Statistics and Investment Calculations
November 1, 2005
Figures often beguile me, particularly when I have the arranging of them myself; in which case the remark attributed to Disraeli would often apply with justice and force: “There are three kinds of lies: lies, damned lies and statistics.”
– Autobiography of Mark Twain
I am not a fisherman, but I remember playing with a fishing reel when I was a boy and having it get all entangled on itself in seconds, but requiring hours to untangle and put into orderly condition. That’s what happens when we get tangled up in real estate investment calculations without a plan and a goal for what we want in a property—instant confusion and hours to make it make sense.
We can calculate the financial return on a rental property at least 17 different ways. There are the Gross Rent Multiplier, the Capitalization Rate, the Internal Rate of Return, the Net Present Value, Cash Flow, Cash Flow Before Taxes, Cash Flow After Taxes, Cash on Cash, Net Operating Income, Debt Coverage Ratio, Effective Gross Income, Return on Initial Equity (both in dollars and percentage), Scheduled Gross Income, and Tax Benefit. Maybe you can think of one I missed. If you can, good.
I know what each of those calculations means, though I might have to look up how to actually figure one or two of them. So what? I can play with numbers; I can make Excel figure stuff out and create impressive-looking charts and graphs. As Mark Twain noted while quoting Disraeli, there are three kinds of lies. The worst is statistics including calculations for rental property investment.
I get calls and emails from real estate investors weekly who have in front of them a slew of numbers that look truly impressive. They are impressive. I am impressed by anyone who can put figures together so creatively. Actually, I don’t know if it’s that creative. Ever since Excel came into its own, all you have to do is plop some numbers into a spreadsheet, and run formulas on them. Then study the whole thing carefully and see which looks the most promising. Is it that cap rate? Maybe it’s price per unit. Maybe it’s the tax benefit. Someone selling a rental property is not going to use a calculation that shows a property in a less than favorable light.
Here’s how to analyze a property and make the figures work in your favor, rather than work as confusion. Know what you want going in. If you don’t know at the outset the kind of return you expect from a property, you will start looking at all those impressive numbers, analyzing how each one may or may not make you money, and try to decide whether or not to buy based on someone else’s idea of what’s important, rather than your own.
What then, should you look for when investing in a property? I don’t know, because everyone should have his or her own criteria for what is important when buying a rental property. It could be the return on investment, it could be appreciation, it could be the income it produces, or it could be something nonmaterial, such as it looks so good you just want to be able to drive by and say “I own that!” Whatever the reason, it is your reason. And your judgment about whether to buy the property or not should be based on the goals you set up before buying a property.
The point is that figures and calculations only become confusing if you have no ultimate investment goal to hold up beside them. Then those figures mean a lot. They tell you if the property meets your investment goals and criteria. They tell you if it is worth investing in.
Without an investment goal those calculations are nothing more than a tangled up fishing line that will take hours to untangle and will distract from your real mission, to find a property that will pay you a good return—however you want to calculate it.