Summary: In the following video and article, we’re going to teach you how to analyze a real estate deal. This is an essential aspect of successfully investing in real estate, because a lot of times, investors receive properties from property providers or real estate agents that say, “Here’s a great investment for you.” You need to be able to sanity-check the numbers that they give you, so you have an idea of what it is you’re buying and whether you want to buy it.
How To Analyze a Real Estate Deal Using a Pro Forma
Here’s an example case study of a brand-new single-family home in Florida. This is a typical pro forma financial statement that the provider will send you. They vary a little bit. Sometimes the line items are different, but this is basically the format. We’ll just walk through this, and then make some adjustments. We can see here, the selling price is $200,000. You put 25% down for $50,000 and your closing costs are $5,000. So, your all-in investment on this property would be $55,000.
Then they tell you that this will rent for $1,800. Your principal and interest payment is $1,065, property taxes, insurance, property management at 8% of rents make your total expenses $1,509. As such, you can expect to net $291 a month on this property, or almost $3,500 a year. You take the $3,500 a year and divide it by your investment of $55,000, you get a return on investment of 6.3%, which is pretty good.
When you see something like this, you have to take it with a grain of salt because, obviously, the seller is trying to make the property look good so you’ll buy it. You can look at this as the best-case scenario. But if you want to analyze a real estate deal like an experienced landlord, you have to trust but verify by going through line item by line item. You need to make sure you understand where these numbers are coming from, and whether you can believe them, and if not, you need to make some adjustments.
Below I’m going to teach you how to analyze a real estate deal by sanity-checking each number. It sounds tedious, but it’s not really that bad. It goes pretty quickly.
The rent is the easy one. The pro forma above shows that this property will rent for $1,800. How do you see if that’s realistic? You go to any of the real estate sites like Zillow or Redfin or Realtor.com, and you check on “for rent” and then you filter for properties that are similar to yours, the same zip code, and number of bedrooms, number of baths, square footage, anything like that, and you see what comes up.
They quoted you $1,800 a month, and on Zillow you see similar properties coming up for $1,775, $1,845, $1,795. You can then tell that $1,800 is pretty much in the ballpark, so you can be confident that the number is realistic.
The second question you have to ask is, how many properties are you competing with? In the video example, you’ll see there’s 36 search results for that exact type of property. If you had four bedrooms, two baths, you might get more. In this case, prospective tenants have a lot of options to choose from.
After seeing all this, you might decide that you’re going to lower the rent from $1,800 to $1,750. It’s not that you couldn’t get $1,800, but that you want to be conservative and you want to get the property rented quickly. Then go back to your analysis spreadsheet and plug in $1,750 to see what that does to the numbers. We’ll do that at the end. We’ll show all the changes that are made and what the final numbers look like.
That’s rent. The next line item is the mortgage payment, and this number can vary a lot.
The next pro forma line item you need to consider when analyzing a real estate deal is your mortgage payment, which is based on a 30-year fixed loan at 7% in this example. So, your mortgage payment is $1,065. After speaking with your lender, you find out you have some other options and decide to go with a 7/1 ARM. An ARM is an adjustable-rate mortgage. What a 7/1 means is that you get this low rate of 5.75%, which is much lower than what you had before with the fixed rate, and that 5.75 is fixed for seven years. After the seventh year, it can change only once a year and there’s a cap on how much you can go up by in any given year.
Seven years is a pretty long time. Most investors hold their properties five to seven years, so that may be more than enough time. What it does is it lowers your monthly payments from $1,065 a month to $935 a month, and gives you an extra $130 a month in cash flow. You can plug in the new number here and see what that does to the numbers as well. Now, the flip side of that is that as the investor, you have to pay two points to get this loan to buy down the interest rate.
A point is just a percent of the loan amount. The $200,000 house minus $50,000, you’re borrowing is $150,000. $150,000 at two percentage points is $3,000. You would have to make the adjustment here on your pro-forma by adding $3,000 to your closing costs from $5,000 to $8,000, but you also could lower the mortgage payment from $1,065 a month down to $935 a month. You make those two changes and go to the next line, property taxes.
On a new construction home, like the one we’re looking at, tax estimates are usually pretty accurate. The home builder has built a lot of these types of homes in this area and knows what the property taxes are going to be. For our example, we’re not going to make any changes to the property taxes. We’re going to take their word for it that it’s $250 a month.
Just as a side note, if this was a renovated house, it might be very different. A renovated house is when someone buys a house that’s, say, 40-50 years old, then they put a bunch of work into it to renovate it to bring it up to speed, and then they sell it to you. In this example of a renovated home, the seller bought it originally for $100,000, put $30,000 of renovations into it, so it’s all-in cost is $130,000, and they’re just going to sell it to you for $150,000 so he can make a $20,000 profit.
Now, what happens here sometimes is that the property taxes that they put on the pro forma is actually the last property tax that was assessed on the property. That was based on the $100,000 number, not on the current value of $150,000. You might get a bad surprise if you think that your taxes are going to be X and then it turns out to be a lot more than X.
You have to go to the County Tax Assessor’s website, find out how they calculate taxes and do some back-of-envelope math. This varies from county to county, even within the same state. See what you think the right number should be, and also, find out how often they reassess taxes. Maybe sometimes they just change it every three years, in which case you’re probably okay. If they change it every year, then you might want to pay more attention to this line. That’s how you check property taxes. In our example, we’re going to leave it the same because it’s a brand-new house.
The next line item you need to consider when analyzing a real estate deal is insurance expenses. The insurance here is quoted at $50 a month. You should be aware that the quote is usually for the minimum or the most basic insurance coverage that’s required by the bank. This is because the bank is using your house as collateral for the loan so they don’t want it to burn to the ground. The bare minimum might be okay, or you might choose to get extra coverage. You should talk to your insurance company, ask for a quote for the basic coverage that the bank requires, and then ask them if they think you need any additional coverage.
Considering that this example is in Florida, you might ask yourself about hurricane insurance or flood insurance. Of course, you have to take what the insurance company says with a grain of salt too because their job is to sell you insurance so they’re going to say you need everything and you may not. You ask them when was the last time you had to pay for a claim on hurricane damage. Since this city is inland, it’s not near the coast, maybe the last time was 20 years ago, in which case you may not need it. You have to use your judgment there.
The other option that’s listed here is an umbrella policy. An umbrella policy is an insurance policy to protect you against lawsuits or any unforeseen events. If somebody trips on your sidewalk and tries to sue you, for example, the umbrella policy will cover it. They’re usually pretty reasonable, like a million-dollar policy costs something like $200 a year. In this example, the investor decided to add the umbrella insurance policy $180 a year for a million-dollar policy. That adds $15 a month to the pro forma so instead of $50 a month, we’ll make it $65.
The last factor to consider when analyzing a real estate deal is the property management expenses. That’s pretty straightforward. It’s usually a percent of the monthly rent. Remember we changed the rent from $1,800 to $1,750. 8% of $1,750 is $4 lower, no big deal. We would change this property management fee from $144 down to $140. Also, as an aside, you should understand the property manager’s entire fee schedule, not just what they charge for monthly maintenance.
Sometimes they have a tenant placement fee, which is equal to one month’s rent. If they find a tenant for you and screen them for you, doing all the background checks, they’ll charge you the first month’s rent, sometimes half a month’s rent. It depends. Then when the tenant renews the lease, they might charge you a flat fee, $150 or so, or it could be as high as 25% of the rent. Just understand their retired fee schedule before you sign with them. For our purposes today, all we’re worried about is the monthly property management fee, which is only 8% of rents.
That covers everything that they put on the proforma. However, there are some things that they left out and some providers will do that. You have to add them yourself. There’s no accounting for vacancy or maintenance expenses. These are missing line items from the pro forma in the example.
Missing Pro Forma Items: Vacancy & Maintenance Expenses
The first missing pro forma item to consider is vacancy. Most tenants stay an average of about 30 months or 2.5 years. That means for every 30-month period, you have 30 months of occupancy and one month of vacancy. One divided by 31 is roughly 3% so you want to take out another 3% of rents as a reserve for vacancy. You’re not losing the money, you still have it in your account. It’s just that you’re setting it aside for a rainy day because sooner or later you’re going to have a vacancy.
The other thing that wasn’t on the pro forma was maintenance. You should put in a reserve for maintenance because sooner or later you’re going to need maintenance as well. For a new home that’s still under build warranty maintenance is very minimal. If something breaks, the builder has to fix it for free because it’s still under warranty if it’s the first year. You might just put a minimal amount, like 3% of rent for maintenance. If the toilet gets clogged, for example, they have to send a guy out to fix it.
Then for renovated homes that are 40, 50 years old, you might want to double that and make it 6% of rents because older homes are going to require more maintenance. That’s all there is to it. No matter how well the renovation is done, it’s going to cost more. In our proforma, we’re going to adjust it by putting another 3% of rents aside for maintenance expenses.
Summary of Adjustments
To summarize it, here’s the original pro forma we saw at the beginning, and then here’s all the adjustments that we made. We added $3,000 to buy down our interest rate. We took the rent down by $50. We added a reserve for vacancy, which is $52. Then we got lower payments because we got different financing, so that adds $130 to our cash flow. Property taxes, we made no change to. Insurance, we decided to get some extra coverage which costs an extra $15 a month. We saved $4 on our property management fee by having lower rents and we added a maintenance reserve. When you add it all up, it’s really pretty much a wash. It’s only $17 difference, so our expenses went down by $17.
Analyzing Cash Flow
The effect on cash flow between that and the lower rent our cash flow went down to $258 a month or $3,000 a year instead of $3,500. Our ROI, return on investment, went down a full percentage point. It went from 6.3% down to 5.3%. That’s not bad at all. You’re getting very positive cash flow with $3,000 a year, and being in Florida, this is an appreciation investment. You’re really buying a property that in ten years will be worth $300,000. You’re basically buying the property so that it pays for itself while it’s appreciating. This is still a good investment, so you should move forward with it or you might choose to move forward with it.
Now sometimes you crunch the numbers and you find out that the property is negative, has negative cash flow, or otherwise is unattractive. In that case, you walk away from the deal. That’s why we go through this exercise. You look at what the provider is giving you and then you do your sanity checks on it and then decide if you want to move forward or not with the deal.
The most common mistakes I see are rent estimates. They’re almost always skewed to the optimistic side. If the rent ranges from $1,750 to $1,850, they’ll put $1,850 on the pro forma to make the property look good to the investor because they’re trying to sell it. You have to be careful about that number in particular.
The second number you have to watch is mortgage payments because that can vary very significantly based on the type of loan you get, the loan terms, and your own personal credit score.
Then finally, maintenance expenses, especially for older homes, you can get nickel-and-dimed. Every time you send a guy out it’s going to cost you $200 just to fix something. That can eat away at your cash flow.
The most important thing to remember is that you need to always sanity check the projections. Go through it line by line and say, “Here’s what they’re telling me. Can I believe this number? What does the final picture look like?” You should get practice at this by looking at multiple deals. When your provider sends you properties, even if you’re not interested in the property, you should go through this exercise just for practice to see what questions come up. Learn what you don’t understand about analyzing a real estate deal, and talk to the provider and find out. In the process, you’ll learn more about the market and the kind of properties that they offer and where things can go wrong.
You’ll find that some sellers are consistently off in certain areas. If you have multiple providers giving you properties to analyze, you’ll find one that always overestimates rents and another one always messes up on the property taxes. After a while when you’re dealing with certain providers, you’ll just know what to look for. Before long you can do a sanity check like the one we just walked through in just a couple of minutes. That’s important because when you do see a deal that you like, you want to be able to act on it quickly. There’s nothing more demoralizing than to spend an hour doing your due diligence and then you call up the provider and say, “I want the property,” and they say, “Oh, we just put it under contract. Somebody called ten minutes ago.” You want to be able to move quickly. Getting practice at crunching the numbers is a very useful exercise.
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