall they’re conservative ones:

• Dividends and rental cashflow. I left ‘em both out of the analysis. But any property that you’ve had for twenty years will be raking it in cashflow-wise, whereas corporate dividends these days are pretty skinny. Advantage: Real Estate.
• Paying down the mortgage. Back in the late '80s interest rates were hovering around 10% (gasp!). At this rate a standard fixed 30 year mortgage would have paid off around 30% of its principal balance over twenty years. That’s another advantage that I haven’t included in the comparison. Advantage: Real Estate

Timing can be important and in some regions now isn't the best time to be jumping into the market, but over the long term it's hard to argue that real estate doesn't have a place in your portfolio. 

I’ve stated in previous posts and articles that running the numbers and making sound assumptions about your potential investments is one of the keys to avoiding real estate investor burnout.  Real estate is a long term game and you can’t build a stable portfolio overnight.  This means you need some staying power, so if you end up packing it in after your first investment or two you’ll never get there.  

So in my view looking before you leap is the best way to keep your momentum as an investor, and that means having an idea about what to expect from an investment in terms of rate of return, cashflow and net present value.  

But analysis is like aspirin, or fine wine, or just about anything, for that matter.  A bit of it can make a big difference – but that doesn’t mean that a massive dose is a good idea.  More isn’t necessarily better.  

How do you strike the right balance?  Well that depends on the investor.  Personally, I’m an engineer by training and I love numbers; that’s why I ended up building this site.  I see the value in using a tool to catch all of those assumptions wrapping them into a cashflow projection.  Plus, I love to tinker.  But therein lies two danger – 1) becoming infatuated with the analysis and forgetting about the underlying uncertainties (no analysis is perfect) and 2) becoming infatuated with perfecting the analysis to the extent that you never get a deal done.  In other words: don't get paralyzed.

Both of these problems happen...probably more than you’d think.  

So...how to avoid these issues?  Again, it depends on the investor and your personality type, but I’d suggest the following rules of thumb: 

• Remember: your analysis is based on your assumptions.  Unless you have a working crystal ball you’re never going to get it all right.  Your analysis will give you your base case.  When you get your results ask yourself “is this target a good result?  Does the potential reward justify the risks?”  if the answer is “yes” then drive on and figure out how to make the deal work – don’t spend time fine tuning.  
• Analysis is a process:  I worked for a while in strategic planning with a major corporation.  We spit out huge, detailed plans.  And we never followed them.  Is this a bad result?  Well, not necessarily – the planning process itself is hugely valuable.  It forces executives to examine their assumptions, communicate their goals, and crystallize their thinking.  The planning process helps organizations to articulate their vision and set their course, even if they don’t follow the resulting plans to the letter.  Real estate analysis is similar: running the numbers will force you to consider the big questions around vacancies, rental rates, repairs, and other risks that you might not consider before jumping into the investment.  
• Evaluate the sensitivities:  Don’t just look at the final “answer” – look at the sensitivities to understand how much risk you’re taking.  Ok, you’re forecasting a 5% appreciation rate...but what if it’s 3%?  Or 8%?  The EquityScout tornado diagrams will help you do this, but if you’re running spreadsheets you can do the same thing manually.  
• Be honest with yourself:  There are two camps that you want to stay out of – the overly conservative camp that kills every deal that comes along by handicapping them with excess costs, and the rose-colored-glasses camp that tweaks all the variables up until they get the result they want.  Nervous Nellies do no deals, and the Pollyannas do bad ones.  
• Remember: once you’ve made your bed you’re going to have to lie in it.  A single fortuitous event (a upgrade in the neighborhood) or misfortune (a mold infestation or a disastrous tenant) will radically impact the performance of your investment.  You’re still going to have a lot of uncertainty to manage once you make your investment; the purpose of the analysis is simply to ensure you’re pointed in the right direction before you pull the trigger.