Welcome to another episode of Passive Real Estate Investing. I’m your host Marco Santarelli welcome to the show. If you’re a new listener or you haven’t subscribed to the show yet, remember to click that subscribe button. I know there are a lot of people around the world, particularly in the United States that listen to this show and actually on a regular basis on and off, but they don’t actually subscribe. They just catch it when they catch it, it would just be great if you subscribed and listened to it on your Android or your iPhone or iHeartRadio or wherever it is that you listen that way, you just never miss an episode and it’s always there. And it tells you when the new episode has been uploaded.
Anyway, one quick announcement before we get to today’s topic, which is all about how to prioritize the calculations on a Pro-forma on a property Pro-forma. And it’s not just to prioritize them, but what does it mean? And what do I look at? What order do I look at them in? What’s important to me. I’m going to share that with you today. But before I do that, just a quick announcement, this is more of a heads up, not an actual it’s ready to go, but we are on the cusp of really seeing Norada Real Estate Funding. It will be a funding arm of our business, a separate company under the same brand that will allow you to essentially get an unlimited number of mortgage loans. So if you are hitting that 10 mortgage cap, that cap that Fannie Mae and Freddie Mac have in place that don’t allow you to have more than 10 conventional loans with them, then you are going to need an alternative source of mortgage financing. Well, what if I could provide a 30 year fixed rate mortgage at a very competitive rate, very close to and similar to the conventional loans that you can get through Fannie and Freddie? Well, that is available here now. And today, it’s just not announced. It’s not on our website. We’re still putting the pieces of the process in place here in the back office, but it will be coming out very, very soon, probably by the end of the month. If all things go well, knock on wood.
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All right, with that, let’s talk about property performance and how to prioritize. What’s being calculated on there when you’re doing your due diligence and analyzing a property, whether it be in your backyard or across the country. Now, this is an important thing, and it’s really a topic I never went too deep into in a previous episode, but I think it’s about time that I’ve made at one of our main episodes here. And this really all came from an email that I got from Corbin, who was asking me a question, essentially, an Ask Marco question.
And I thought, well, you know what? This is actually a good topic. So I’ll read you the question here. And then I will dive in. So Corbin writes in and says, when looking at a Pro-forma, there are so important calculations to pay attention, to and analyze when looking at the debt service coverage ratio, cash break, even ratio, loan, constant cap rate, et cetera, which would you rate from most important to least, for instance, I am looking at a property where the loan constant is a tad bit higher than the cap rate. However, the cash break-even point is 85% cash on cash return is 5.17% debt to service is 125%. I’ll explain these to you in a moment here. So just hang tight. Corbin goes on to say, even with all these pros, I am hesitant to move forward on my first potential deal because of the loan constant being higher than the cap rate, because of the idea that you should have a higher cap rate than the loan constant Corbin just concludes here by saying, how would you prioritize the different calculations you see on a Pro-forma? And that is really the core question that we are talking about here today.
So let’s unwrap this and peel back the layers of the onion. First of all, let’s understand what a Pro-forma is. So if you’re looking at a property and you’re looking at actual financials for this month or the previous year or year to date, those are real numbers. Those are tangible. They can be verified and proven and you know exactly what that property is doing now or what it has done in months past. That’s all well and fine. In fact, when you’re looking at a commercial property or even residential, you can look at the previous 12 months, what they call a 12 trailing, 12 months of income and expenses. Those are essentially what you see on your P&L, your profit, and loss with a Pro-forma. The word Pro-forma, I believe is Latin. I have to look this up, but it really means, and this is a loose definition, not the exact definition, but it essentially means what is to be. So a Pro-forma describes how a property could or should, or actually would be performing based on assumptions and what-if scenarios that you are making. So you have to make some assumptions in order to project out what this property is going to do for you. So the flip side is the actual reports, the true financials, the P&L’s, those are history. They’re in the books are on the books. Whereas when you’re looking forward, not in arrears or behind, when you’re looking forward, you’re looking at Pro-forma.
So this is exactly what Corbin is doing in analyzing this potential deal. He is looking at the numbers and evaluating it and essentially underwriting this deal. Now what I do and the order that I do, it depends on what my strategy is, but the order of what I look at and not necessarily in this priority order are the following. The first thing I look at just to give it kind of a litmus test or the quick sniff test is I look at the rent to price ratio or RV ratio, rent to value ratio. I want to just see what the ratio is of the monthly rent to the purchase price. Again, I like to use very simple numbers. Let’s call it a hundred thousand dollar property. If it’s a hundred thousand dollar property, I’d like to see the rent be somewhere around a thousand dollars a month. It doesn’t have to be in, especially if it’s new construction, because I know it won’t be, but if it’s 900 or even $800 a month on a hundred thousand dollar property, that ratio is okay with me. It passes that sniff test, and I can move on to doing a deeper analysis, a deeper due diligence on the property from a price perspective. I’m okay to look at properties, especially if it’s new construction on single-family, detached homes up to about 200,000 to two 25, the numbers start to break down and the returns start to fade somewhat quickly. When you get over 225 to 250,000. So up to 200,000, you’re probably fine. And then you’ll start to see things fade away and become less and less attractive as you get closer to about $250,000. Now, keep in mind, this is very much market-specific because different markets have different rates on their property taxes, which will affect your cash flows as well as how strong the rental market is in the particular area. Some might be higher than others. Some might be lower. So that plays in. That’s why it’s not an exact number, but I’m just saying, you’re typically doing well up to about $200,000. And then you have to start looking at a little closer at the numbers, especially the Pro-forma numbers. So that’s the first thing I look at now.
The RV ratio is not on a Pro-forma. That is just a litmus test. It’s a quick way to analyze a property before you go any further. If you’re going to go further, now you start looking at the Pro-forma and what you typically see on a Pro-forma is essentially what you would see on a profit and loss statement. You have income at the top, and then you have all your expenses underneath that, and that gives you your net operating income. So essentially it’s your gross operating income minus your total operating expenses leaves you with an NOI, Net Operating Income. Now that’s a key number, and we’re going to come back to that again here in a minute. But one of the reasons the NOI that net operating income is so important is because it is one of the numbers that you use to calculate a critically important number that a lot of investors look at, but I don’t necessarily put a lot of weight into. And that is your cap rate, your capitalization rate, which is essentially your net operating income divided into the value of the property. And if it’s a new purchase, then you’re dividing that into your total purchase price. And that will give you your cap rate. That could be a low 4%, could be five, could be 6, could be as high as 8% or maybe more again, that’s going to be market-specific. And more importantly, it will be area and neighborhood-specific because in the same market, that cap rate will differ and change dramatically from an A neighborhood to a B to a C and even a D neighborhood. You will see that cap rate go higher and higher as you go down into lower income and cheaper property areas. So keep that in mind. But your cap rate is really a valuation metric that allows you to compare one property to another, without the influence of having financing. There’s no leverage. It’s essentially the rate of return on that property. If you were to purchase it all cash 100% cash. So the cap rate, in that case, would be the same thing as your cash on cash return. So that’s the first thing I look at as the cap rate. It’s not the most important metric to me, but it is something that a lot of investors do consider because it gives you a quick snapshot of what the property’s Pro-forma is without any financing.
Now, when you finance the property, of course, you’re making some assumptions here on a Pro-forma to what your interest rates going to be and what your loan to value is. In other words, how much your financing could be 75% of the purchase price. It could be 80% of the purchase price, but you obviously will do a mortgage calculation to find out what your principal and interest payment is for the month in the year.
With that, once you deduct that mortgage expense, what you’re left with is your cashflow and your cashflow hopefully is positive. It could be negative, but I’m not saying it should be. I’m just saying, depending on what you’re looking at, it could be negative. You want it to be positive. So your cash flow is what’s leftover after you deduct all expenses, including your vacancy allowance and your maintenance and repairs, you budget for those things, to give you a true number, then you get your net operating income. You then deduct your mortgage expense and you’re left with cashflow. Now, when you take that cash flow and you divide that into whatever your down payment was, now you get a more tangible number, something that’s a little bit more important. In fact, one of the most important numbers, if you really want to prioritize things, especially if you’re a cash flow investor or you’re looking for immediate rates of return or immediate yield, you want to know what that cash on cash return is.
Now that could be a percentage, which is what you use in the formula to calculate cash on cash return. You can spit out a percentage, but also people look at cash on cash from a cashflow perspective, meaning in dollar terms, what is my cashflow? And that gives you that number. So to put this all in another way, it’s essentially this, how much am I making every month or every year from this property in dollar terms, you take those dollars, divide them into your down payment. And what you end up with is a percentage that is your cash on cash return. That is the yield that you are going to make or expect to make on the Pro-forma. And that could be as low as 6, 7, 8%. It could be as high as 10 to 14%. Again, depends on the market. More importantly, the neighborhood and also what your purchase price is and how much it rents for all these things come into play.
So this is more of a bottom-line number when people say, well, what’s the bottom line? What’s my cashflow. How much am I making on this property each and every year in dollar terms, not talking about equity, just in terms of real cash flows, that is your cash on cash return. That is an important metric. That is something you want to look at both in terms of percentages and dollars, because that is what you are getting paid today and right away, and this year and next year, the equity returns. Those come in time. Those build up year after year, month after month. So cash on cash return is important. That’s one of the things I would look at carefully. I pay attention to that number.
Now, the other number that’s very important that you have some control over because you’re going to shop it around, is the interest rate on the mortgage. So if you’re shopping for a 30 year fixed rate mortgage, you want to get the best rate you’re going to shop around. Honestly, there’s not going to be a lot of difference between one lender and another, you know, they can play with the numbers. You could buy down the rate so you can adjust it a little bit up or down, but obviously, you would just want to get the best rate available in today’s market and environment to keep your monthly principal and interest payment as low as possible. So that is also a key metric. Now that’s not actually on the Pro-forma, but indirectly it is because that mortgage expense that you’re deducting from your net operating income is affected directly from the interest rate. So obviously it makes financial sense to get the best and lowest rate. So we’ve talked about cap rate. We’ve talked about cash on cash return.
Now, when you start running a little deep on a Pro-forma, by the way, that’s pretty much what you’re going to find on a Pro-forma on our website with attached to each and every property, at least for the properties that we post cause a lot of the properties. In fact, most of the properties that our clients are purchasing through our network are not actually posted on our website because they don’t make it there. But for the ones we are able to post on an ongoing basis, you will see that there is a financial calculator attached to every single one. And if you look on there, we take this a little deeper. We also do an equity analysis, not just an income analysis. And again, this is Pro-forma. We are making some assumptions. We are making the assumption that on average, over the long-term, your appreciation will be X percent.
I believe we use 4% as a global variable, and you can change this yourself and modify it to run your own scenarios. But if you run this on our calculator and you can do this in a spreadsheet as well, but you’re basically saying, okay, each and every year on average, we’re going to get 4% growth price growth because of inflation because of market demand and whatever price appreciation is being pushed onto that property to grow the value. So 4% is a fair number, but when you start to look at equity growth through the lens of appreciation and through the equity growth from amortizing, the loan, meaning your tenants paying off a little bit of that principal each and every month and each and every year as time goes on, that grows by the way, this is a good time to really point out the episode I did about a month ago called The REAL Returns of Real Estate Investing.
Take a look at that episode or listen to it because I really go depth about the different ways you’re actually making money in rental property. So it’s the cash flows and you have a cash return. You have the amortization of the loan. So you have equity gain, which gives you an equity return. And then you have the market value, which grows in value through appreciation, which gives you a return on appreciation. And when you add up those three, what you find is your total return on investment. Your total ROI from those three gains ends up being in the 20’s and 30% range, if not more. So it’s an amazing thing because your cash on cash return, which we talked about a few minutes ago can be 8, 10, 12%. But when you start to look at the equity gain, even though it’s not realized that in your pocket, it’s there it’s equity growth that adds to your balance sheet, therefore it adds to your net worth.
That could be 6, 7, 8% or more. And it actually increases year after year after year. If you were just to run the numbers and pencil this out or do it in a spreadsheet, you’d see that it starts at 6% a year. It averages 13.3% over the life of a 30-year mortgage. So think about that. If you were to have a 13% rate of return on your equity each and every year, over the course of those 30 years, again, this is an annual average over the course of 30 years. Then on top of that, you have the gain or the return on the appreciation on the price of that property. That’s pretty powerful because when you add it up again, you are a very healthy, double-digit total return on investment. So listen to that episode, The REAL Returns of Real Estate Investing. Now, going back to the overarching question here, how do I prioritize the different calculations on the Pro-forma?
I guess the last one, which could be the most important for some people is that expected appreciation rate. And this is something that you can do, your due diligence and research on, or talk to one of my investment counselors about if you are looking at some of the markets that we are in, but at the end of the day, if you are investing mostly for growth, you are building your portfolio. You want to maximize your equity, growth and appreciation. You’re going to be looking at markets that have above-average expected appreciation rates, because you want to maximize that equity growth in your portfolio because you’re going to tap into that equity down the road, be it three, four, five, six, seven years down the road, depending on how fast that equity grows, because then you can redeploy that equity into more property and grow your portfolio faster.
So if I boil all this stuff down, when you look at a Pro-forma, you don’t have a lot of stuff on there, but you have some important metrics. And for me, cash on cash return and the expected appreciation rate, which is really not directly on the Pro-forma. Again, it’s your equity analysis, but those are the two things I look at cash on cash return. Usually, first it’s my highest priority item. And then the expected appreciation rate that way. I know I am making a smart investment because I’m going to have a strong appreciating investment that provides me monthly and annual cash flows. And at the end of the day, if I’m focused on growth and my cashflow nets out to zero at the end of the year, because I’ve had unexpected maintenance and repairs, I’m okay with that because I can look back and I can say, all right, well, I know what my Pro-forma said. It was what was to be expected, but it didn’t happen in this year. And my cash flows were zero or maybe a little bit negative, but I can look at the equity growth that happened through amortizing, my loan I’ve paid down the principal. And then I’ve got that growth in equity. Plus I’ve got whatever appreciation I was able to get over the previous 12 months. And that’s also a return. And so if I can keep doing that year after year, where I have years of cashflow and years of maybe low to no cash flow, but I continually grow the equity in my property that grows into a very large, stable, and equitable portfolio that I can use and tap into and convert down the road into a strategy of cash flows, where now I shift from having all this equity into a portfolio of strongly cash-flowing properties with higher cash on cash returns.
So we’re getting into the strategy weeds here, and I don’t want to go too deep down that road on this episode, but Corbin that’s basically how I look at a Pro-forma. I don’t overcomplicate it. I don’t get into the breakeven points, the debt to service ratio, because if you really have a cashflow positive property and you just follow our methodology, your DSCR or Debt Service Coverage Ratio will always be the worst-case scenario, 110% or what they call 1.1. If you’re at 1.2 or above, you’re doing well from a debt service coverage ratio, cash on cash. You know, you want as high as you can possibly get. And I don’t look at breakeven points that doesn’t even really matter to me because I am a buy and hold, long-term prudent investor. I’m buying and holding valuable equity properties in good markets in good locations that cashflow and I know we’ll have strong price growth over the long term.
That’s how I invest. And I’m not concerned if the cap rate on the property is slightly above or slightly below the loan constant. That really doesn’t matter to me because I know it will work out in the longterm. And especially today, it’s really not much of a concern because interest rates are so low. In fact, they’re still at historic lows. This is cheap money folks get as much as you can. I don’t know when interest rates are going to rise and I don’t foresee them rising anytime in the near future, but I can’t speak for three years or five years down the road. So load up as much as you can, as fast as you can. So you can control a large portfolio of income-producing real estate that will continue to build wealth for you and your family. And it will start to stack towards building a pile of cash flow in the years to come.
Okay. Thanks for the question Corbyn, and I appreciate everybody listening today.
If you have any other questions about real estate investing, just go to passiverealestateinvesting.com or click the Ask Marco button at the top, or go to AskMarco.com help us share the show with like-minded. People share this with your friends. And again, thanks for listening. And I’ll see you on the next episode.
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