I had to put the exclamation mark in there – I think it helps to blunt the boring feeling you get when you know that equations are coming. Great news for you! There aren’t any (in this post).
Last time you heard about all the troubles with my first rental purchase. I gave you all the numbers and told you it was a good deal. But how do I know it was a good deal? When I bought the place I really had no clue whether it would be a good deal or not. What about when you are presented with more than one possible property to purchase? They are usually different in significant ways. Perhaps one has a garage and the other doesn’t. One has 2,000sqft but the other has 1,600. How can you get an apples-to-apples comparison of the properties?
Is there any way to calculate a good deal?
Sorry, but there is no single calculation that can do it for you. In a similar way is why being a physician is so difficult. Say you are a doctor in the Emergency Department. A mother brings her six-year-old son in with abdominal pain. He had a fever earlier but the nurse found a normal temperature right now, no vomiting, and he is back to normal. The pain was in the right lower quadrant of the abdomen. You push on the belly and he says ‘ouch’ over the right lower quadrant. After the examination, he goes back to smiling and being playful. What is his diagnosis?
Some of you savvy individuals might be thinking ‘appendicitis’. And you might be right. But you might be wrong. He may have reported “my stomach hurts” to Mom but it was really more of the way kids describe being nauseated. The fever may have been “he felt warm” to Mom which may or may not have been a fever. He doesn’t have pain now. Do you send him to the Operating Room to take out the appendix, do you order a CAT scan, or do you send him home?
The CAT scan might be your middle-of-the-road choice, but it gives a large exposure of radiation, which increases lifetime risk of cancer. Maybe it would be better to just let him go home because he is feeling better, but what happens if he really does have appendicitis. Perhaps you want to operate. If it turns out not to be appendicitis you have given him pain, risk of infection, anesthesia reaction, and risk of bleeding. All for nothing.
Unfortunately, a CAT scan is not perfect either. It misses about 1 out of 10 cases. So, if you are going to be a physician, you better have another way of knowing. No single test can give us the answer. We need to put together all the information and come to a judgement on the diagnosis. Appendicitis might come with fever, but it might not. Usually it has abdominal pain, but sometimes not. It probably will have nausea, many times vomiting, but not always. Having abdominal pain in the right lower quadrant is more strongly associated with appendicitis than having a fever is, so it carries more weight when present.
It is the same way when evaluating a deal. When we start to talk about all the ways we evaluate, keep in mind that one method might make the deal look great, but another looks bad. Don’t simply jump because one method looks very good (or very bad).
Let’s say that your aunt Betty just died and bequeathed to you some money. All told, you get to take home $100,000. That Porche 911 looks mighty fine right now, but you are smarter than that. You decide you will invest. You could put it into real estate, or maybe the stock market, but let’s say you buy all the gold you can with your windfall. You purchase a paltry 80oz of gold, which is 5lbs or 2.3kg.
Two of this 1-kilo bar about the size of your cell phone is what you will have. Seems tiny right?
You keep these bars in your safe, buy a security system, and in one year sell them. Good for you – the price of gold went up and you come home with a check for $101,000. Was it a good deal?
For that, let’s look at the Cash-on-Cash return…Next time.
