Jason Hartman guides you through his process for how to read a property Pro Forma.
(0:50) Jason introduces Episode #405
(4:07) Jason plays a video on how to read a property pro forma
(16:56) Jason discusses the extremely important financial indicators section
(24:57) Find out more at www.jasonhartman.com!
ANNOUNCER: Welcome to Creating Wealth with Jason Hartman! During this program Jason is going to tell you some really exciting things that you probably haven’t thought of before, and a new slant on investing: fresh new approaches to America’s best investment that will enable you to create more wealth and happiness than you ever thought possible. Jason is a genuine, self-made multi-millionaire who not only talks the talk, but walks the walk. He’s been a successful investor for 20 years and currently owns properties in 11 states and 17 cities. This program will help you follow in Jason’s footsteps on the road to financial freedom. You really can do it! And now, here’s your host, Jason Hartman, with the complete solution for real estate investors.
JASON HARTMAN: Welcome to the Creating Wealth Show. This is your host, Jason Hartman, this is episode #405, #405. Thank you so much for joining me today. Today I wanted to talk about analyzing a real estate deal. Analyzing a property pro forma. And you know, this is really pretty easy to do. And as soon as you spend a little time learning how to do it, you’ll find that it just makes your life a lot easier. And one of the things that you must do as an investor, is standardize data. Data standardization is super, super important, because you don’t want to have to be a detective each time you’re looking at a deal. You want to keep things in the same format so that you don’t miss things. When things aren’t standardized, there’s a reason the whole world runs on standardization. Or at least the parts of the world that run well, I should say. And that’s because it works. Pilots, even very, very experienced pilots, are constantly using checklists so that they don’t miss anything. So, standardizing things is critically, critically important.
And that’s what we do. Ten years ago, when I got into the business of nationwide real estate investing, one of the first things I looked to do is figure out data standardization, so that I could look at a one-page document, and pretty much know if a deal would work or not. And that’s what I want to help you with in this episode.
This episode, I’m going to play the soundtrack of a video. But you really don’t need the video, unless you are a total newbie, and you’re not familiar with the way I present my properties to you. And the way we look at those pro formas. And you can see all of these pro formas at www.jasonhartman.com/properties. www.jasonhartman.com/properties. If you’re in the car, or you’re at the gym, or you’re taking the dog for a walk, or whatever you’re doing, where you can’t run over to YouTube and type in Jason Hartman Media on YouTube and find this video, which you can look at it later there, you don’t really need the video. You can simply listen to my explanation as I run through this one page pro forma that certainly you can see many, many of them at www.jasonhartman.com/properties. And talk to you about how I analyze a deal, and how I know if a property makes sense or doesn’t make sense.
So, that’s what we’re gonna do today, and I think this’ll be a very good fundamental episode for you, even if you have purchased lots of properties, and you’re experienced with this, you’re going to want to hear this. Because like the famous Vince Lombardi football coach said, at the beginning of every season, when it was time to start practice: gentlemen, this is a football. Famous line from him. The fundamentals; this episode is fundamental to real estate investing.
Let’s dive in, without further ado, and listen to that, and if you haven’t already joined us for our Little Rock Creating Wealth in Today’s Economy Boot Camp and Property Tour, do that at www.jasonhartman.com in the events section, and we will look forward to seeing you there and meeting you in person. But without further ado, let’s jump over to how to read a pro forma, and how to analyze a real estate deal. Here it is.
Jason plays a video on how to read a property pro forma
JASON HARTMAN: This is Jason Hartman, www.jasonhartman.com. Thanks so much for joining me for this quick video on how to read a property pro forma. So first of all, when you want to find properties for sale, and look at these great income properties, go to www.jasonhartman.com, click on properties, and by the way, I should mention, we are just rebuilding this site. It’s a little bit old. So it’s time for an update. By the time you see this video, the site may be completely different.
Here are six of our featured markets. We always have kind of our featured markets that are usually the busiest for us, where most of our investors are purchasing, shown here. So here we have Atlanta, Memphis, Indianapolis, Houston, Birmingham, and Kansas City—the Missouri side of Kansas City. And then here we have a map of the entire country. You can see that there are more markets where we have properties, if you just hover over a state. So, if you hover over Florida, you can see we’ve got three areas and six properties there. Georgia, South Carolina, Alabama, Mississippi, Arkansas, Tennessee, Missouri, Illinois, Indiana, Ohio, Texas, and Colorado.
So, you can see we’ve got than just the featured markets there. But for purposes of today, since Memphis is a city with such fantastic cash flow, I just wanted to show you a property in there. So, we click on Memphis, and sometimes our markets have a nice featured video here that gives you a little area orientation, although you’ve probably already heard that on my podcast, or from one of our investment counselors or local market specialists. But for some of them it’s there. And then we click, browse Memphis properties. And here we see a whole list of properties. And note that this is page four of seven. Page four of seven. I’m gonna turn on my highlighter here, so it’s a little more apparent. You can follow my mouse around. And here we have several properties; you see they’re organized by price in this example. And here’s the return on investment that is projected for each property. And the status—the market is moving very quickly nowadays, so many of these properties are sold, but some of them are available. Some are under contract. They’re just all different statuses.
So, I picked a property for this example. This property is in Memphis. As we’re going through the pro forma here, we see that this property is a nice looking home. It’s 1400 square feet. Memphis home built in 1980. Some little information there. Initial market value is $82,000, and purchase price is $82,000.
Now, one of the tricks I’ve seen a lot of promoters and a lot of groups play, when they’re looking at these pro formas, sometimes they use the same software we do. Mostly they don’t. One of the big things I want to caution investors for, and one of the first things I did years ago when I really got into nationwide investing, is I standardized the data. I’m a huge believer in data standardization, because then, once you learn how to read this one page pro forma that we’re going to learn right now, you don’t have to be a detective. You can find all of the basic information you need about at least the numbers side, the quantitative side of the property, right here on this pro forma. So, data standardization is absolutely critical.
One of the things I see a lot of promoters and groups doing, that I think is really wrong, is they will set the initial market value different from the purchase price. And that will make your return look astronomical. And even though some of our properties, I believe, are actually below market properties, I will not allow any of our local market specialists to represent the properties that way, because I think it sets false expectations. And besides, in our business, we’re really in the business of cash flow investing. Buying properties that make sense from day one, from the day you buy them. It’s not about appreciation for us. If appreciation happens, hey. That’s great. It’s icing on the cake. I’ll take it. But I’m certainly not depending on it as a good conservative investor.
So, speaking of which, before I even finish going through this top part, let me scroll down here and let’s look at assumptions. Assumptions is critically important, because it drives a lot of the numbers on here. And you’ll see, we have the appreciation rate, the vacancy rate, the management fees, because all of these properties are including property manager fees. So, you never get the midnight call, you know, the metaphorical midnight call that, by the way, on my self-managed properties has never happened to me, in over 20 years, I just must mention that. You’ll never get that, because your property manager is managing the property for you, and the tenants don’t even know who you are. And the maintenance percentage, showing that we’ve got maintenance.
So, here are the assumptions that this pro forma is using to drive some of its stats. And we’ll get back to that in a moment. But I just want to mention it now. we’ll get back to why the assumptions are the way they are in a moment. We’ve got the down payment. Now, here is the mortgage info section you see over here. You see the mortgage info section. This is, of course, subject to qualifying for the loan. But in this pro forma we’re assuming 20% down, 80% loan to value. That would mean that you would need about $16,400 down. Then you have some closing costs. And I want you to note, the closing cost will vary depending on your lender and the type of loan program you choose. So, those vary, and those also have some impact on your interest rate, where it’s really a game where the borrower can make the decision between, do they want a lower rate or a higher rate? And that will affect the closing cost. Talk to your lender for details on that. And of course, we have lender referrals available for you as well.
Now, if the property wasn’t rent-ready, if it wasn’t a turnkey property, you see where it says other closing costs and fix up costs? Here it says $0, because this is a turnkey property, so it’s ready to rent the day you close on it. And some of our properties are even pre-rented, where there’s a tenant already in them. But some are not. So that varies. But this one—no fix up cost. Occasionally, not often, we have properties where the buyer does their rehab on the property, the investor does that, after they close on the property. So, in that case, it might show $10,000 in rehab or fix up costs here. Total initial cash invested here is projected at just over $20,000, and that’s based on qualifying for this loan, the cost per square foot on this property—I always want you to look at cost per square foot, because that’s a really neat thing. You know that I talk a lot about something I call regression to replacement cost.
In my risk evaluator I talk about buying at or below the cost of construction, and why that’s important, and basically getting free land in the deal, so that you can minimize your risk. I don’t like high land value markets at all. Those markets have proven historically to be very risky. And if at all possible, I want to buy below the cost of actual construction. We can see here that this property is only $58 per square foot, and I would venture to guess that you can not build the property for that price, for $58 per square foot. It will probably cost you, at a minimum, and this of course varies by area and construction quality and the builder and so forth. But at a minimum, you’re probably looking at about $70 per square foot, plus the cost of the land. So, I like cheap or free land, and I like all of my costs to be in the improvement, or the house, sitting on the property. Because that dramatically lowers my risk. For more on that, listen to the podcasts that I’ve done at www.jasonhartman.com, or iTunes, or Stitcher Radio, where I talk about how to minimize risk when investing. It took me 19 years to discover that. And it is truly new thinking, in terms of investing, and I think it’s very, very helpful.
Monthly rent per square foot—that’s kind of interesting. This one’s projected at $16. However, we don’t pay a ton of attention to that one. As we look down here, we can see that the projected rent on the property is $975 per month. Now, the annualized numbers are here, but in commercial real estate, most investors talk about annualized numbers. And for some reason, in residential they mostly talk about monthly numbers. It all boils down to the same thing at the end of the day. And you can see the vacancy losses here. That’s driven by the vacancy rate down here, that we require our local market specialists to put in at least one month per year. Or about 8%. So, you see how we have vacancy losses. Then we have operating income.
Moving down the sheet, we have property taxes, and again, these are estimates by the local market specialists. We make them put in all the data so that they’re representing it. No one knows the market better than they do. But again, things can vary a little bit, so, you know, we always recommend that investors ask a lot of questions, check things out. We teach a whole program on due diligence and all of that stuff. That’s not what this one is about. We’re talking about how to read the pro forma, so I’m gonna try and stick to that and focus on it. Insurance is pro forma’ed at $37 per month. Management fees—now, management fee is driven by the assumption here, which in this case is 8%. So, 8% of your rent every month of this $975 totals $71. See how that works? And then leasing and advertising fees, and association fees—those are both zero in this case, with this property. Maintenance is driven by the assumption down here of 3% per month. So, 3% of your rent every month adds up to about $29 in maintenance fee. Operating expenses total, right there, $247.
Going down we’ve got our net operating income, $649 per month, we’ve got our mortgage payment—how is that calculated? Right here it shows the type of loan that we’re talking about on this property. And then, we’ve got our cash flow here, is positive cash flow, projected at $296 per month. Or, almost $3600 per year! Pretty darn good. Principle reduction, see our tenant is paying off our mortgage for us every month. That’s a beautiful thing. $80 per month, paid by our lovely tenants, or almost a thousand dollars annually. Our first year appreciation here of $410 is driven by the real estate appreciation rate assumption, at 6% annually. If you look at appreciation rates, historically, you’ll see that over many, many years, 6% is about the commonly considered average. Of course you can slice and dice this about a thousand ways, because it depends on the market. That’s a national number. It depends on the exact period, because it’s an average.
So if you average just the last few years, well, if you start at the financial crisis, that would have been devastating, because real estate depreciated. In some places a lot more than others. Then it started appreciating, about three years ago or so at the time of this recording, and it’s had some fantastic appreciation since then. You know, it depends if you look at new homes, or resale homes, and all kinds of different things. but, generally speaking, the accepted number is about 6% annually. And look. Keep in mind, we don’t invest for appreciation anyway. We invest for cash flow. We want yield. It is all driven by yield, in our mind. Being the conservative investor, you invest for cash flow. If you’re a gambler, you invest for appreciation.
So, there, we’ve got some additional numbers. Now, none of these—we don’t pay too much attention to gross equity income. We’re not going to address tax savings at all in this pro forma discussion today, because that’s a fairly complicated issue. We have addressed it on many of the podcasts on the Creating Wealth Show at www.jasonhartman.com.
Let’s go over here. We talked about the loan assumptions. One thing I do want you to know, is that interest rates for investment properties are a little bit higher than they are for owner occupied properties. And we always try to get our local market specialists to be a little bit conservative on this number. In other words, estimate a little higher than it’s probably going to be. But the interest rate varies based on the closing cost you pay, and the type of loan you choose, and your credit score, your ability to qualify, etcetera. But just know that for investment properties, the rate is a little bit higher.
Jason discusses the extremely important financial indicators section
JASON HARTMAN: Financial indicators. This is a very important section. I really want you to pay attention to this particular section quite a bit. So, the first one is, debt coverage ratio. With the debt coverage ratio, that’s the number that, had a lot of investors paid attention to it, the financial crisis, or at least the mortgage meltdown crisis, may have never actually happened. But investors weren’t really investors; they were gamblers, and they were doing a lot of silly things. They weren’t paying attention to debt, they weren’t paying attention to income on the property, they were just investing based on the Greater Fool Theory, and the Greater Fool Theory goes like this: no matter what I pay for the property, some greater fool will come along and pay even more. That is not investing, my friends. That is gambling. That is speculating. And it’s stupid. Okay? So, don’t do that. Let’s invest, let’s invest conservatively, let’s invest for cash flow. Cash flow, pretty darn reliable. Appreciation, very unreliable. Very, very fickle.
So here you see the debt coverage ratio on this property is excellent. It’s 1.84. Meaning, you have positive cash flow here! Of about $300 per month, almost, or almost $3600 per year, based on this pro forma. That debt coverage ratio is excellent. You’re very unlikely to get into any trouble with this property. You would have to have a lot of vacancy problems, collection problems, repair problems, just be a bad landlord, have a bad property manager. You’d have to have a whole host of problems to mess this one up. So, this property looks pretty darn good. Gross rent multiplier, both monthly and annual—we don’t pay too much attention to that. Not really that meaningful. It is kind of a nice rule of thumb, but if you want to have a rule of thumb number, the one I would rather have you use is the RV ratio that I talk about a lot, or the rent to value ratio. I always say that a good rent to value ratio is about 1% per month. So here we’ve got an $82,000 property, and the rent is projected at $975 per month. That’s more than 1% per month. Because if it was 1% per month, an $82,000 property would rent for only $820 per month. And here, you’re in pretty darn good shape. So, I like this property quite well. 1% is ideal; sometimes you even do a little better. Rent to value ratios are getting worse as properties appreciate, because remember, prices go up a lot faster than rents go up, historically speaking. So, great property here. I really like this one.
Capitalization rate, or, cap rate, as it’s known, is commonly used with commercial real estate investors. I think it is a relatively flawed metric, because it doesn’t take into account a couple very important factors. Number one, it doesn’t take into account appreciation, and number two, it doesn’t take into account leverage. Remember that acronym, real estate is IDEAL? Well, the ‘L’ in the word IDEAL stands for leverage. And the ‘A’ stands for appreciation. Cap rate completely leaves those two very important metrics out. Now, the reason you might be asking, why is it such a big deal in commercial real estate? Why does everybody say, you know, it’s an eight cap, or it’s a six cap, or a four cap, or whatever the cap rate is, when they’re talking about commercial real estate? Well, the reason I believe they say that is number one, real estate in the commercial category does not appreciate as well as residential real estate. Why is that? Because it’s based mostly on income. And I’ve leased many commercial properties over the years for my companies, and the typical commercial lease will include rent increases based on the Consumer Price Index, the CPI.
And as you know, I believe, and many other people agree with me on this, that the CPI is understated intentionally by the government. Two major reasons for that. Number one, all the government spending, and the government entitlement programs, and the government employee wages and salaries, are indexed, typically, to the CPI. The Consumer Price Index. So, if that is understated, then the government can save some money. Number two, main reason, there are others, but big reason, is that they want to keep the populace happy. They want to keep the electorate happy. And if we believe inflation is really high, we’re not likely to vote the incumbents back into office and let them keep their jobs. So they want to fool us into believing inflation is lower than it is. And they do this in many ways that I’ve talked about. Weighting, substitution, hedonic indexing, etcetera. Lots of information on that on the podcast, and at my live seminars.
So, the cap rate on this property is 9.5%. That is an excellent cap rate. On a commercial property, you typically wouldn’t see that high a cap rate. Occasionally you will, but 9.5%—excellent cap rate. Even though I don’t really like the cap rate metric, and I don’t really pay a whole bunch of attention to it. It’s okay, but it’s limiting. One that I actually like better is this next one: cash on cash return. Cash on cash return is better, because what it says, is that as long as you maintain the same income and expense ratio on the property, the property could go to zero in value. It could be cut in half in value. This $82,000 property could be worth only $41,000, just half that amount, a few years from now, but as long as you receive $975 per month, you maintain the same expense ratio, you are going to earn 18% annually on your property. That is phenomenal. As I always say, even if it only goes half as well as projected, in this case, you’re still going to get 9%. That’s pretty darn good.
The total return on investment—this is the metric that considers everything, and it’s kind of debatable that it doesn’t even consider inflation-induced debt destruction, which is another subject I’ve talked about in detail on the podcast. But, this overall, or total return on investment, includes everything on the pro forma, and here you can see it’s projected at 46% annually. Now, you may be thinking, wow. This is too good to be true. The reason that is possible, and the reason that income property, especially residential income property, has created millions of wealthy people, and made lots and lots of money for decades and decades, historically, for people, is that it is a multidimensional asset class. And because it’s a multidimensional asset class, unlike gold and silver that’s just one-dimensional—you buy it and hope it appreciates in value—or stocks, most of which are one-dimensional—buy low, sell high—dividend-paying stocks, two-dimensional. Buy low sell high, but also get some dividends in between.
Income property is multidimensional in all of those ideal ways! Income, depreciation, as a tax benefit I mean depreciation, assuming you qualify for it, appreciation, equity, and leverage! So, all of these great benefits are offered in a multidimensional asset class. That’s why the returns can be 46% annually. They can be 20% annually. 25% annually. Even if it only goes half as well in this example, 23% annually. Which I think would make most investors pretty darn happy.
ANNOUNCER (FEMALE): I’ve never really thought of Jason as subversive, but I just found that’s what Wall Street considers him to be!
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ANNOUNCER (FEMALE): If you want to be able to sit back and collect checks every month, just like a banker, Jason’s creating wealth encyclopedia series is for you.
ANNOUNCER: This show is produced by the Hartman Media Company. All rights reserved. For distribution or publication rights and media interviews, please visit www.HartmanMedia.com, or email [email protected]. Nothing on this show should be considered specific personal or professional advice. Please consult an appropriate tax, legal, real estate, or business professional for any individualized advice. Opinions of guests are their own, and the host is acting on behalf of Platinum Properties Investor Network, Inc. exclusively.
Transcribed by David
The Jason Hartman Team