A proper real estate education is a well-rounded real estate education, and you would be wise to remember that. It should go without saying: The more you are able to broaden your horizons, or at least as they relate to your own comprehension of the industry, the better. And while most new investors are eager to jump right into the fun stuff, like rehabbing “sizzle” features for example, there is a largely overlooked, but nonetheless important, numbers element that can’t be ignored. Quite simply, you can’t ignore the basic financial principles, no matter how “boring” they may appear.
Whether you like it or not, realizing any degree of success in an industry as competitive as this will require a real estate education worthy of your own name. That means you must demonstrate an inherent level of confidence in everything you do. For every fun task at hand, you must know several tedious ones, not the least of which include crunching numbers and making sure everything adds up. To get to that point, however, you must have an understanding of the basic concepts that make up the financial components of your typical real estate deal. Let’s take a look at some the most important financial concepts you should know as a real estate investor, and how they can boost your real estate education in no time flat.
It’s a sad truth, but a reality nonetheless: expenses are a necessary part of the real estate equation. Not only that, but they are about as important as they are feared. Expenses, for one reason or another, are hated by most business owners, and justifiably so. What are expenses, if not for a way to eat into your bottom line? Or, as Investopedia so eloquently puts it, business expenses are none other than those expenses “incurred in the ordinary course of business.” Either way you decide to look at it, you can’t run a successful real estate business without expenditures, so perhaps it’s time to embrace them — so long as they stick to a budget.
You can’t make money without spending it — no surprise there. So while you might not like the idea of calculating your expenses, it’s certainly a necessary evil. In fact, you can’t possibly know how much money you stand to make on a respective deal if you don’t calculate your expenses accurately.
I maintain that calculating your expenses as a real estate investor is a rather simple endeavor. If for nothing else, all you are doing is accounting for all the things that cost you money on an investment. It’s really not rocket science, but I digress. The real issue most investors run into when calculating expenses isn’t in the math, but rather the volume. While calculating your expenses is literally as easy as adding up all of your expenditures, the hard part is making sure you have accounted for every dollar leaving your business.
For the most part, expenses are relatively easy to account for. The average investor is obviously aware of a number of popular expenditures: The mortgage, utility bills, rehab costs, maintenance and a number of other things are simply a given over the curse of a typical rehab. However, not all expenses are created equal; some are a lot harder to identify than others. Holding costs and escrow fees, for example, are less readily identifiable than standard expenses, but are nonetheless deducting from your bottom line. That said, it’s in your best interest as an investor to mind due diligence and to be absolutely certain that all of your expenses are accounted for. Only once you are certain that all of your expenses are brought to light can you even begin to truly analyze a deal’s profit potential.
2. Cash Flow
While the previous item on this list discussed the variables that will detract from your ability to make a profit, cash flow is quite the opposite. Whereas expenditures literally witness investors spending money, cash flow represents the amount of money you have left over after all of the expenses have been accounted for. In other words, cash flow is another way of saying how much money you made on a respective deal.
Investopedia explains it perfectly: “Cash flow is the net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company’s liquid assets are increasing, enabling it to settle debts, reinvest in its business, return money to shareholders, pay expenses and provide a buffer against future financial challenges. Negative cash flow indicates that a company’s liquid assets are decreasing.”
And again, not unlike the expenses I touched on earlier, calculating your cash flow isn’t exactly rocket science. To determine the cash flow of a particular deal, all you have to do is subtract the total expenses from the total income. Whatever is leftover after you have paid all of your expenses is considered cash flow, and yours to do whatever you would like with. Instead of spending it recklessly, however, I implore you to reinvest said cash flow back into your company and use it to facilitate another deal.
When all is said and done, cash flow is the one financial indicator most investors are most excited for, and for good reason. However, it’s important to remember that it’s only part of the whole equation.
3. Return On Investment (ROI)
While not all that different from the previously discussed cash flow concept, your ROI (or return on investment) breaks down how much money you made into a rate. Some consider it a fancy way of identifying the interest rate you are making on your initial investment. I, however, prefer to think of it as the rate of return you make on an investment relative to the amount you spent. Investopedia, on the other hand, prefers their own interpretation of ROI:
“A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments.”
However you want to look at it, calculating the ROI is always the same. Simply divide the return on an investment by the cost of the investment, and express the result as a percentage or a ratio. And for what it’s worth, it’s that same simplicity that many people choose to calculate their own ROI on a given deal. Since ROI can be turned into a percentage, it makes it a lot easier to compare returns on different investments. With a simple ROI calculation, it’s entirely possible to measure and pit a variety of different investment types against each other.
In the end, ROI is none other than a rudimentary gauge of a particular deal’s profitability. However, it serves as a tangible number that can transcend exit strategy valuations and allow for investors to make comparisons between flips and wholesales that would otherwise be more difficult to comprehend.
A proper real estate education covers every aspect of the industry, and number crunching is no exception. To exercise a truly valuable real estate education in your line of work, you have to be able to understand simple financial concepts and how they relate to what it is you are doing. And to get you started off on the right foot, here are three of the best places to get started.