This book attempts to be different. It is designed to help you, personally, make decisions in real estate, by showing how successful practitioners actually think about and solve problems. ”
William J. Poorvu, The Real Estate Game:The Intelligent Guide to Decision-Making and Investment
I agree that the bookThe Real Estate Gameis different. It won’t teach you the latest hot real estate techniques (although it getsvery detailed at times). And itwon’t promise to make you a millionaire over night (although it includesgreat case studies of deals byboth beginners and billionaires).
Instead,this book does something much more valuable. Itteaches you how to think and to make decisions about real estate. It gets inside the heads of expert real estate professionals, and itshares the mental models and practices that these successful investors use.
The book is based upon the metaphor of a game. In many ways that’s what real estate really is. As a player in real estate, you have rules, a scoreboard, atickingclock, competing players, a little luck, and many obstacles you can’t control. And like a game, if you don’t prepare properly and train yourself before competing, you are asking for trouble.
What I really like about this book is that it gives usa useful lens to see the real estate world. Absorbing and using the game model is like putting on apair of night-vision goggles that help you see more clearly. With these goggles on, I began to see the information and the decisions in my own real estate investing in a new light. That clarity has certainly led to more profitable decisions.
What follows are a few of my favorite ideas from the book, but I can’t even begin to give youthe many excellent case studies and stories shared throughout the book. Those are what make the book most valuable. So if you find this book review interesting, certainly buy the book for yourself or check it out from the library.
Now on to my favorite big ideas!
The Rules of the Real Estate Game
Monopoly™ … is a very popular real estate game, but it’s not a very good one. It’s not contingent enough: one move doesn’t affect all subsequent moves to a sufficient extent. Players don’t have enough control over their fate. Luck counts for too much. Things don’t change fast enough. The properties aren’t different enough … The rules specifically forbid informal negotiations to arrive at win-win outcomes for two or more players.”
William J. Poorvu, The Real Estate Game
Traditional games likeMonopoly™ can not perfectlymimic the complexity of the real estate world. Reallife is too fluid. If you change one variable, all the others change too. And the overall market is infinitely complex and changing all the time.
So instead of a rigid set of rules, this book proposes areal estate game centered around four imaginary decks of cards, which represent the four key variables of all real estate deals. These decks of cardsare:
- Properties – These can be extremely diverse, from land, to small houses, to huge sky scrapers. Properties can also be an idea on paper andnot even built yet.
- Capital Markets – This is the money to fund your deals. Real estate capital markets are a small part of much larger capital markets. These larger markets affect the cost, availability, and sources of financing for real estate.
- Players – These are the change agents who connect, organize, and executeeverything else.There are traditional players like small, local, entrepreneurial investors, and there are larger, institutional players like REITS, hedge funds, and other types of pooled capital that develop and own real estate.
- External Environment– These cardsincludemany factors that can change the calculations and outcome of a real estate deal. It could be ashift in tax policy, regulation (local and national), demographic and job trends, consumer tastes, technological changes, and more.
To play the game you simply have to pick up a card. For example, you could identify a property you want to buy. Or you could also begin by being dealt a card. For example, you could inherit $50,000 that you want to invest in real estate.
The firstgoal of the game is to simply match four cards. For example, you would match a specific property, with a source of capital (financing), fitting into the existing external environment, with all thenecessary players organizedon a team.
But in this real world game, matching four cards is not so simple.
Why? Because you could be dealt a new card at any time. These new cards could be obstacles, like changingtax laws, collapsing demand for real estate, drying up of capital markets, and strife among players on your team. But these new cards could also be opportunities, like unexpected appreciation, low interest rates, easy sources of financing, etc.
The core reality of the real estate game is change. You have to constantly adapt as additional cards are drawn.
In addition to the four decks of cards, the game is played within the framework of a scorecard, which measures how you are doing. You and your partner’s get to determine your own scorecard criteria, butthe important stepis to track your progress along the way.
Finally, the game is played in phases or periods of play, sort of like quarters in a football game. The game is not over until you dispose of the property in the final phase. Not all deals go through every period of play, but the following periods represent the normal sequence of real estate deals:
- Concept to commitment (find an opportunity andget it under contract)
- Commitment to closing (due diligence, gettingfinancing, and obtaining title)
- Development (for example, the rehab during a fix and flip deal)
- Operation (for example, managing the tenants and the property)
- Harvest (liquidating the property, hopefully for a large profit)
The entire book is organized around this basic game structure. The author shares numerous case studies, and he references how the deck of cards are played, how the player keeps score, and how he or she proceeds through the periods of play.
This game model can be useful on many levels as you learn more about it. But I find that simply learning the rules and frame-work is the most useful part. Like a pair of glasses, these new lenseshelp you see more clearly, organize all of yourinformation, and ultimately make better decisions.
Back of the Envelope (BOE)Analysis
For the most part … [real estate] practitioners tend to rely heavily on more informal kinds of analysis to make their initial commitments. To the uninformed, these techniques can seem like an unreliable, ‘gut feel’ approach – like Grandmother throwing together her chicken soup with no discernible recipe. But like Grandmother’s soup, the BOE analyses employed by real estate professionals almost always perform as expected.”
William J. Poorvu, The Real Estate Game
When I first began investing in real estate, Iwas shocked howexperienced investors could seeminglywork magic. They evaluatedcomplex deals and quickly decided to pass or to move forwardsimply by doing math in their head or on the back of anenvelope.
Were these experienced investors just geniuses? Or did they have a secret technique I could learn?
It turns out they used something called Back of the Envelope (BOE) analysis. You can learn it too with some basic math skills and practice.
A BOE analysis focuses on a few key numbers for adeal (which will be covered in the next section). It then simplifies these numbers so that they can be easily and quickly understood.
The “magic” of this technique is that it allows you to spend more time analyzing the underlying assumptions instead of doing math. When you first evaluate a deal, whatyou really want to know is whether ithas potential. Then you can decide to keep digging for more information or move on to another deal.
You also want to know which variables, like a certain amount of rent, a certain resale value, or a certain cost of repairs, affect the overall quality of the deal. If you know which variables are most important, you will be sure to do your due diligence to verify that they are in fact accurate.
I use BOE analysis every single day as I evaluate deals. It’s an incredible time management tool that helps me sift through many mediocre deals in order to spend more time on the deals that have real promise.
In the next section, I’ll share some of the specific metrics that the author, William Poorvu, suggests that we evaluate during our BOE analysis.
A Financial Snapshot of a Deal (aka aSetup)
During your BOE analysis, you simply need a piece of paper and a pen. You’ll use the pen and paper to write down and summarize the important metrics of your deal. This summary financial snap shot is sometimes also called a “setup.” You can use a setup either to evaluate a new deal or to analyze an existing property that you own.
The following are the keymetricsof a financial snap shot of an income property. You may not use all ofthemon every deal, but it’s important to be familiar with them all. They are thebasic building blocks that you will use to analyze and purchase profitablereal estate deals.
Net Operating Income (NOI)
The NOI is the net amount of money left over from rental income after taking out all operating expenses. I created a tutorial video on YouTube to explain this concept. The formula looks like this:
Here’s an example with real numbers:
Cash Flow From Operations (CFO)
Cash Flow From Operations begins withthe NOI and then subtractsother important cash outflows, like capital improvements (roof replacement, HVAC replacement, new driveway, etc), tenant improvements (primarily in commercial properties), and leasing commissions (also on commercial or high-priced rentals), and reserve accounts for all of these items.
In my experience with small, residential real estate businesses, very few investors correctly calculate this very important formula. Skipping this stepoften leads to unexpected and often damaging negative cash flow at the worst possible times.
The formula looks like this:
Here’s an example with real numbers:
Return on Assets (ROA)
This number tells you the current yield or return given by the income of a property. It is similar to the inverse of the P/E ratio in stocks. It is also very similar to a popular real estate term called a Capitalization Rate (Cap Rate). The only technical difference is that a Cap Rate uses Net Operating Income and a ROA uses Cash Flow From Operations. Sometimes these terms get used interchangeably, so be sure not to depend upon another person’s calculations.
Because cash flow is the primary consideration in real estate, I find theROA to bemore important than a Cap Ratefor personal deal analysis.
Here’s an example with real numbers:
Financing Costs (FC)
The financing costs are simply the total debt payments of principal and interest. If a debt payment is interest only, the formula is simple:
Here is an example with real numbers:
But if your financing is amortized, like most mortgages, you mustget the loan constant from an amortization table book like this one(I carry one around in my briefcase), or you must use an online amortization calculator (my favorite) or an app on your phone (the free one I use).
In the spirit of BOE analysis, I like to memorize the monthly mortgage factors for commonly used interest rates and loan terms. This allows me to calculate the monthly financing cost without using a calculator or a computer.
For example, a 6% interest, 30-year loan has a monthly payment of $6.00 for every $1,000-increment of the loan. So a $100,000 loan would have a financing cost of $600/month ($6 x 100). Or an $80,000 loan would have a financing cost of $480/month ($6 x 80 = $480).
You can memorize the monthly mortgage factors for other interest rates and terms so that you can do a quick analysiswith different scenarios.
Cash Flow After Financing (CFAF)
This formula tells youthe amount of cash flow remaining after subtracting your Financing Cost (FC) from the Cash Flow From Operations (CFO). This is an important number because it’s the money that actually goes back into your pocket. This is why youinvested in the first place, right?!
Here is an example with real numbers:
Return on Equity (ROE) or Cash on Cash Return
Equity is just your personal investment of capital (and/or a partner’s). It’s often thought of as the down payment, thoughequitycould include additional cash outlays like closing costs, repairs, and holding costs. The Return on Equity would be exactly the same as the ROA if you used 100% equity (i.e. no debt). But most real estate deals do use leverage, so this number is very important.
In the simple math of a BOE analysis, the Return on Equityis the same as a Cash on Cash Return. Here is the formula:
Here is an example of ROE with real numbers:
Now that you’ve learned all of theseformulas and numbers, how do you use them to make better decisions?
First, they allow you to compare a particular deal to other potential investments. Ifonedeal producesa ROE of 10% and another produces a20% ROE,you might prioritize the deal with the higher return.
You might also compare these metrics to returns and cash flows from non-real estate investments, like stocks, bonds, and CDs. These non-real estate investments can be very passive, so you should receive a premiumfor your time, effort, risk, and entrepreneurship with real estate.
Second, the formulas allow you to set goals and make offers. Sellers of real estate will often ask high prices that will not make sense for you. Your investment decisions must be based upon objective analysis if you want to make money and invest safely. These formulas help you figure outwhat is a good deal and what isn’t.
You may, for example, decide that you won’t do any deals purchasing apartments in a certain part of townunless you can get a ROA of 10%. If someone’s asking price gives you aROA that is too low, you will have to purchase it at a lower price or just walk away.
Profits Are More Than Just Numbers on Paper
[U]nless you create and maintain a property that is able to reach a particular market over the long run – and help the community in the process – you will eventually lose the ability to make money. People who get lost in the numbers often also wind up as losers in the real estate game. In saying this, I don’t mean to minimize the value of quantitative analysis … I simply mean to emphasize that running numbers is not how value gets created in the real estate game.”William J. Poorvu, The Real Estate Game
Analyzing the numbers of a real estate can be a lot of fun. It’s excitingto anticipate a profitable deal, and it’s fun to celebrate when you actually put money in the bank. There is nothing wrong with the excitement or the celebration, butgetting too focusedon the numbers themselves is actually a losers game.
Like in sports, the scoreboard is just a reflection of reality. It’s not the game itself.
The real game of real estate is all about people. The game iswon by adding value to other people’s lives, including your tenants, your sellers, your buyers, your lenders, and society as a whole. The value you give comes back full circle in the form of even more profits.
Old school personal development teacher Earl Nightingale explained this concept best:
Money can’t be sought directly. Money, like happiness is an effect, and the result of a cause. The cause is service.”
So, ifyou want to get rich in real estate, focus on serving people in an incredible way at each step of the process.
What’s Your Game?
The Real Estate Gamepresentsa metaphor for success in real estate. It also shares numerous case studies demonstrating how this success works. But themost important game is the one that you are playing.
So, I’ll turn the attention back to you.
What type of player are you? What are the important metrics on your scoreboard? Which properties present the best opportunities in your market? What financing sources are available and affordable to help you put together deals? What forces in external environment are the currentchallenges? Which ones are the currentopportunities? Which BOE process do you use?
I’d love to hear from you in the comments section below.
Enthusiastically your Coach,
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