5 Key Aspects to Evaluating Investment Properties - Pro-Forma (Part 1)
In this series we will be looking at the 5 key aspects to evaluating investment properties. Today we are starting with a key component, the pro-forma.
5 Wealth Building Strategies
There are 5 wealth building principles and only real estate is able to encompass all 5 of these principles into a single investment.
Just as a reminder, the 5 wealth building principles are:
1. Income: cash flow
2. Deductions: tax benefits
3. Equity: equity buildup when your tenant pays down your mortgage principle
4. Appreciation: property values climb
5. Leverage: borrow money from the bank, private lender or creative financing to purchase real estate
Over the upcoming posts we will break them down and create massive clarity for your real estate investing efforts.
How To Determine Cash Flow For Your Real Estate Investment
Wow: I have never seen so many ways to look at cash flow. Over the years it has become very obvious to me that the wealthy people (better than 90% ) of them invest in real estate. While I know every investor has their objective for investing, the one common denominator all investors want to have is the proverbial cash flow.
I see many pro forma’s (the tools used to calculate cash flow) and the math is simple. Income, minus expenses equal cash flow. ( $$ - $$ = $ ) With such a simple formula, how can there be so much confusion around calculating what your cash flow on a property will be?
I believe the phrase “garbage in equals garbage out” comes to mind. Many people who are selling investment property are motivated to have YOU believe their properties are great investments. Let’s look at a true cash flow portion of a pro- forma, then let’s look at what most sellers show you, so you can see the difference.
A True Real Estate Pro-Forma
Annual Income: $14,400 ($1,200 monthly rent X 12 months)
Real estate taxes - $1,200 Repairs - $600 Vacancy Loss - $720 Insurance - $800 Landscaping - $600 Property management - $1,200 Association fees - $50 Trash removal - $400 Misc - $200
Total Annual expenses: $5,770
Total Cash flow: $8,630
This illustration is to show you all the expenses that should be considered. I just randomly input numbers, so do not focus so much on the numbers but the line items of these expenses. The huge disparity in how people look at expenses is what I want to point out. The above should be representative of the line items to be considered.
Here is what a "typical" sellers Pro-Forma will show you
Annual Income $14,400 ($1,200 monthly rent X 12 months)
Real estate taxes - $1,200 Insurance - $800 Landscaping - $600 Association fees - $50 Trash removal - $400
Total Annual expenses: $3,050
Total Cash flow: $11,350
Wow: notice the difference in these two pro-formas. One shows a cash flow generating $8,630 annually while the other pro-forma shows a whopping $11,350, A difference of $2,720. They both used the same calculations, income minus expense, but if you only input part of the expenses you get a false reading of what the true CASH FLOW really is.
I want to pay particular interest to 4 missing lines (the underlined items) from the first example. The line items for repairs, the vacancy loss, the property management and the Misc.
Why These 4 Items Are So Important to Factor In:
• Repairs. It is often stated that the property you are looking at has been renovated or perhaps a new property so there will not be any repairs. This may be true for a while but eventually something will need a repair. Depending on the age and condition of the property the amount of money you want to earmark for this line item is discretionary. I typically will use 5% of the rent as a benchmark. There is no right or wrong number to put in here. It is more of an estimation to future expenses. Putting this money aside each month will keep your returns more accurate.
• Vacancy loss. The most expensive line item we have is vacancy loss. Even a property that is fully rented for a year will eventually experience some loss. When a tenant moves out, you have a short period of time where you are cleaning, painting or simply waiting for the next tenant to arrive. 1 week worth of vacancy in this example will cost you 1/4th of month's rent. Again, no right or wrong number to put in here but you should consider listing something.
• Property management. This is typically left off the pro forma as it is assumed you may elect to manage your own property. Even if you do you should be compensated for it. You want to consider the fact that the properties financial merit is based on all expenses. Whether you take compensation or not the merit of the property should support a payment for this line item. If you manage it yourself your cash flow should be that much greater.
• Misc. This is more of a place holder, you may or may not have added expenses, but if you look deep you usually encounter something like advertising costs, a fee to pay the property manager to fill the vacancy, perhaps a legal fee.
I am totally aware of the fact not all properties have all these expenses. For example, a single family property may not have any utility expense as the tenants typically pay these expenses. You do however want to remember to consider each expense that may occur. Landscaping expense is another often overlooked line item. Things like lawn mowing and snow removal. If these expenses apply they must be factored in the equation.
Whatever You Do, Do Not Buy Off Of The Sellers Pro-Forma
Much of this seems very obvious and transparent. However working with investors for the past 20 years, I often see these items overlooked simply because they were not stated on the pro-forma. A seller is motivated to keep expenses low; I always recommend having your criteria for investing established with an action plan. This action plan should include a check list for virtually every expense to be considered.
True Cash Flow
Yes, the projected rate of returns will be less but the safety and sustainability will be much stronger. Establishing what true cash flow is, and making sound decisions on safe and sustainable returns is always much better than buying a property based on non-sustainable returns that are generated from most pro-formas. You do not want to make buying decisions based on a bait and switch set of numbers.
Next post, we will be taking a look at the next wealth building principal, 5 KEY ASPECTS TO EVALUATING INVESTMENT PROPERTIES PRO-FORMA (PART 2 – TAX BENEFITS)
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