How To Tell If A Real Estate Deal Is Good Or Not

Note: This is Chapter 3 of an entire guide of How To Buy Your First Investment Property.

When you see a property, in-person or virtually, you'll start to have instant opinions on each property. One property might have an amazing surface value, but deep problems in the renovation. Ultimately, a beautiful property might not look good from a financial standpoint.

This chapter is focused on how to evaluate properties based on the numbers (finances).

The Pro-Forma

💡 Definition

Pro-Forma

A Pro-Forma is a financial statement used to analyze investment properties that gives approximate projections of anticipated income and expenses. However, it typically does not show operating numbers.

Pro-Formas are always going to be the first step in looking at the financial aspect of an investment home. The selling agent should be able to provide this information to you as a potential buyer. However, note that many pro-formas change in structure even from the same agent as the houses are different. But this becomes less important if you understand the foundation components.

The breakdown of the numbers:

All of the numbers below are typically found on a pro-forma, but as noted before, they sometimes change structure.

1. Price — The expected purchase price
2. Cash-on-Cash (CoC) return — the annual cash flow divided by the downpayment
3. Count of Units — this refers to the number of bedrooms, square footage, bathrooms, and other home details
4. Income — total income from a unit
5. Vacancy Rate — the expected percentage decrease in rent due to a vacant property not being rented by a tenant
6. Other income — rent not coming from the unit (i.e. parking, etc)
7. Reserves — money that is set aside for capital expenditures (CapEx) or repairs
8. Net Operating Income (NOI) — total operating income minus the total expenses of the property
9. Levered Cash Flow — the cash flow of the property minus all expenses including mortgage and interest payments

The pro-forma should be the first step taken to understand a property's finances to make sure that it makes sense with your investing strategy.

Analyzing a Pro-Forma

Now that we have an understanding of what a pro-forma is and the key components, we can understand the information and make it into actionable items that can be used to analyze the property. This section becomes a bit more thought-driven, so it may take time for you to analyze a pro-forma.

Note: In the beginning, analyzing a pro-forma takes significant time. Don't worry as you'll get better at it over time, and you'll learn exactly what you are looking for as an investor.

1. Income— Look at the historical income to figure out the monthly rental income. Then figure out what the area or house should be renting out for. Can you increase the rental price while still remaining competitive in comparison to similar rentals in the area?
2. Vacancy— Look at what they put down for their vacancy rate and compare it to the competitive vacancy rate in your area. Is this a factor of low rental income? Can it be reduced?
3. Other Income— Can you add income in other areas? In the case of multi-unit properties, it's common to have central laundry units that could add potential income.
4. Expenses— Do the expenses make sense? Can they be lowered? Are they concentrated in one area (i.e. maintenance) that could be an indicator of issues?

Creating the Action List

By this point, you'll have an understanding of the important financial operating aspects of your home. And now is the fun and more creative part.

You will want to look at the numbers and the possibilities to increase income and/or decrease expenses. In an ideal scenario, there would be multiple action items that you could do to do both increasing the potential upside of investing in the property.

For example, a property might be currently rented out for below market value in comparison to other properties. This means that rent could potentially be increased to increase income. Another example could be that you could increase the value of a property by performing more extensive renovations, which will then defer maintenance that might add into your expenses later.

Below, you'll find a few of the questions you should ask yourself when creating your Action List.

• Do the tenants pay for water and other utilities?
• Can you increase income via extra amenities?
• Would adding improvements like double-pane glass, new flooring, and more increase property value and rental income?
• Can you make the house look more presentable to make it more competitive (nicer garden, new paint, etc.)?
• Can the house be added to (additional units, more bedrooms, etc.)?
• Can you find a better tenant that is likely to stay longer and pay consistently?

This list is obviously not exhaustive, but would be a good starting point for you!

Conclusion

At the end, after analyzing 10 different pro-formas, you might only come out with 1 that you truly like and resonate with. It's time to make and pursue the deal!

To recap,

1. Get the pro-forma from the selling agent.
2. Analyze the pro-forma and look for key components.
3. Decide what your Action List would look like if you were to purchase.
4. Out of many pro-formas, decide on the properties you want to pursue.

The next chapter will be focused on how to approach the deal, making offers, and more!