Even after you master such terms as “cap rate” and “IRR”, there’s an old-fashioned method to analyzing real estate deals that might be more appropriate in today’s Covid-19 riddled market. And I call that “worst case/best case/realistic case”. It’s a formula that can keep you out of trouble while also making sure you don’t miss out on opportunities. So how does it work?
In this scenario, you run your evaluation of the deal based on the worst-possible scenario. Assume large vacancy amounts and costs that escalate. Take your worst fears and put them on paper – and don’t hold back. The point is to check exactly how bad things could get if you had the worst luck in American history. Then see if you could financially handle this event. For example, let’s say you’re looking at buying an RV park. You say “the last three years the average revenue was $100,000 per year, but with Covid-19 I want to play it safe and predict $80,000 instead (a 20% reduction)”. And then on the expense category you say “this property has too little insurance and the property tax will adjust upon purchase, so I want to ramp up the expenses by $10,000 per year”. Then you run the numbers with these assumptions and see if you can still make the mortgage payment. And, of not, can you personally handle the negative cash flow until you turn things around.
Now you shift from your greatest worries to your most blatant optimism. Going back to the RV park example, you say “this property has virtually no on-line visibility and a lousy website so I know I can increase the revenue by 30% in the first year” or “I found a way to improve the energy efficiency on the clubhouse and that will save $5,000 per year”. Once you run this most optimistic analysis, see how much money could be made if everything ran perfectly. This shows you the reason to take the risk associated with the worst case scenario, and it better be big!
In this analysis, you are somewhere between the worst and best case determinations – the odds on landing spot in reality. This position should give you a comfortable ability to cover the mortgage and have an attractive cash-on-cash return (how much you make on your down payment). And the realistic case should not be too tight, but give you room for a rainy day and low stress in covering your commitments and meeting your goals.
Putting it all together
So here’s how it works. If you can survive the worst case scenario and love the best case scenario – and be 100% happy and content with the realistic case – then you should move forward with the deal. If you can’t survive the worst case scenario, not that excited about the best case and don’t look forward to the realistic case, then don’t buy it. This type of analysis will also dispel a lot of your worries as it scientifically puts in motion your fears and allows you to quantify them in a factual manner and not just based on myths and legends.
The “worst case/best case/realistic case” analysis can tell you a huge amount about your deal and if it is a fit with you as the buyer. It’s an old-fashioned method, but is still infinitely better as a tool than many on-line spreadsheet concepts. If you can survive the worst, love the best and be content with the realistic, then you will have a profitable and low-stress experience.