One of the greatest services that Empowered Investor offers (for free) is to deliver Pro-Forma analysis of pre-screened real estate deals. These Pro-Forma summaries are constructed using the Property Tracker software suite, and communicate a wealth of useful information about the deal in question. To demonstrate the power of this tool, let’s examine one of the low down payment deals in Atlanta.
In the upper part of the Pro-Forma, you will find the location of the property along with the bedrooms, bathrooms, and square footage. The summary also includes the estimated purchase price and market value, along with the estimated down payment. In this case, the house is a special deal where the investor can purchase for only $5,265 down with a ‘two step close’ that involves purchasing the property and then immediately refinancing it to get into the deal for much less down than is typical.
Other useful figures on the Pro-Forma are the estimated loan fees, closing costs, and rehab costs to get the property ready for renters. These items are added up to estimate the total cash requirement for the investment, and are displayed next to the cost per square foot and forecasted rent per square foot. As you move down the left hand side of the summary, you will see the forecasted monthly and annual rents, expenses, cash flow, and net performance.
One of the most important things to note is how Empowered Investor uses very conservative assumptions in constructing its Pro-Forma analysis. First of all, Platinum always incorporates the impact of vacancy in the rent income projections. Many other (and less ethical) sales organizations fail to account for the fact that finding new renters can sometimes take time, and will inflate the income forecast for their deals by neglecting to incorporate the impact of rent vacancy. Furthermore, Platinum only forecasts value appreciating at 6% per year, which is slightly below the long-term average rate of real estate appreciation. This is purposefully done to avoid presenting deals that are heavily dependent on appreciation, and is fully consistent with the Platinum philosophy of only investing in properties that make sense on the day you buy them.
Looking over to the right side of the Pro-Forma, you will see the estimated loan information, and financial indicators. The indicators provide a highly valuable barometer of the characteristics implicit in the deal. The first item in the indicators section is the debt coverage ratio, and demonstrates the extent to which Net Operating Income for the property can cover the debt expenses. It is worth noting that this ratio has somewhat limited value, since it is highly influenced by the down payment amount. (More equity = less debt = better coverage) At the Financial Freedom Report, we like to carry more vs. less leverage, since more leverage lets us invest our available cash in more deals.
The next two items on the Financial Indicators section are the Annual and Monthly Gross Rent multiplier. What these numbers show is the ratio of the purchase price relative to the annual or monthly rent. The importance of this ratio lies in the fact that it demonstrates the extent to which the property produces an attractive amount of rent revenue. When this ratio is low, it means the property generate a large amount of revenue, relative to its price and vice-versa when the ratio escalates. We can clearly see that the price for this deal is seven times the annual rent revenue. Practically speaking, this is an attractive rent multiplier since it means that the gross revenue collections will be equal to the purchase price in seven years. Bubble markets frequently have Annual Gross Rent Multipliers in excess of 10, with some going above 15. Needless to say, we do not advocate investing in markets that produce cash at such a low rate.
The next item is the Capitalization Rate or “Cap Rate” as it is frequently referred to by Realtors. The Capitalization Rate indicates the Net Operating Income as a ratio of the Purchase Price for a property. It is important to note that the Cap Rate does not incorporate the impact of debt servicing, and only shows the rate of operating cash flow you would experience with no leverage. (Did we mention that we love using leverage to increase the total returns of our investments?)
The next item on our list is the Cash on Cash Return. When investing in a flat or declining market, this can become one of the most important indicators for a deal. The reason for this is because it measures the annual Net cash flow as a ratio of the total cash invested. Practically speaking, this shows the rate at which your initial investment will generate cash, with no value appreciation incorporated. In finance, there is a popular statement that “Cash is King” . . . that sentiment is no less true in real estate. It is also worth mentioning that if you can reduce the amount of initial cash invested while still maintaining positive cash flow, your cash on cash return will rise dramatically. This happens because you are lowering the amount you need to invest in order to capture the rental income. Needless to say, we like this strategy quite a bit.
The last two items on the Indicators section is the Return on Investment (ROI) and the ROI with tax savings. This represents the total value you are capturing as an investor when looking at cash flow plus future appreciation in relation to the amount you initially invest. This is the place where leverage has a BIG impact, because it lets you capture more appreciation for less initial cash. It is important to note that appreciation can be very volatile and is not captured until you sell or refinance the property. However, in the long-term a dollar of cash flow and a dollar of appreciation are the same money. Because of this, we like to look at the total ROI of our investments as the primary indicator of their long term prospects. In this case, the extremely low down payment required catapults the ROI into the stratosphere with an astounding 77% return on investment after tax savings!
The final section that you will find is the key assumptions and comments. This is shown to be clear in the way that the Pro-Forma is built so that the investor can judge the quality of the estimates for themselves. Thus, we have seen that the Pro-Forma is a very powerful tool for evaluating deals, and Empowered Investor provides it for free to prospective investors. By learning to read, understand, and act on the information contained within these summary sheets, investors can generate tremendous amounts of wealth that will allow them to realize their dreams.
The Creating Wealth Team
Flickr / @boetter
