Not Sure if a Property is a Good Investment? Fill out a Pro Forma Sheet
Investing in Real Estate is no rocket science; it just requires an understanding of some real estate financial jargon and the audacity to make a move. As someone who is in the beginning stages of my investment career I find that the ladder is often the hardest part. While it may not be possible to completely rid yourself of apprehension you can mitigate some risk through sound financial numbers.
Learning to fill out and read a Pro Forma sheet may seem intimidating at first but once you get the hang of it you can start determining whether a property fits your investment needs. In this post I am going to take you step by step through the process of setting up a simple pro forma sheet. For this example I will be using a single-family rental home but the process is fairly similar for multi-family properties. Let’s take a look at the first step.
STEP 1 – Fill out Property Details
Let’s say that we will be analyzing a property in Roseville, Ca. First, enter in the homes address, offering price and details about rent. In this example, we are using a single family home that’s 1,151 Sq. Ft and will be renting it out for $1,000 a month ($12,000 a year).
STEP 2 – Determine Gross Revenue
Gross revenue is the amount of income the property will make without factoring in expenses. Assuming we have someone to rent the property for the whole year, our Gross Revenue will be $12,000.
Less Vacancy is used to give an estimate of the loss of rental income from property vacancies. There will be no less vacancy in our example because with single-family properties the vacancy rate is either 0% or 100% and having a vacancy would greatly throw off the numbers. Less vacancy is a great tool for investors who are looking into Multi-family properties. 5% less vacancy rate is usually used however for the conservative investor it is always a good idea to budget an even higher number, say 10%.
STEP 3 – Calculate Operating Expenses to Determine Net Operating Income
The Net Operating Income of a property is the gross income minus the operating expenses. In order to find NOI we must determine what the operating expenses are.
These will include items such as, but not limited to:
-Utilities (Electric/Gas, Water, Gardening, etc.)
-Maintenance (in home repairs)
-Reserves (money set aside in case of repairs)
– Management (paid to someone to manage the property)
-Property Taxes (approx. 1.25% of home value)
-Insurance (approx. 0.25% of home value)
Once we have the Operating expenses accounted for then we can subtract this number from our Gross Revenue to determine our NOI. In our example it looks like this:
Net Operating Income = Gross Income – Operating Expenses
The CAP rate of a property is a measure of the potential return of the investment. The higher the CAP rate the higher the return. You will often see this term on investment properties and while a higher number is better I suggest investing in properties that have a positive cash flow.
=Net Operating Income/Property Price
=($7590) / ($150,000)
=.051 or 5.1%
STEP 4 – Understand the Loan
In this example we have put a 20% down payment on the house. This means that we need a loan for 80% of the purchase price. In typical Real Estate financing you will find that loans will run for 15 or 30-year terms at fixed rates. To be conservative, I used a 30-year fixed term with a 4% interest rate. Therefore, our mortgage payment for the year would be $7,042.
STEP 5 – Determine Cash Flow
Cash Flow is the annual income obtained from subtracting mortgage payments from the Net Operating Income. Now that we have our Net Operating Income we can determine what our cash flow will be for the year.
Cash Flow = NOI – Mortgage payments (Interest + Principle)
=($7,590) – ($5,001 + $2,041)
STEP 6 – Year 1 Summary
While cash flow is important (and the higher the better), we must factor in appreciation because that’s where the bulk of the money as an investor is going to come from. To be conservative, I gave this property a 6% appreciation rate per year. This would go up if you were to invest in areas, such as ones documented here on Housing Rebound. Assuming this 6% appreciation and adding in the cash flow, this property is now worth $159,548 as compared to the $150,000 we bought it at a year ago. That’s not a bad investment and assuming the market continues to grow this investment will continue be worth even more.
Investing in Real Estate is a great way to grow wealth and it’s not all too difficult. If you can master the Pro Forma sheet then you will have the confidence to pull the trigger on a deal. Whether you are looking into buying Real Estate with your own money or an investors I hope this simple overview on the Pro Forma will help you feel more confident. If you are would like an Excel Pro Forma template or have any other questions please feel free to email me at firstname.lastname@example.org.