EVERYTHING INVESTORS NEED TO KNOW ABOUT TO UNDERSTAND A PRO-FORMA
Real estate investments don’t get made without looking at the numbers. A pro-forma is an estimate of the costs to acquire, operate, and dispose of investments.
Pro-formas use a combination of known numbers and estimates which can be based on experience, actual numbers from similar properties, or industry data. With a good pro-forma, investors can analyze a property and decide if they should move forward.
The field of finance is riddled with initials, acronyms, and jargon. To make it even more confusing, many terms have multiple words for the same thing!
Arrived’s mission is to make real estate investing simpler and more accessible. To do that, below we’ll break down all the terms we use in our pro-forma to underwrite an investment.
Acquisition, Renovation, & Financing Items
This is exactly what it sounds like: how much does a potential investment property cost to acquire?
When you buy a property, it doesn’t just cost you the agreed upon price. There are various fees for a private inspection, fees for escrow, and fees to purchase a title insurance policy. All together these are usually a few thousand dollars.
The goal of real estate investing is to start earning income from day 1. But sometimes there are unexpected expenses or delays in collecting revenue. Cash reserves are working capital for the property to pay its bills for a few months without having to raise additional capital. It’s like an emergency fund for the property.
So you’ve purchased the property and are working to remodel it. Before a tenant moves in, there are holding costs that need to be paid by someone. Since there is no tenant and therefore no rent, you’re on the hook to pay these costs.
The most common holding costs include property taxes, insurance, interest, and utilities.
If you’re using a loan to purchase the property, lenders will often assess an origination fee.
Some rental properties need a lot of work, some need a little, and some need none at all. Arrived likes to invest in homes that need a little bit of improvement. This allows us to buy homes and quickly increase their value and the amount of rent.
The size of the renovation budget depends on how costly the improvements you want to do are. A fresh coat of paint will be cheaper than re-doing a bathroom and adding a new roof.
Loan Size (Financing)
Just because you’ve agreed to a purchase price doesn’t mean that you need to come up with 100% in cash. Real estate purchases are usually financed with a combination of equity from the buyer and a loan from a bank.
Determining how big the loan is will determine how much you need to pay at closing. And of course the loan isn’t free – you’ll need to pay interest and usually an origination fee and loan related transaction fees.
This is also just called the “financing”. Loan sizing is expressed as a percentage. In this case, the loan is going to be 57% of the purchase price.
There’s costs associated with using a loan to buy a property. The interest rate is one of the factors that determines the size of the monthly payment. The payments will depend on the size of the loan, the interest rate, and the time period. It will also change based if it’s an amortizing or interest-only loan.
If you’re buying the property in all cash, then the amount of investment (equity) that you need is equal to the total costs. If you’re using a loan, the equity you need to invest up front is the total upfront costs minus the size of the loan.
This is also called the equity requirement or the total initial investment.
Number of Shares
Now that we’ve determined the raise amount, we can figure out the number of shares available for investors. The raise amount tells us the investment that we’ll need to acquire the property. By dividing by the $10 price per share, we can calculate how many shares will be available.
Once the property is purchased and improved, it’s time to rent it out. This part of the pro-forma helps us determine how much income we think the property can generate each month. These costs are usually calculated as a percent of rent.
How much rent do you think the property will generate? Investors look at competing properties in the same area to try and get an idea.
It’s necessary to understand the local market and the neighborhood that the property is in. Then you need to compare your property to other properties of similar quality. In the industry we refer to these as “comps” which is short for comparables.
Most properties aren’t occupied by a tenant all 365 days a year. Often this is because a tenant moves out and the new tenant does immediately move in the next day. Sometimes there’s vacancy because you’re remodeling the property or there is transition time needed between a tenant moving out and a new tenant moving in.
Vacancy costs are estimated costs for not having a renter in. Since our rent line item assumes the property is fully rented, we need to adjust by assuming that there will be some days in between tenants.
The amount of vacancy depends on a lot of factors. These include the competition in the market and how long renovations are expected to last. A common range for vacancy is 2-7%, which translates to 7-26 days per year.
There’s a balance between achieving high rents but not leaving the property vacant for too many days each year. Price your rental accordingly!
Marketing and Leasing Incentives
In a competitive market it can be difficult to get a tenant to sign a lease. Sometimes you may offer an incentive for a tenant to live in your property compared to the one down the street. This will depend on your market conditions, your asking rent, and your tolerance for vacancy.
Other marketing costs can include ads or signs for the property.
The reality in life is that things break. Owners pay for maintenance on the property as it goes through regular use. Maintenance costs vary with the initial quality of the property and the desired level of quality, but commonly range from 5-9%.
Hopefully you never need to use your insurance! This is to make sure you’re protected in case something really bad happens, like a fire. Arrived carries liability insurance in case there is ever an accident at one of our properties.
Property taxes depend on the city, county, and state tax rates. These are public information, so you can look up the exact amount of property taxes for a prospective property. Some markets have property taxes that can increase quickly each year, so make sure you’re familiar with the situation in the area.
Finding a tenant is a big piece of property management. Then, as the name suggests, you need to manage the property. Property managers communicate with the tenant about things that break and organize repairs. They collect the rent and pay the utility bills and property taxes. They also ensure compliance with all of the local landlord/tenant laws which are complex and always changing.
Some investors like to do this themselves because they can save some money. On the flip side, they’re responsible and on call if an emergency happens, and they need to deal with fixing things when they break.
Net Operating Income (NOI)
This is the big one: how much money does this property make? Net Operating Income is the rent minus all the operational costs we’ve talked about so far. This is a major item to investigate and analyze as it will make a huge impact on deciding if a property is a good investment or not.
Notably, financing costs are EXCLUDED from the NOI. NOI is a measure of how the property does operationally, without regard to financing. There is no difference in NOI if a property is leveraged or bought with cash, but there is a difference in the cash-on-cash returns, as we’ll see in the Analysis section.
Arrived earns a 1% management fee each year. This goes toward paying for our overhead and regulatory costs. This fee allows us to bring real estate investing to everyone with low minimum investment requirements.
If you plan on purchasing the property with a loan, this is where you enter the costs associated with the financing. Interest is marked as an expense each month.
Cash flow is the best part about real estate investments. Instead of waiting for the property to appreciate to make money, the property actually makes money for you every month!
The property collects rents and pays the expenses associated with the property. If it’s a good investment that’s performing, there will be extra cash left over at the end of every month. The property then pays this cash flow back to its investors.
70% of the return from investment properties comes from the cash flow, so it’s important to make sure that the numbers look good in this section. Cash flow is the NOI adjusted for any financing considerations. If there is no loan, cash flow and NOI will be the same. If there is financing, the cash flow will decrease but your returns will go up.
Along the way, you’re hoping that the property value will appreciate. Then you’ll be able to sell it for more than you bought it.
In the pro-forma, investors plug in how much they think the property values are going to increase each year. A common number to use is between 1.5-3.5%.
The amount of appreciation is highly dependent on the economic prospects of a region, city, and neighborhood.
This will calculate what you think the sales price will be in the future.
It isn’t cheap to sell a property. It often costs 5-8% of the sales price to pay for the real estate agents, excise taxes (if applicable), escrow fees, and pro-rated property taxes. The agents for the buyer and the seller are paid by the seller, which is a big reason why it costs more to sell a property than buy one.
If you used a loan to buy the property, you’ll have to repay the loan balance when you sell the property.
We’ve kept the cash reserves from the Acquisition section just in case we needed the money to pay for an unexpected expense. Now that we’re selling the property we can distribute the cash reserves left back to investors.
This is how much money is left after all the costs associated with selling the property. It’s calculated as the sales price minus all the above costs and loan repayment, plus the remaining cash reserves.
Analysis Line Items
Now that we’ve collected a host of information about a property on our pro-forma, we can analyze if it’s a good investment.
The capitalization (cap) rate is one of the biggest metrics in analyzing real estate deals. It’s calculated by taking the NOI / Purchase Price. It’s measuring the ratio of income a property generates compared to how expensive the property is.
A low cap rate means that the property produces little income each year. However, it doesn’t include the potential appreciation. High cap properties produce more income relative to the purchase price. In general, a higher cap rate is also a signal of a riskier investment.
A property with a lower cap rate will generate less cash flow than a property with a higher cap rate. However, properties with low cap rates usually appreciate more than properties with high cap rates. Determining a “good” cap rate depends on if an investor wants more cash returns, more appreciation, or a fair mix of the two.
Cap rates are used to compare different properties, regardless of the investment size. It also allows for a fair comparison between markets.
Because the cap rate uses NOI (which doesn’t include financing costs), it’s also a way to fairly compare the returns of different properties that may be financed differently. Otherwise it would be unfair to compare 2 identical properties, one of which was purchased with all cash and one of which was purchased with a large loan.
The dividend yield return is a metric that tells you the actual cash returns each year. The dividend yield is the return are the actual cash returns that investors get compared to how much cash they invested.
Dividend yield is cash flow of the property divided by the original investment. It measures how much cash the investment generates after considering all the operational expenses and financing costs.
Dividend yield is also called the cash-on-cash returns, yield, or the cash returns.
The Internal Rate of Return is another good way to conceptualize the return of an investment. This metric shows you the return of an investment based on the timing of the cash flows.
The time value of money demonstrates that you’d rather have $1 today than $1 in the future. The IRR looks at how much the returns are and WHEN those returns are to determine the return percent. This percent is equal to what the annual return is after adjusting for the timing of the cash flows.
The Arrived Pro-Forma
Arrived looks at all of the purchase price, rents, and costs associated with the property to see if it’s a good investment. We use complex data science and valuation models to accurately predict the fair market value of homes and the rents. This enables us to buy great investment properties at scale.
All pro-formas utilize a mix of known information and best estimates to determine the potential returns. Then investors analyze the information and the projected returns to determine if a property fits their investment criteria.
Pro-forma’s can be filled with different terms that can be hard to understand. Please let us know if you have any questions about how underwriting a property works! Sign up below to start investing in rental properties through Arrived.