I was having an interesting conversation yesterday with an investor client who was trying to evaluate some properties.
She was confused at seeing properties and how they can be so similar yet have such incredibly different returns on investments (ROI). Instantly suspecting the reason for variances, I began to ask the routine questions about prices, rental rates and expenses.
As I suspected, she quickly mentioned the pro forma report.
She was perplexed by my smirk, so I asked her if she was reading a pro forma report or a performance report.
Now she was the one smirking (inquisitively) and asked what the difference is.
I replied that the differences may be the answer to her query, “Why are two similar properties producing such different ROI?” I shared with her that there are two basic types of pro forma reports, and they are both speculative in nature.
Whenever possible, you should get a performance report, and of course I shared the differences.
6 dangers of the pro forma report for real estate investors and the potential surprises
No. 1 – Taxes and insurance
What I shared with her was most properties (especially those properties that do not have rental income history) provide a pro forma report, which is nothing more than a snapshot of assumptions of income and expenses. Some of these assumptions are based on a great deal of diligence, such as identifying what the exact property taxes are, while others are based on averages, such as a tax calculated as a percent of home value.
No. 2 – Insurance
This also may be based on a percent of home value. Insurance can be yet another fee that will vary person by person. Some people have a higher risk tolerance, so they may opt for a higher deductible, which in turn reduces their insurance premium, while the person with a lower risk tolerance will pay more money for a policy that has lower deductibles.
No. 3 – Mortgages
Then you may have an assumption of mortgage payments, which is going to be different for most people, as the interest rates and terms will vary depending on their credit-worthiness.
No. 4 – Repairs
Surprise! Most pro formas conveniently leave these line items out altogether, and this is the No. 1 difference creating a large variable between the ROI of similar properties.
When they are included, what is an accurate amount to assume for repairs? This may vary on the age and condition of the property as well as your risk tolerance. Some people like to border on the side of safety and put 5 percent to 7 percent of the rental income in here, while others are more tolerant and are comfortable with 3 percent to 5 percent. At this stage of the game it is more of a guess than mathematical knowledge.
No.5 – Vacancy loss
Surprise, again! Most pro formas conveniently leave this line item out, as well. A tenant occupying a property more than two or three years will not burden the expense of vacancy loss.
However, if you have a tenant turnover and it sits vacant for a week or two or three while you clean, paint and prep for re-renting, this line item expense will add up.
No. 6 – Property management expense
Surprise, once again! Most pro formas also conveniently leave this line item out and often get away with it, as some people like to manage their own properties. That may be fine (though I do not recommend it), but the property should be able to support the cost of paying this line item fee whether the fee is paid or not.
As the value of income-producing property is based on its ability to generate income, you do not want to create a false inflation of value by ignoring this expense item.
Now, this woman is a very smart business person, but just like many smart investors, I find that until they are exposed to this, they are unable to embrace it or even stop to think about it. They are out of sight and therefore out of mind. So I love sharing these important “must-knows.” I could see the light bulbs popping on inside her mind.
The performance report
When you purchase a property that has already been used as an investment property you should have access to a performance report.
This report is based on historical mathematical data. You now have history on these expenses, so the line items for each expense should be much more accurate.
How you can create a more accurate duplicable pro forma report?
Nothing replaces your own due diligence, as this investor was pointing out the two similar properties and two very different ROIs.
This is in large part because they were generated from two very different sets of eyes. As an investor, I shared you can always create a clearer picture of what a property’s ROI will be by simply using the same ROI calculator for each and every property you evaluate. (Yes, you should input all the numbers based on your research.) Being purposeful and establishing the truest numbers as they relate to expenses is key. Remember, garbage in equal’s garbage out. No shortcuts when it comes to evaluating the property.
As every investor tells you, you make your money going in, so taking a shortcut on this step may be the difference of a great investment and a terrible mistake.
My last comment is that a pro forma report is best used to quickly evaluate a few different prospected properties and identify which one may be the better investment. Then, to be clear, input all your research and expenses into your own ROI calculator.
[hs_form id=”4″]
0 Comments