Today I thought I would give you an idea of what a comprehensive pro-forma should look like as well as giving you some information on where to find a free pro-forma tool that you can use to analyze
Analyzing An Investment Property
So in my last blog I talked about the Golden Pages-aka Pro-formas- and now I want to dive into what information can be derived from a good pro-forma. When evaluating a potential acquisition, get as much info as you can from the seller so that you can get an accurate picture of the current performance of the property. A good proforma should allow you to determine the annual Net Operating Income (NOI), which is defined as the AdjustedGross Income minus the Operating Expenses. Adjusted Gross Income is defined as the rental income plus any additional income like from coin operated laundries, tenant paid utility reimbursements or late fees and the Operating Expenses are loosely defined as any expense neccesary for the day to day operations of the rental and can include things like taxes, insurance, utilities, grounds maintenance, snow removal, repairs and maintenance. Note that a mortgage payment is not classified as an operating expense. Once you have established your Net Operating Income (NOI), you can divide that amount by the proposed purchase price to determine the Rate of Capitalization or Cap Rate. In its purest form the Cap Rate is a measure of the Return On Investment (ROI) if you paid cash. Since most folks will leverage their investment the most useful thing you can do with a Cap Rate is compare it to the Interest Rate that your lender wants to charge. If the mortgage interest rate is higher than the Cap Rate you can bet that the property will not be a winner under the proposed terms.
Okay, if you aren't paying cash then how do you figure your Return On Investment (ROI)? Well once you have established your Net Operating Income (NOI)-you subtract the total of the mortgage payments in a specific year. What's left over is part of your ROI, your cash flow- But Wait! (No I am not going to send you additional items for free like the advertisers on tv)- I just want to say that is only part of the ROI and part of the story. Recall that the tenant rents are technically paying your mortgage payments so that means the annual amount of principal reduction is technically income to you. Take the total amount of mortgage payments made over a one year period and then subtract the interest paid in the calendar year from the total of the payments and what's left is the amount of Principal Reduction. Add the Principal Reduction to the Cash Flow and this is your taxable income from the investment for the year. But that is still only a part of the story. Rental properties have unique advantages that allow you to reduce your tax burden through not only your expenses but also through a mechanism known as depreciation and recent changes in the tax laws have made rental property depreciation even more advantageous by utilizing a mechanism called segregation of Assets. Also, I mentioned the creativity part of investing in my first blog. Next time I will dig into the concepts of depreciation, segregation of assets, capital improvements vs. repair/maintenance and finally strategies to creatively tailor an investment to your specific goals.
Until next time
Broker Owner of Cygnus Great Lakes....