Knowing how to analyze a real estate deal is an essential skill for investors. Analyzing deals helps you determine if a property is a good investment or one you need to pass on adding to your real estate portfolio. To help you become a real estate deal analysis pro, we’ve broken down the steps.
How To Analyze a Real Estate Deal Using a Pro Forma Statement
Below is an example case study of a brand-new single-family home in Florida. The image below shows a typical real estate pro forma statement a provider will send you. The line items are sometimes different, but this is the basic format. Before we analyze each line item, let’s review the details of our sample real estate pro forma.
The first section starts with the following information:
- Address: 123 Main Street in Ocala, Florida, 34472
- Selling price: $200,000
- Down payment: $50,000
- Closing costs: $5,000
- The total upfront investment comes to $55,000.
The following section outlines monthly income and expenses:
- Rent: $1,800
- Mortgage payment: $1,065
- Property taxes: $250
- Home insurance: $50
- Property management: $144
- The total monthly expenses come to $1,509.
The last portion shows calculations for:
- Monthly cash flow: $291 ($1,800 rent-$1,509 expenses)
- Annual return: $3,492 ($291 x 12)
- Return on investment: 6.3% ($3,492 / $55,000)
Return on Investment Calculation
To calculate your return on investment, divide the annual return of $3,492 by the total invested, which is $55,000 ($3,492 / $55,000). In that first year, you’d get a 6.3% return on investment (ROI).
Typically, the first year is the worst because that’s the year you pay closing costs, which you don’t do any other time. Also, the cash-on-cash return is worse in the first year but gets better as the rent increases.
If you are new to real estate investing, I suggest reading Leah Collich’s article, “Pro Forma Real Estate Analysis Made Easy: Increase Potential & ROI.”
Real Estate Deal Analysis: Checking the Numbers
When a seller presents you with a pro forma real estate statement, it’s obviously in their best interest to make the numbers look as good as possible. Think of it as the best-case scenario. If you want to do a real estate deal analysis like an experienced landlord, you must trust but verify by going through each line item.
The goal of the real estate deal analysis is to determine if the numbers are accurate and where they might need adjusting. As a potential investor, you need to understand where these numbers are coming from. As part of your due diligence, it’s up to you to check these numbers line by line to ensure that they are accurate and believable.
Real Estate Deal Analysis Case Study
Below, I will teach you how to analyze a real estate deal like a pro by sanity-checking each line item number. It sounds tedious, but it’s not that bad and goes pretty quickly. If you prefer to watch, follow along in my video below.
1. Checking Rent Price
The projected rent is $1,800 a month. How can you tell if that’s accurate, especially if you’ve never been to Ocala, Florida? An easy way to check this is to use real estate websites like RentCast, Zillow.com, or Redfin.com. RealWealth members receive an exclusive discount with RentCast. If you are not a member yet, join RealWealth today.
In the search field, input the zip code for the property. Then, filter the features to look for properties similar to the one you are considering as an investment property. For example, if the property has three bedrooms, two bathrooms and is 2,000 square feet, adjust the filters for these features.
In the image above, we can see that properties are renting for $1,775, $1,845, and $1,795. The projected rent of $1,800 is within that range and not extravagant.
As you check this line, the main questions to ask are:
Is the rental price in the ballpark of what similar properties are renting for?
If the rental price is higher, ask the seller why they gave you that price. For example, if our example property was listed as renting for $2,000, but your rental price research showed that properties are renting for around $1,800, you’d need to call the seller out. Ask them to clarify why the price is $200 above the going rate. Why would somebody pay $2,000 a month when there are other properties just like it for $1,800?
How many similar rental properties are you competing with?
No matter which website you choose, it shows you the total number of properties available for rent in that area. In our Ocala example, there are 36 properties just like this one, which might make you a little uneasy as you’ll want your property to rent immediately.
Even though our research shows that the $1,800 a month rent for our example property is believable, you might want it to rent faster. You decide to lower the rent to $1,750. Adjust your pro forma statement to reflect how you plan to market the property.
2. Checking the Mortgage Payment
The mortgage payment is projected at $1,065 monthly, based on a 7% interest rate on a 30-year fixed loan. You’ll want to talk to your lender and negotiate your options to verify this number.
In this example, our mortgage loan options are:
- Option1: $150K loan at 7%, 30-year-fixed at $1,065 per month
- Option 2: $150K loan at 5.75% with a 7/1 ARM at $935 per month
With the second option, you’ll get a lower interest rate, but the rate could change after seven years and only once a year; that’s what 7/1 means.
Since you usually would only pay off a little principal during the seven years of a fixed loan, and since many investors only hold their properties for seven years, you decide you are losing little by choosing the 7/1 ARM. What you are gaining is a monthly payment that is $130 lower.
However, there is one caveat:
- You must pay two points (2%) of the loan amount to “buy down” the interest rate, or $3,000.
In the pro forma statement, you would adjust this by adding $3,000 to the closing cost number and reducing the mortgage payment by $130.
3. Checking the Property Taxes
The projected property taxes are $250 a month. For this example, the property is a new construction home, and tax estimates are usually accurate. We won’t make any changes to the property taxes.
Property taxes and renovated homes
There’s a pitfall to be aware of with renovated homes. Sometimes, the property tax listed is the assessed tax amount before renovations, not the current condition or value.
For example, the seller bought the house for $100,000. They put $30,000 of work into it and are all in for $130,000. They sell it for $150,000. The property tax on the real estate pro forma statement might be based on the pre-renovation value of $100,000, not what it’s currently worth. The current tax rate might be higher, with the property valued at $150,000.
How do you find out an accurate property tax amount? First, go to the county tax assessor’s website and determine how they assess property taxes. Be aware that some counties may tax rental properties differently than owner-occupied ones and that taxes vary from county to county, even within the same state. Once you figure out the correct amount, adjust that line item on the pro forma statement. If the tax assessor’s website isn’t clear, you can always call the assessor for an estimate. They’ll need the address and listing price.
4. Checking Insurance Expenses
The projected home insurance is $50 a month or $600 a year. Now, the bank requires property insurance because the property is being used as collateral for the loan. Banks have specific policies requiring you to protect their investment, so they want you to ensure it properly. You’ll want to talk with your insurance agent about coverage and get a final quote to check this.
Additional Coverage & Umbrella Policy
You’ll also want to ask them if the property needs additional coverage, such as hurricane or flood insurance. This property is in Florida, which has hurricanes. However, Ocala is inland and not on the coast, so there’s less hurricane risk.
In this example, let’s add an umbrella insurance policy, which helps ease the monetary burden if you get sued. The million-dollar umbrella insurance policy costs $180 a year or $15 monthly. Go to the insurance line on the pro forma cash flow statement and add $15.
5. Checking Property Management
The last factor to consider when analyzing a real estate deal is the property management expenses. These are usually pretty straightforward, as they are typically a percent of the monthly rent.
The projected property management fee is $144 a month or $1,728 a year. This fee is 8% of the rent ($1,800 X .08), which is typical. But, we lowered our rent to $1,750. So, with that new calculation ($1,750 X .08), the fee comes to $140 a month, which is $4 cheaper. Adjust that line in the pro forma statement.
It’s also essential to understand the property manager’s entire fee schedule. When brand-new tenants move in, they usually charge a month’s rent just for that. If the tenant renews next year, they typically charge a flat fee or 25% of a month’s rent.
It’s up to you to understand the fee schedule and determine where that fits into your financial projections.
For additional property management tips, please check out my article “How to Manage Your Property Manager.”
6. Missing Pro Forma Items: Vacancy & Maintenance Expenses
The final step in how to analyze a real estate deal properly, is adding missing items from the pro forma statement. One is vacancy rates, and the other is maintenance.
Vacancy Reserve
Most tenants rent a property for an average of 30 months, meaning there will be a month of vacancy every 30 months. When a property is vacant, an investor takes some time, let’s say a month, to do a deep clean, clean the carpets, put on a fresh coat of paint, and advertise. A good rule of thumb is to add 3% of the rent for a vacancy reserve. You can also ask the property management company for their average vacancy rate.
The reserve is not an expense; it’s just money you set aside because you know the property will not be occupied 100% of the time, and you want to be financially prepared. Adding this projection to your pro forma statement helps you understand how much cash flow the property is really going to net.
Maintenance Reserve
Houses have problems; roofs need fixing, and a toilet backs up; whatever the problem, it is good to have a maintenance reserve. Here are some guidelines:
- For a new home: 3%
- For an old home (ex. 1970s): 6%
- For an older home (ex. 1950s): 10% (No matter how well an older home has been renovated, it will require more maintenance.)
A benefit of newer homes is that everything’s still under builder warranty, and the builder fixes things for free. For the first year, there’s a bumper-to-bumper warranty. Then, there are extended warranties for the second year and up to 10 years.
In our example, the investment property is a newer home, and you will subtract 3% of the rent for a maintenance expense.
Real Estate Deal Analysis Quick Summary
To help visualize the changes, we’ve created a new column to display the original and revised projections and compare the adjustments.
Pro forma statement summary:
- Closing costs: We added $3,000 to the closing costs because we paid two points to “buy down” the interest rate. It is now at $8,000.
- Rent: We reduced the rent by $50 to get it rented faster. It is now at $1,750.
- Vacancy reserve: We added a line item for a vacancy reserve that subtracts $52.
- Mortgage payments: We have better mortgage terms, with a $130 reduction. It is now at $935.
- Property taxes: We left this line item alone.
- Insurance: We added an umbrella insurance policy, which increased the price by $15. It is now at $65.
- Property management: We reduced the rent, which reduced the property management fee by $4. It is now at $140.
- Maintenance reserve: We added a maintenance reserve of $50 monthly in case anything happens.
Return on Investment Calculations
Our total expenses are now $1,492, compared to $1,509 in the original pro forma real estate analysis—a difference of $17. Our monthly cash flow is $258, or $3,096 annually. Our return on investment went from 6.3% to 5.3%. How can that be? We chose to “buy down” points, and our closing costs went from $5,000 to $8,000. The ROI calculation ($3,096 / $58,000) results in a percentage point decline.
Now that we’ve done a reality check against the seller’s projections in the pro forma statement, we can see that the numbers are reasonably close. As the investor in this example, you are happy with the 5.3% return and know it will only increase. Since this is a good investment, you move forward with the new-build property.
Negative Cash Flow
On the flip side, if you went through this process and determined that the property was not a good investment or had negative cash flow, you would need to talk with the seller to see what can be done or walk away from the deal. That’s why we, as investors, go through this exercise. We look at the numbers the provider is giving us, check them for accuracy, and then make a decision on the deal.
Common Mistakes
Rent estimates
The most common mistakes I see on real estate pro forma statements are rent estimates. They are almost always skewed to the optimistic side. For example, if the rent ranges from $1,750 to $1,850, they’ll use $1,850 on the pro forma to make the property look better to the investor because they’re trying to sell it. Be very careful about this number and always check it.
Mortgage payments
The second number you have to watch is mortgage payments because they can vary significantly depending on the type of loan you get, the loan terms, and your personal credit score.
Maintenance expenses
Maintenance expenses, especially for older homes, can add up quickly. Every time you request a repair person, it will cost you at least $200 to fix something, which can eat away at your cash flow.
How to Analyze Real Estate Deals Like a Pro
The most important thing to remember is that you always need to check the projections for real estate deals. 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?”
Practice this by looking at multiple deals. When your provider sends you potential investment properties, even if you’re not interested, go through this exercise to see what questions arise. The more you practice, the more you’ll discover what you do and don’t understand about analyzing a real estate deal. If questions come up, talk to the provider and find out. The more you go through this process, the more you’ll learn about the market, including the kind of properties offered and where things can go wrong.
If you want to learn more about real estate deal analysis and other aspects of investing, becoming a RealWealth member is a great place to start. Membership is 100% free, and you’ll find a ton of educational resources to help support you on your journey, including our core curriculum and real estate investing webinars. I also highly recommend you subscribe to Kathy Fettke’s RealWealth podcast.
When new investors are learning how to analyze real estate deals, they often get stuck in analysis paralysis. Joining RealWealth can help you understand what you need to do so you can move forward. When you’re ready, you can speak to a RealWealth investment counselor like me, who’s been investing in real estate for years. Ask us specific questions and get advice about your next steps. It’s all free, so there’s no reason not to do it.
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