How do you know if you're getting a good deal on an investment property? I've talked with many people who believe that if they're upside down on rental payments (meaning, they're getting less in rent than the cost of their monthly expenses), then they're okay as long as the house is appreciating in value.

That sounds great until the house is no longer appreciating -- or is actually depreciating -- in value and now the investor doesn't even have a monthly cash flow to make up for the loss in capital appreciation.

The astute investor must look over several financial requirements to determine if the house is a good buy or not. Is it a cash-flowing wealth-builder, or is it a bank-drafting poverty-maker.

Keep in mind, you make money in real estate when you buy it -- not necessarily when it's sold. Buying low and selling high is still the proverbial rule for creating wealth in nearly any financial venture. If you can purchase the house for $150,000 and sell for $250,000 -- you've created wealth quite easily.

There are two basic ways of creating wealth -- asset growth and cash flow. Your analysis will include looking over both.

As you purchase the house, are you moving in with equity in place? How much? Will it grow more in future? If so, will it grow because of debt reduction (from your rent income) or solely from the appreciation you'll receive in your marketplace? If you're not receiving adequate rental payments, you could be in a situation that you'll grow your equity only by appreciation -- which is fine, but you have no control over that as an investor.

Look over the past appreciation of homes like yours in your area. Have they been moving upward over the past years? If they are on a downtrend, what are the economic forecasts as far as job growth, economic growth and home appreciation in the next year, 5 years and 10 years? (Check in with a local college/university, local economic development authority, or chamber of commerce for these forecasts).

The appreciation helps you determine your cash on cash growth which will help you to determine if it's a good deal. For instance, let's assume your acquisition cost was 10 percent on the above $150,000 purchase. So you're spending $15,000 to get into the property. If the growth projection is 2 percent per year over the next 5 years, then you will see a total appreciation over that time period of $15,612 -- that's more than 100 percent cash on cash appreciation. Not bad. Next we'll roll in the wealth growth from cash flow.

As far as your monthly expenses are concerned, be sure to roll in all your expenses, not just your monthly mortgage payment. You will have to deal with items such as home owners association fees; real estate management fees; insurance; property maintenance (air conditioning, carpet, paint, plumbing, etc.); taxes, etc. While many of these are tax deductible in certain cases, it's not wise to plan all your wealth building based on how many tax deductions you can receive for money spent. At some point, you have to build wealth through actual income or asset growth, and then pay taxes on what you've built.

So on your mortgage of $135,000 ($150,000 less 10 percent down payment), your payment could run about $1,100 per month (assuming 6.5 percent interest on a 30-year note with $150 per month in taxes and insurance in Anytown, USA). Your cash flow will then help determine your wealth growth each year, depending on your rental rate in the area. If you can rent it out for $1,400 per month, for instance, then you will experience a $3,600 per year cash flow before expenses. If your expenses (management fee, maintenance and miscellaneous) run $200 per month, then your net cash flow is $1,200 per year.

Thus on your acquisition costs of $15,000 -- you're making 8 percent on your money from cash flow and roughly 20 percent on your money via capital appreciation (about $3,000 per year at a growth rate of 2 percent per annum as mentioned above).

Thus, your total appreciation on your cash investment is 28 percent per year, when you combine the cash flow with the capital appreciation. Sounds great, right? Well, this apple cart can be turned over pretty quickly with a number of things: appliance breakdown, furnace replacement, vacancy, you-name-it, etc. Thus, don't spend all your money at one time and be sure to have reserves enough to weather those short-term downturns.

So is it worth it? Of course it is. The key is to create your model, understand how much cash flow you really need to make it work and stick with the model regardless of how many dollar signs are flashing in your eyeballs.

Published: March 30, 2007

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Mr. Carr has covered real estate since 1989. He is the author of Real Estate Investing Made Simple. Got a personal real estate issue? Post your questions and comments at Anthony’s blog: commonsenserealestate.blogspot.com.