Although the title of this chapter is admittedly a bit daunting, be assured that the math is very easy to do. One of the great tricks of mathematics is to make things sound difficult so mathematicians can sound smarter. To those who have read the flipping material, you will see some striking similarities at first; but the analysis is a very different animal. Please pay attention.
The initial feasibility study is merely a fictional project where you will put in all the known variables. For instance, for an income property you would put in your available cash, the financing terms from the lender, and local rental rates. The goal is to develop an ideal scenario of a project that meets your investment goals while considering your financial constraints and lenders requirements. In technical jargon, this is a model. Once complete, the model allows endless scenarios allowing you to see the impact of unforeseen events. For example, suppose you are unable to rent your space for three months or the impact of a newly proposed property tax. These various model runs make up a sensitivity analysis. This helps determine what events would have the biggest impact on our returns so you can keep on top of them.
You will run the model before you even search for a property to purchase. The model helps determine a reasonable estimate of the total project costs that you can afford. Then taking into account your return goals, area rental levels, and profit expectations; the model will estimate the price range of the properties you need to be considering. "Shouldn't I be looking for properties at deep discounts?" Always, but with income property you will be looking for property that is valued at its current income. In many instances, the income value of the property is under what the seller's asking price is. "Why?" Well, if the seller is smart, they are simply looking for someone to overpay. In other circumstances, the future expectations of income and value growth are different. The seller wants you to compensate them for positive future expectations. In that case you can simply ask them if the property is so valuable - why are they selling? It is a crazy world out there. You will soon see that income property investment weighs heavy on future expectations, but with a model you can test a broad range of outcomes to assist your fortune telling skills.
Now before you begin to build your model, a few subjects need to be tackled. You need to determine your investment goals on the project. Then, gather information on the required project expenses and local rent levels. Finally, you must account for the time it will take to purchase, repair (if needed), hold, and finally sell the property. It is hard enough to predict what will happen in a week, now you must attempt to predict five years into the future. If you are pretty familiar with forecasting data you would know that you are probably going to be wrong about 99.9-percent of the time.
Riskier investments need to pay much higher than lower risk ones. For example, U.S. Treasuries are very low risk investments backed by the U.S. Government. Returns on treasuries are low with an average of around 2-percent. At the other end of the investment risk spectrum are stocks. Over the long haul, stocks tend to produce a 10-percent return. "Where does real estate fall?" On average, income real estate is expected to yield around 8-percent. Real estate is expected to have a better return than treasuries and bonds, and slightly lower return than equities. Again, these are long term averages used for comparison sake - not guarantees or appropriate expectations. Another caveat to the figure is that the real estate returns at 8-percent only apply if you purchased the property for all cash. Not a very normal occurrence. Real estate is attractive to many individual investors due to its ability to utilize leverage to generate higher returns. Utilizing leverage, however, increases your risk and that risk needs to be considered. In investment and finance in general, risk is considered by adjusting the return requirements. Ever hear of risk adjusted returns?
Why is leveraged real estate risky? First, leveraged real estate always has a the chance of defaulting on the financing. A fully owned property has no mortgage to pay so there is no chance of losing it to a lender. If the leveraged property goes into foreclosure, all the equity you put into the project (about 20-percent of the purchase price for starters) is lost and the lender takes the property. Second, real estate is not liquid. Stocks and bonds trade online with a click of a button. Residential real estate typically takes around two to three months to sell in a normal market. This increases the chance you can't just bail out of the project when you need to cut your losses; lock in a loss if you want to be fancy. Finally, there is uncertainty to the project's actual value. Traded securities are valued at an exchange with publicly available data and you pay the actual current market value. In real estate you will only find out what the property is worth when it sells. The property you are considering may be worth less than what you are willing to pay (no, that wasn't a typo), and the rental income you are depending on may not exist. Your expected sales price in the future could be too high. As you can see, even real estate investment carries significant risk.
"So, what is a reasonable return for income property?" For all cash deals you should keep it at or above 8-percent. Your still more risky than bonds so you need to be compensated. For leveraged real estate the returns should be calculated. Returns for leveraged real estate requires the use of the Weighted Average Cost of Capital formula known as the WACC. The WACC takes into account leverage and risk to calculate the required equity return, r(e).
r(e) = [r(p) - (LTV) * r(D)] / (1-LTV)
LTV is simply the loan to value ratio of the mortgage ;r(D) is the interest rate on the loan. The last variable r(p) is the real property return that is generally 8 percent. If you set the LTV to a typical 80 percent and the interest rate at 5 percent the WACC equation calculates the required equity return, r(e), at 20 percent.
r(e) = [0.08 - (0.80) *0.05] / (1 - 0.80) = 0.2 or 20 percent
"That seems pretty steep. In fact it is the same return recommended for flipping houses. Didn't you say income property was a safer investment?" The WACC return that you compute is not a hard set rule, just a good indicator of where the return needs to be. It is your money in the end. If you feel at the end of the day that 15-percent is a reasonable return - it is. However, if you are looking at a ten percent return your investment goals may be better handled in the equities markets. Otherwise, you are taking on a higher investment risk for a lesser return which does not make sense. You should always be looking to get the maximum return for your risk. "Then why is a all cash deal acceptable at 8-percent?" Simple, no debt load. If you buy an income property all cash at a reasonable price, you would receive all the income minus expenses. You cannot default since you don't owe anything to anyone. True you can lose the property if you don't pay your property taxes, but if you can afford to pay all cash for a project the property taxes are probably not a big deal. You still need to generate a return of 8-percent though, and when you put down a huge amount of cash up front it can still be challenging to make a project pencil out. There is no free lunch.
Another bit of advice. Researchers had found that on larger developments the actual return tended to be about half of what was originally projected in the model. While many would take this bit of knowledge to back up their claims that modeling is worthless, you should take a minute to think this through. The projects were large and most likely had budgets to hire experienced experts to help generate the model (a.k.a. the pro forma). Forecasts of the future market were done based on hundreds and perhaps thousands of variables with Ph. D's in economics putting the models together. With all of this firepower they were still 50-percent wrong. "So what are you getting at here? Are you saying instead of 20-percent it is reasonable to accept 10-percent? This is kind of flip-floppy don't you think?" This is not what we are saying. Basically, investors are a bit optimistic - which makes since. If they were pessimistic why would they invest? Anyhow, the world goes through its cycles, bubbles, and random events. You cannot predict it. So by making sure the project will achieve higher returns with reasonable expectations could be considered a form of risk reduction for loss. Imagine if the developers were willing to accept a project in the planning stage with a 10-percent return. If the researches were right, the actual return may end up at 5-percent if all goes well. So, in a nutshell; you cannot predict accurately out into the future and it seems actual returns are about half of the projected in many cases. Therefore, if you are willing to take a 15-percent return just be aware that what you end up with may be less. Give yourself some wiggle room.
Because of the long time lines involved, it is critical to consider expenses in income property. Without an actual property to analyze, these numbers will be very rough approximations. However, you need to develop a reasonable model to make sure you don't buy a poor investment.
There are plenty of different types of property expenses. For the fundamentals, the expenses have been broken down into before and after the property purchase. The many expenses which will be unknown will be expressed in the percentage of the property cost - the price you negotiated before closing costs. In the pro forma section below we'll put all of this information in one place for you. Now, you just need to read and get a basic understanding.
Before you purchase a property, there are a few expenses you may incur. Since you are modeling a property, you should include most of the expenses to develop a robust and safe scenario. The expenses are:
Upon a quick glance of the list you will notice that most of these expenses are incurred during the due diligence period. The due diligence period is the time granted by the seller for the buyer to inspect the property prior to final purchase. How long the due diligence period is would be spelled out in a Letter of Intent or the sales contract, which could be anywhere from 30 to 90 days.
Property inspection is very important. You need to find a licensed and certified company to inspect the property for any potential issues. These issues can range anywhere from structural problems, insect infestation, mold, plumbing, electrical, and mechanical (heating and air conditioning). If the home is an older home you may want to ask them to check for lead paint, asbestos, and lead welding joints on copper drinking pipes. The inspector's job is to report these issues to you. Your job is to make sure you do not buy a money pit, so call around and get a few quotes to account for the fees in your model.
An environmental inspection is really only needed if the property is known to have underground storage tanks for fuel. The property inspection company may be able to handle the inspection, but if the tank has leaked fuel into the ground you have a serious problem. If you were still considering purchasing the property you would need to hire an environmental engineering company to assess the extent of the contamination. Here it gets trick since they are required to report the contamination to the state's environmental agency. The state agency will require the current owner to clean up the mess. You probably already guessed the seller is going to be weary. Cleanup of fuel leaks is very expensive and can easily run into the tens of thousands of dollars. Be sure to ask if the home has underground tanks. If so, be sure to have them checked for leaks. Call around and get some quotes if you are dealing with properties that have underground storage tanks (UST) with fuel. If nothing else, you have a rough idea of costs if you are able to take advantage of the situation. Otherwise, in the beginning it is best to stick to "clean" properties.
Closing costs are a toss-up as to whether you consider them before or after the purchase. Since you usually don't get the keys to the property until after the closing is complete (and you technically paid the closing costs), putting them in the before purchase category is not a crime. Getting our lingo inline for real estate analysis, the "before" expenses are considered acquisition costs. They are what you need to pay in addition to the purchase price of the property at closing. If you don't know, closing is where you formally sign documents and have the money transferred to the seller from your lender - it is usually a disaster since something always seems to get screwed up in the paperwork. Typical closing costs run 2 to 3 percent of the property purchase price.
"Whoa, that's pretty high. Why are closing costs so high?"" Closing costs are high, because there are a lot of that goes into them. Here is a list of some of the common items included;
The market study is needed for the final go or no-go decision. You should look to obtain one prior to contracting to purchase a property. These days there are market studies available for almost all product types in most markets. Prices also vary from expensive to somewhat reasonable. For a single family rental there is no need to spend thousands of dollars on a market study for the specific project, however; you should look for general regional studies for residential rental property. The studies offer an independent verification of your hunches and research. The study should comment on the regional market rental rate growth, supply, and vacancy. Now for the bad news - the market research will not be able to determine the future any better than you could. "Then why are you pushing me to buy a market study? Are you getting a royalty?" The market study helps you to make sure your initial assumptions about the market are in line with the actual data. Although the long range forecast ability of the reports is dubious, the initial data about the current state of the market is pretty good. Also, they may have a few bits of data you have not considered and can research a bit further. Your main purpose in buying the report is to calibrate and fine tune your assumptions. Trust us, you need to avoid going with your gut feelings on this - accept only data driven reports.
Determining what income a property can achieve takes a bit of work. You must be sure to honestly compare similar properties to determine the rent you can reasonably expect. A mistake many investors make is expecting your property to achieve the same rents as newly constructed projects. You need to ask whether you are offering the same amenities (pool, gym, etc.). With a single family residence you may have the pool, but it is unlikely you have a gym or other large property amenities. "So where should I look for comparable rents?" These days it's almost all online.
Scour the web looking for apartment rental rates. A good reference is Rentometer. The site lists rental properties in the vicinity of your site and computes the low, medium, and high ranges of rent - along with the average. Craigs List can also give you a good idea for rent expectations too. At this point you can take the information from rental units which are similar and put a spread sheet together. The spread sheet should have the rental rate, address, unit area, number of bedrooms, number of bathrooms, garage, pool, and any other characteristic that you fell may be important. Try to get as many rental properties as possible in your list. Now you can begin to get a feel for what the market is willing to pay by analyzing the comparables.
Determine the average rate per foot for each property, and then take the overall average. If there are units with two bedrooms and three bedrooms - split the categories and average the rates to see if the market has a higher demand in one type over another. All things being equal, the larger unit should be equal or slightly less per square foot of rent than the smaller unit. If you see a noticeable jump in rate in one category or the other, the demand for that property type may be higher. You'll never really know, but higher demand is usually accompanied by higher pricing.
Once you go over the data a few times, you will begin to have a pretty good understanding of the regional market rents for various property types. You'll refine the data once you find a few properties for sale, but for now the data should provide a reasonable expectation for the income.
Now for the bad news; it is rare for a rental property to go fully rented during the entire holding period. At some point the renter will leave, and you will have to find a new tenant. If your property is in a great location you may be able to immediately fill the vacancy prior to the first tenant leaving; however, most properties may take a bit of time. In real estate an empty property is a vacant property. To account for vacancy the model will have a vacancy rate included that reduces the income for the anticipated vacancy level. To determine the vacancy rate call around to some of the local property management companies. These are the folks that manage rental properties for a living. Tell them you are looking to purchase a small rental property in the area and were wondering if they know what a good vacancy rate would be for the area. You haven't found a property yet, and you are putting a feasibility study together. Ask about other expenses as well while you're at it.
One last thing to account for is credit loss. You may consider this splitting hair, but a few hundred bucks a year to account for bounced checks or missed payments may be a consideration. If the area being considered generally has problems with tenants paying it may be wise to include the credit loss line item. Remember to ask your local friendly property manager.
Because the main goal of income property is to have revenues exceed expenses, knowing the actual expenses is a high priority. Although the cash flow may vary from month to month due to seasonal effects of weather (heating bills, etc), yearly modeling is used for feasibility modeling. If you know that expenses in one season will be higher than others, feel free to model the project by quarter or monthly to understand if there are months were you will need to cover the expenses. This is known as seasonality. For most purposes using a yearly time period is acceptable. Some typical expenses you need to model are:
The mortgage payments should be self explanatory. Hopefully, you shopped around and have a good feeling for what the market will bear. From the amortization period, loan to value, and interest rate you will be able to calculate your anticipated mortgage payment. Many spreadsheet programs have payment functions included, so don't sweat the calculations.
Repairs and remodeling are where many new real estate speculators and investors make mistakes by over doing it. Repairs and remodeling should be kept to an absolute minimum. More than likely, the bank will not finance these activities and you will have to pay for them out of pocket. Focus on minor painting, cleaning, and some landscaping. Many folks have someone pressure clean the exterior of the property to include the roof. If it looks good - they leave it alone. Shy away from major renovations that require significant structural changes to the property, such as, adding a bathroom or additional bedroom. For our preliminary model, do carry a small budget to cover some miscellaneous work. Costs will vary widely based on your location, but a budget of 5% of the purchase price is reasonable for the first year. For each subsequent year set aside a few hundred dollars to fund a maintenance and replacement reserve. Chances are you are not looking to hold the property beyond five years. If you are you need to anticipate roof, appliance, and mechanical equipment (air-conditioners, boilers, etc) replacement. You can determine the time left until replacement by knowing when the existing item was installed. Then check with an expert or knowledgeable individual in each area or look up estimated life spans of those items. Then simply subtract the time it has been in use from the life span to get the remaining life. Find today's estimated price to replace each item and increase it by the estimated inflation rate for each year into the future (say 2-percent per year). Then divide each item by the lifespan left and add them up.
To illustrate a quick replacement budget, imagine you are considering a property that has ten years left on a twenty year warranted roof, and five years left on the air conditioner. From a trusted contractor you find the roof replacement will cost $10,000, and the air conditioner around $5,000. If we figure inflation is 2-percent the roof price would increase by $10,000 (1.02)^10 =$12,190 , which is roughly 22-percent higher ten years from now. The air conditioner replacement is estimated to cost us $5000(1.02)^5 = $5,520 in five years. To set our budget we need to deal with the two different time lines - you can't simply add them up since one life span is half the other. Figure you want to sell the property in year eleven and won't replace the air conditioning again. For the air conditioner you need to set aside $5,520/5 years = $1,104 per year. The roof will require $12,190/10 years = $1,219 per year. Our budget becomes a stepped value. For the next five years you set aside money for both the roof and air conditioner for a yearly budget of $1,219 + $1,104 = $2,323. From years 5 to 10 the replacement budget would be the roof alone with a yearly budget of $1,219. It takes some work, but worth the effort if you intend to be able to raise your rents over time. Otherwise you are going to end up being a slum lord unable to afford expensive replacements.
Landscaping for the model is the cost of keeping the lawn and plants in tip top shape. Call around to get a feel for what to budget. You could do it yourself to save a few bucks, but just make sure you can handle it and do it properly.
If possible, have the tenant pay for the utilities. Otherwise, you need to budget sufficiently to cover the electricity, water, trash, and heating oil or gas as required. Even if you intend to have the tenant pay the utilities, carry a small budget to cover any vacancy periods projected.
Lastly, there are the expenses insurance, broker's fees, and taxes. You'll need property insurance for the project - in fact, your lender will insist. Again, simply calling around for a quote will get the data needed for the model. Real estate brokers fees. If you are smart you'll use a real estate broker to drudge through the posers and find you a buyer. Sure you can do it yourself, but you will probably take a bit longer which you will soon learn is perilous. Go ahead and put the 3% into the model. Taxes. By checking online with the local property appraiser you will be able to get the property tax rate plus any other imposed taxes. The taxes can be anywhere from 2-percent to over 10-percent. The amount of taxes can be significant so make sure to understand what you need to pay, and whether any tax increases are forthcoming. It may explain why you find a lot of willing sellers in an area all of a sudden. "Where are my tax advantages everyone keeps talking about?" Those are applied to your income taxes. Property taxes are local taxes accessed by the local government.
Property management fee. If you are buying a single rental unit you within a few hours from your residence, you should be able to handle the management of the unit. Or you may not be a people person and wish to offload this responsibility to somebody else. Either way you should put it into the model and the final pro forma. The reason being is that the lenders like to see that if you are not able to manage the property, you can afford to pay someone to handle it. Income property is a people business more than bricks and mortar. If you do not wish to deal with the problems directly, now is the time to account for it before settling on a property which cannot support the expense.
These are just some of the expenses that you could encounter. We could probably write a book solely on this subject if pressed. If you can think of any other expenses you'll incur such as accounting, go ahead and add them. Each project is unique, and in the early model you'll not get everything right. That is OK; you are only trying to get a basis of the types of projects to hunt. Let's carry on.
Timing for income property is still important, but not so much from sweating over a week or two delays as much as where the economy is headed. Remember, your project exists years out into the future. It is obvious that you look for either good or level economic indicators, but again; nobody is really good at this. If you are hoping to flip the property after a year or two, then the delays are very critical.
With such long periods of time under consideration, the time value of money becomes more important to understand. The following two sections (3.3.1 and 3.3.2) are pretty much the same as in the flipping information. Skim over the info again if you feel the need to. It never hurts. Our assumptions in the sections are for short time frames, but you can easily see how instead of months you consider the time period in years.
You probably remember a parent or grandparent discussing what they used to be able to buy with a dollar. No doubt it was significantly more than today. "Why?" Well, various factors are at play. Inflation, national debt, and a myriad of other things. The end result being that a dollar today is worth more than a dollar at some point in the future. "How much less?" It really depends on your expectations and what you are modeling. You need to determine the appropriate discount rate, which is merely a percent discount you choose. For instance, if you just wanted to look at the dollar and how it would depreciate, you could use the average interest rate for the dollar as the discount rate.
Let's look at some simple numbers. How much would $100,000 be worth in a year if the average inflation is 2-percent?
$100,000 x 0.02 = $2,000
$100,000 - $2,000 = $98,000
In a simplified calculation to see what a $100,000 would be worth in a year, you simply have to subtract the 2-percent inflation from the initial amount. So, at the end of a year your $100,000 is only worth $98,000 - it's present value.
Because real life calculations are a bit more complicated, you can use the present value formula (also known as present worth), which is simply:
P = F/(1+i)n
This formula makes it a bit easier to push out the time horizon. Figure what $100,000 would be worth in five years. Instead of an interest rate, you will use yearly average inflation, 2-percent, as a discount rate. Since the calculation is in years, n will be simply 5. Time to crunch the numbers.
P = 100,000/(1+0.02)5]
P = $90,573
Hopefully this was a bit of an eye opener. For investment purposes, money loses value with time. Instead of "time is money", the phrase should be "time costs money" for clarity. In the next few sections this concept will be introduced into your model.
The net present value is simply the sum of the future cash flows minus the purchase price. You take the time series of your cash flows and discount them (expenses out and income) - then add them up. Now you have the present value. Subtract the purchase price and you have the net present value. Let's look at the formula.
NPV = sum[Fn/(1+i)n + + Ft/(1+i)t] - Project Costs
If you look closely you should see a striking resemblance between the NPV and present value formulas. The variable F is the value of the expenses or cash flow for that particular period of time. If your project is expected to last under a year, you use months. Each period of time is represented by the variable, n. The second month in the project would have n equal to 2, and so forth. The starting period for your project, n equal to one, should be when you purchase the property. Any expenses from inspections or other due diligence activities can just be added to the purchase price to represent total project costs.
The variable, i makes a dramatic transformation. Instead of representing inflation rates or interest, it now represents your opportunity cost of capital. The opportunity cost of capital is merely our return expectations for the project. Remember back in Section 3.1 when you figured the return a speculative housing investment should have to compensate you for your risk? For a highly leveraged property the required return would be 20-percent annually; the opportunity cost of capital. As you gain experience, you'll find a return rate that you are comfortable with. Perhaps 15-percent is sufficient - it is your money, you get to set the hurdle rate. Just remember you are working in months, so you need to adjust your required return to the project period. For instance, a five month project would multiply a 20-percent yearly hurdle by (5/12). If you wish to require the project to make the hurdle (20-percent overall) then just divide the hurdle by the project months (i.e. 20-percent / 5 months).
The final item that you compute before summing the present values is the sales price, Ft. The letter, t is the period the sale takes place. Hopefully sooner than later. "How do I figure the sales price?" Expectations on the sales price will be covered a bit later. For now you are just trying to understand the logic of the computation.
Now for a few refinements before jumping into an example. First, your main concern is the return on your cash investment; the equity. More than likely you utilized financing such as a mortgage to purchase the property. To simply model the mortgage you would input the monthly payments as expenses and subtract the payoff balance from the sale. Now you see the return on your equity in the project. Second, the project should be less than a year in duration with six months or less being ideal. Your calculations are going to be for a brief period with little to crunch.
Time to take the NPV formula for a spin. Now imagine you bought a fixer-upper with a total project cost of $100,000. The bank required 20-percent equity, which you put on the table: $20,000. Closing costs are 3-percent, $3,000. You did no major renovations, just some paint and yard clean up over two weekends and week nights - you spent $500. Monthly expenses run around $700 with the mortgage. Five months from purchase, you flip this property for $135,000. Closing costs, fees, and expenses add up to $6,000. Time to put all of this information in a table.
Now for a little shortcut. Instead of computing the present value of each month, you can use the net present value function in your spreadsheet of choice. Take a few moments to find out how to do this on your spreadsheet - it's the NPV function in Excel. For the opportunity cost of capital, i, the 20-percent return was divided by five. You could divide the yearly opportunity cost by twelve and be correct for a monthly value. However, it is probably better to consider each project as being required to hit the return over the project life. There are really no hard set rules, again, your money you decide what works best for you.
When you compute the NPV for the totals, the result should be around $14,200. "What does this mean?" The positive result means that the project's return exceeds your investment requirements - a good thing. A good rule of thumb is only consider projects that produce a zero or positive NPV value. Remember, a NPV value of zero means the project meets your opportunity cost requirement. "How does the NPV translate into a return percentage?" That's where the NPV's cousin, the internal rate of return, IRR comes in.
The IRR is the value of i, the opportunity cost of capital, that will cause the NPV to calculate to a zero value; a complex iteration that is easily handled in a spreadsheet with a single command. The IRR is a handy way to visualize a percentage of return. Remember, if your project is month to month the IRR value is monthly.
Looking back at the example, the IRR calculates to a project return of 17-percent per month. "Does that mean I would make 90-percent profit" Potentially, remember you are still only modeling a potential project. Reality has a way of dampening things. If the investment hurdle for the project was 20-percent over five months, you would check to make sure the IRR exceeded (20-percent divided by 5 months) 4-percent per month.
Where the real value of NPV and the IRR calculation come in is when you change the time schedule. Messing around with the pro forma values such as time is called stress testing or sensitivity testing. Imagine your project went sideways and couldn't sell for twelve months - not the quick flip you had hoped for. Keeping all of the numbers the same and extending the sale out has some immediate obvious impacts. First, the mortgage payments and expenses pile up since you must pay them each month. Second, and less obvious is the impact of the time value of money. Running the NPV calculation, you find the result is a NPV of around $9,140. The project still exceeds our investment goal, but notice the NPV value has dropped by $5,060 from your initial calculation of $14,200. That is roughly a 36-precent loss in project value by extending the project out from 5-months to one year. The IRR has also dropped from the initial 90-percent to 53-percent.
"So what if the project slips, those returns are still great" The end result is not the point. The point is that the project has lost almost half its value in a very short period of time. So you need to really be on top of making sure you have a realistic schedule. The project model is showing that you lose about 5% of return for each month the project does not sell. This is very valuable insight when it comes to negotiations.
The pro forma is nothing more than laying out the NPV calculations you had done so you can feel confident the project would actually produce an income. It also forces you to do your homework in order to have the information the pro forma requires. Initially the pro forma will guide you to the best project in terms of available investment capital and the local market. Once a property is selected, the goal of the pro forma will to explain to the lenders and/or partners how the project will make a profit; and why they should give you their money.
For our example pro forma below, imagine you want to get started investing in income property. Specifically you would like to buy a single family residence or small apartment building if possible. With only $27,000 to invest you know it is going to be tight, but you have to start somewhere. Below is the preliminary pro forma / feasibility model that you put together. The income and expense data is what you acquired when you called around to property managers and searched the web. Mortgage payment estimates are from the terms the local financial institutions gave you - you chose the worst terms just in case you had to use that bank. So, what type of project do you need to find? Let's find out.
|Category||Year 1||Year 2||Year 3||Year 4||Year 5|
|Monthly Rent Rate||$1,100||$1,133||$1,167||$1,202||$1,238|
|Rental Income per year||$13,596||$14,004||$14,424||$14,857||$15,302|
|Rental Growth Rate||3%||3%||3%||3%||3%|
|Repairs / Maintenance||($850)||($250)||($250)||($250)||($250)|
|PROJECT CASH FLOW||($101,611)||$9,202||$8,377||$9,871||$150,639|
|CASH FLOW TO EQUITY||($28,586)||$2,227||$1,402||$2,896||$66,409|
The pro forma is easily done in a spread sheet. The math is mostly arithmetic with the exception of the NPV and IRR functions. Each expense and revenue has been broken out and they have been placed into one of four logical categories; acquisition, revenues, expenses, and sale. Next, the money spent or received is placed in the time period where it is expected to occur. Ongoing expenses such as the mortgage payments occur each month and are totaled for the year. Meanwhile onetime events such as the acquisition and sale take place in only one period. Looking at the pro forma you have a reasonably good idea of the projects investment expectations.
Looking back at the pro forma, if you had read the flipping material you would notice some items have been rearranged a bit. First, the mortgage payments have been removed from the expenses. This was done to allow the spread sheet to consider the project as a cash deal first. If the project could exceed an 8-percent return, which is considered the industry baseline in our example, you would then check the equity returns that are based on the leverage. You would check if the computed NPV was positive, and the IRR exceeded your investment hurdles. You could just do the equity returns, but you would have no idea how the project is expected to perform verses the typical project norm. Second thing to observe is the project anticipated time line from purchase, through the holding period, to sale is five years. A lot can happen in five years. Across the time line in both the income and expense categories are growth rates. For income you are trying to model what the future rise in rental rates will be. Here you used a flat 3-percent based on some preliminary research you did. The growth rate under expenses is called inflation, the expected future rise in costs. Again, based on long averages, two percent seemed a reasonable assumption. Lastly, the first year net operating income is much lower due to the very high vacancy rate. The high vacancy rate is a result of the project taking time to rent along with some time required to renovate the property (the renter can't stay in a construction site).
The next item is where many projects make the biggest mistake; estimating the capitalization rate or CAP. The capitalization rate is the projects price divided by the NOI, and it is used by many as a quick way to gage if a property is reasonably priced. The ratio is literally an indicator of the income yield, the percentage return you get for the current price - unleveraged of course. A low CAP rate indicates a low yield. For example if you purchased a property valued with a 5-percent CAP, you are basically accepting 5-percent per year return unless you expect fast growth in the future (we'll be getting back to this). Without expectations for growth you would have purchased an overly risky asset for a bond level return - better to just buy bonds. On the other end of the spectrum, if you are fortune enough to buy a property with a high CAP rate, say 12-percent, you would expect a healthy income. "So what is a good CAP rate?" Here is where you run into trouble. Nobody really knows, it just depends how you feel about the future.
Because of the importance of this one number, the CAP, let us take a close look at how to estimate it. First, if you look at the CAP as a yearly return on a all cash project things get a bit easier to estimate. You need to estimate the yield on properties five years in the future. Think back the past five years and how many past events that you would have never expected. How in the world are you going to peg a yield on an investment that is very sensitive to macro and micro economic events and variables? It cannot be accurately done. So you are left to your best guess. A good barometer of where the project should be is the long term average returns - five to ten years. You already know that real estate is expected to return at least 8-percent over the long term. Because each region is different in this regards, you should check the local data. For small houses it is not usually possible to find any CAP data, so look at Loopnet or other similar commercial real estate sites. See where large projects are asking for and simply divide the NOI by the asking price to get the CAP. Check out a few listings in the same property type - multifamily in our case although we are a single home. Compare the CAP rates for the properties being offered (even better if you can find properties that sold). Multifamily also has a CAP around 8-9 percent over time, so if the values are less 8-percent the market expects growth in income. If the values are higher than 8-percent, there may be issues with the market coming up - or - you found a deal. What a conundrum. The best advice we can give is to only purchase properties at or above the long term average CAP if possible. During the bubble and other property value drops, the CAP rates dropped well below their long term averages. If you already own a property and the CAP rate drops significantly (2-3 percent), sell the property. You can buy it back at a 12 CAP or higher when the buyer defaults.
"OK, I get I need to be careful with my assumptions, but let's cut to the heart of the matter. Did I make any money?"Equity returns: here is where you see if you and any potential partners make money. Also, the mortgage or financing payments were put in this section of the pro forma. In the example you are the only partner in the deal so the equity cash flow is from and to your bank account. If you had partners or hard money lenders you would model the returns to each in this section. With multiple equity lenders and partners, the equity returns become known as a waterfall distribution. As income comes into the project, it is taken up by each layer of lender and partner. Generally you are at the bottom taking whatever is left (if any) or dividing it further between partners. If the number is positive you are receiving income, if negative you are losing money.
To compute the Cash flow to Equity you simply add up the income and debt for the project. The bank loan was left out as income since you are trying to compute your equity return. When the project is sold, you take the net sales price and subtract the mortgage balance left to get your proceeds. Each period's income and payments are tallied to determine your expected cash income - before taxes.
If you noticed, in the equity returns the total required equity for the project is around $28,600. This is higher than the $27,000 we had budgeted. So you have two choices, find more money or reduce the value of the property to purchase. If you have been realistic with the rental income and expense expectations, the project will return a healthy before tax return of around 28.16% per year. Just remember this return is only realized, as the project return, once the property is sold. Until then the bulk of your equity may still be tied up in the property.
"Before taxes? What about all those tax advantages everyone keeps talking about?" Most income property's tax advantages are due to the ability to take deductions. You are able to straight line depreciate the entire income property value over 27 years (check with your accountant - this stuff changes). If you have a good accountant, you can use accelerated depreciation on various components of the buildings such as air conditioning systems. All these tax deductions allow you to pay less tax on that equity cash flow you computed and keep more cash in your pocket. However, many folks forget to inform you that most of the deductions in taxes you take are recaptured when you sell the property. Since money is supposed to be worth less in the future than the present, it makes since to keep current more valuable money. To really get a handle on the after tax returns you must speak with a knowledgeable accountant. Depending on how you are operating you property (sole proprietor, corporation, etc.) may have a large impact on how you can take deductions. Once you feel you have a handle on this trick subject, feel free to weave it into your pro forma. With the deductions you can sometimes add an additional two points or more to your return - after taxes of course.
"How do I compute an after tax return?" This really depends on your total income and tax bracket. The income received will generally be taxed at your income rate, at least for federal. Then you must include any state and local income taxes that may come into play. The final issue is when you sell the property. The sales gain are generally considered long term capital gains and taxes at a lower rate than short term capital gains (that would be you flippers). In any case you should seek professional advice and help with your specific tax situation prior to purchasing any investment property. Little things that were simple to do at the beginning can have huge negative consequences in the future. See what works best for you in your specific region - talk to an accountant.
Below the Cash flow to Equity you find the debt service coverage ratio, DSCR. To calculate the DSCR you simply divide the NOI by the mortgage payment (use the absolute value for the mortgage payment if it shows up negative as in the table). The first year indicates the DSCR is a low 0.63. Not to worry, this year includes time for purchase, renovation, and lease-up. Banks are generally concerned about the DSCR when the property stabilizes, which can be up to three years in a large development. For a small house you can show that each full year after the first you meet their DSCR threshold, which is generally from 1.15 to 1.2.
Now to the project returns. Notice the equity returns are much higher than the project returns. " Why?" This leads us into the next subject - leverage. Leverage allows you to make higher returns than if you utilize all cash. To illustrate, if the project was an all cash deal your total required equity would be $101,611. With the sale of the property your total cash profit over the five years would be $76,500; about 75-percent of the initial investment. With leverage, you are only putting $28,600 into the project and borrowing the balance of the money for the project. So in effect your $28,600 is leveraging a $101,611 project. When you add up the cash flow up you see the resulting profit is less at $44,300; however the ratio of the profit to the initial investment is now 155-percent. The use of leverage has increase the projects profit potential by a factor of almost two over the same time period. As discussed earlier though, leverage can turn against you if you are not careful.
In summary, the pro forma can be thought of as your business plan for the project. Up to this point you have only modeled a hypothetical project. In fact you haven't even looked at physical real estate at all. You have been building a model of a project that is a realist representation of the project you should be looking for. If $27,000 is all that could be invested into a project, the model has shown we are limited to properties under $100,000. So you have now filtered out wasting time looking at properties over $100,000. You also learned that you need to have the average rents in the region to be near $1100 per month. If regional rents are lower, then you will need to adjust your model accordingly. So, now your search is further narrowed to finding properties in neighborhoods with an average value around $135,000 with a sales price around $100,000.
Finally, be sure to run a few scenarios with your pro froma. Increase the vacancy rate, see where the breakeven (zero income) rent is at, move the CAP rate up and down a few points. Find what components of the expenses are your most critical. All in all, be honest with your input, run some stress tests, and you will discover the ideal project profile for you to look for.
Time to find a project.