Back to Basics: Deal Evaluation
How do you know if a deal is a “good one” or not? There are so many factors to consider, it can be overwhelming at times. This is probably why you see so many people touting certain investing rules or formulas, like the 1% rule, the Golden Formula, minimum cap rate requirements, etc. While these can be helpful guides, to me they leave questions unanswered.
How does this investment fit into your financial goals?
How will it impact your life?
What will you lose by doing it and what will you gain?
Especially for women, real estate investing is part of an overall plan, and it’s imperative to ensure the investment is not only sound on its own, but fitting in your life.
The Portland Women Investors October 2023 meetup was focused on answering those questions. In my opinion, the best tool to start to answer these questions is the proforma. Proformas can be as simple or as complicated as you want them to be, but every proforma should have some key metrics. Let’s start with some important terms:
Financing terms:
% Down: this is your down payment on the property. While it’s typically cash that you have on hand, you can sometimes borrow against your retirement accounts, use a HELOC, or take out private money to get this cash. When using borrowed money for your down payment, make sure that is appropriately accounted for in the proforma as that is additional debt that will need to be returned.
Amortization: the period which your loan is amortized for (meaning, your payment is determined by dividing the total amount owed of this period of time). Keep in mind that this is not necessarily the duration of the actual loan nor does it factor in changes in interest rate.
Interest rate: the rate you will pay on the money you have borrowed.
Cap Rate:
The capitalization rate is a point of reference often used on larger scale multi units (in my opinion it is not a great metric for 4 units or less).
Cap rate = NOI/Purchase Price
Note: The cap rate does not include your financing costs, as those will change person to person and this metric is designed to remain consistent across properties, regardless of financing.
Debt Service Coverage (cash flow coverage): the amount of cash left over after the debt has been paid, shown as a ratio. Banks typically want to see 1.2 minimum.
Return on cash: I always like to understand the return on the cash I invested as part of my down payment, especially when evaluating whether it’s the right investment (could I make more by doing nothing? By putting my money in a HYSA or the stock market?). This is done by dividing NOI/Down Payment.
Key Aspects of a Proforma:
Financing: this is perhaps the most important, and variable, part of your proforma. These numbers must be accurate for you to fully understand your investment. The key parts of your financing (aka mortgage cost) must include your % down, amortization period, and interest rate.
Present & Future Analysis: the key to a good analysis is to understand what the investment will be at the time of purchase, but also at other moments in time. What will it look like in 1 year? 5 years? Are you accurately reflecting both rental rate increases and increase in expenses each year? I typically have at least 3 sections - one with what the investment is now, then at the 1 year mark and 5 year mark.
Income: What are the current rental rates? Are these reasonable? What could or should they be? Are there income streams not captured; for example is laundry income or parking accounted for?
Expenses: Do the listed expenses pass the “straight face” test? Are there basics accounted for? How can expenses be optimized (for example tenants pay their own utilities). Are all expenses accounted for, even if they don’t feel relevant right away (for example, is there a property management line or snow removal line, even if you plan to do those yourself)?
Tips for mastering your proforma:
Practice! Start to build a “scorecard”. When potential investments come online, make a spreadsheet of their numbers so you can start to gauge what seems reasonable and what seems out of whack (especially when it comes to expenses).
Play around with your spreadsheet; see how a deal changes with different % down, interest rates, or amortization schedules.
Link your cells: when building your proforma, link the cells together so that if one aspect changes, the rest automatically follows suits.
Double (and triple!) check your work! One typo can drastically change the outcome, so confirm your work is accurate.
If you’d like to see an example of a proforma, I am always happy to share! If you’d like to book a session to get more detailed help building your own, you can do that here.
**As always, I am human and can make mistakes. Please consult professionals for any specific advice about your situation.**