man inspecting building plans

Two Questions Every Investor Should Ask About Real Estate

The two-step recipe for real estate success

When it came to real estate, rich dad had two questions:

  1. Does the property cash flow?
  2. If yes, have you done your due diligence?

Calculating cash-on-cash return

The most important financial ratio of a piece of real estate to rich dad was his cash-on-cash return, which is calculated with the following equation.

Cash-on-cash return = Positive net cash flow / Down payment

Let’s say you buy an apartment building for $500,000. You put $100,000 down and secure the mortgage for the $400,000 balance.

After all expenses are paid, you have a monthly cash flow of $2,000.

Your cash-on-cash return would be 24 percent or $24,000 ($2,000 x 12 months) divided by $100,000.

To me, cash-on-cash return is the easiest and surest way to know if a real estate investment is worth your time and money. Additionally, there are other, more complex equations you can take into account:

  • Internal Rate of Return: This is a return on an investment that assumes all the income (passive/cash flow) you receive is immediately reinvested so that you would be getting a return on that money as well.
  • Net Present Value: This takes into account an estimated discounted rate for the future value of money. It takes the value of the money invested today and compares it to the value of the future cash flow at a discounted rate of return.

Each equation has its strengths and weaknesses, and none of them are as straightforward as cash-on-cash return. They rely on estimates, which can create widely varying valuations depending on the quality of the analysis. As the old saying goes, “Garbage in; garbage out.”

The importance of due diligence

Once rich dad determined whether a real estate investment provided enough cash-on-cash return, he would then make sure he was getting what he paid for through due diligence.

In my opinion, the words “due diligence” are some of the most important words in the world of financial literacy. It is through the process of due diligence (the careful evaluation of a potential investment to confirm all material facts) that a sophisticated investor sees the other side of the coin.

When people ask me how I find good investments, I simply reply, “I find them through the process of due diligence.” Rich dad said, “The faster you are able to do your due diligence on an investment, the better able you will be to find the safest investments with the greatest possibility for cash flow or capital gains.”

The Rich Dad Due Diligence Checklist

Rich dad had a checklist that he always used. I use one as well. It is very thorough and includes items that did not exist years ago (such as “Phase I Environment Audit”).

When working through this list, if I have questions about the property, I often bring in the experts and have my attorneys and accountants review the deal.

  1. Current rent roster with paid to dates
  2. List of security deposits
  3. Mortgage payment information
  4. Personal property list
  5. Floor plans
  6. Insurance policy, agent
  7. Maintenance, service agreement
  8. Tenant information: leases, ledger cards, applications, smoke detector forms
  9. List of vendors and utility companies, including account numbers
  10. A statement of structural alterations made to the premises
  11. Surveys and engineering documents
  12. Commission agreements
  13. Rental or listing agreements
  14. Easement agreements
  15. Development plans, including plans and specifications, and as-built architectural, structural, mechanical, electrical, and civil drawings
  16. Governmental permits or zoning restrictions affecting development of the property
  17. Management contracts
  18. Tax bills and property tax statements
  19. Utility bills
  20. Cash receipts and disbursements journals pertaining to the property
  21. Capital expenditure disbursement records pertaining to the property for the last five years
  22. Income-and-expense statements pertaining to the property for two years prior to the submission date
  23. Financial statements and state and federal tax returns for the property
  24. A termite inspection in form and content reasonably satisfactory to the buyer
  25. All other records and documents in Seller’s possession or under Seller’s control which would be necessary or helpful to the ownership, operation, or maintenance of the property
  26. Market surveys or studios of the area
  27. Construction budget or actuals
  28. Tenant profiles or surveys
  29. Work-order files
  30. Banks statements for two years showing operating account for property
  31. Certificate of occupancy
  32. Title abstract
  33. Copies of all surviving guarantees and warranties
  34. Phase I Environmental Audit (if it exists)

In addition to securing everything on this list, I also physically walk and inspect the property, including each unit if purchasing an apartment building. I take inventory of all damages and use that inventory list to negotiate a fair price.

I’ve seen lots of investors who skip their due diligence get burned big time. Don’t do it.

In the end, the recipe for real estate success is easy, cash flow + due diligence. Do those right, and you’ll be in great shape.

Get going on your own real estate investing career here.

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