As part of our continuing series on real estate investing Pro formas, today we are going to look at why they vary so much. The purpose of this post is to help understand exactly what the pro forma is and how you should use it.
As I outlined in Part 1 (Performance Reports Versus Pro Formas For Real Estate Investing), Pro formas are a speculative look as to what a property may bring in for returns, and many pro formas focus on just cash flow and returns. These of course are the big items, but to know how your new investment will truly perform you want look at the performance of all the 5 wealth building Principles. (See wealth building principles)
- Income (cash flow)
- Deductions (tax deductions and appreciation)
- Equity (equity acquired day one by purchasing correctly and debt reduction causing equity build up)
- Appreciation (value increase of property)
- Leverage (the ability to use borrowed funds to create powerful leverage)
Remember: these are not Performance reports; they are a speculative look into the possibilities of returns. The sources delivering the information typically are the sellers or the representative of the seller and often do not have a track record of a performance history. There are many variables they do not know so they border on the side of less information, Such as:
- Will the new owner manage their own property or will they hire a property manager. If there is no management expense, then they can omit this expense making the cash flow much stronger. As this helps get the sale, they figure why would I include it.
- Often when a sales person puts them together, they use software that uses average information such as an insurance expense is calculated as a percentage of property value instead of exact insurance quotes. This is done because many insurance companies’ rates very and the investor purchasing the insurance policy will require different types of policies. For example an investor with high risk tolerance may buy a policy with high $5000 deductible, while an investor with low risk tolerance will want a policy with a small (say $1000 deductible). This of course can mean an insurance premium that has a high variation. So the low figure is usually stated in the pro-forma to make the returns look better.
- It is believed most people do not take the time or diligence to understand the pro formas, so their interests are to keep it simple.
- Often they believe most investors have unrealistic expectations and want massive returns so they make the Pro formas look the way they want them to.
- The assumptions in a Pro forma will look different for cash buyers versus a leveraged buyer.
The reasons for the Pro forma being less than accurate are many, but the bullets above are intended to help you understand there are many many variables to a Pro forma and you, as the investor, should look at it as a Snapshot of the property. When comparing a particular property to another property, the initial pro-forma that looks best is most likely the one to spend time doing deeper diligence on.
Next post lets break down the sections of the pro-forma and things for you to consider.