The idea is to estimate the cash flows and rates of return a rental property may produce for future years by projecting its income, operating expenses, and loan payment out for maybe ten years based upon some assumptions.

The concept is straightforward. Increase the income and operating expenses annually by some estimated percentage rate to arrive at a net operating income (income less expenses), then deduct the mortgage balance owed for that particular year to compute the property’s cash flow and subsequent rates of return. The proforma income statement (or proforma) is generally the report used to project these revenues, and in this article, we’ll discuss some simple basics to give you the idea. Please feel free to visit my website if you would like to see a sample proforma.

How to Create a Proforma You can choose one of two methods. You can use a spreadsheet or you can invest in a real estate investment software solution that provides the forms and will create a proforma income statement for you.

In any case, the important thing is to start the proforma with numbers that accurately reflect the property’s current financial position, i.e., income, operating expenses, and loan payment. This will represent year one.

Next, make an estimate as to how much you think income and expenses will increase annually (use separate percentage rates for each if you wish) and multiply your starting numbers by these rates to calculate for year two, year two’s numbers again for year three, and so on out as many years as you deem necessary (ten years is typical). Be sure to include the loan repayment for each of those years.

Finally, for each year, subtract the operating expenses from the income to determine the rental property’s net operating income then subtract the loan payment to arrive at the cash flow (or more specifically, cash flow before taxes).

For a more elaborate income statement that shows cash flow after taxes, sale proceeds, cap rate, return on equity and so on, you will need to include tax information such as depreciation, mortgage interest, amortized loan points and the investor’s marginal tax rate, a projected selling price for each of the years, and a round of additional computations for the rates of return.

Start with year one and then add each of the figures to the following years. You can inflate a sales price in exactly the same manner you did for income and expenses or select another way to project a sales price such as with a cap rate, gross rent multiplier, or set dollar amount. The depreciation rate depends on whether the rental property is residential (a home rental or apartments), or non-residential (commercial use). The loan will also have to be amortized so you can determine the amount of interest paid during each year.

You can find information regarding the depreciation schedules online if you’re planning to construct your own proforma, otherwise a good real estate investment software solution will have it built in to the program and you will just have to fill in the forms.

Whether you choose to use real estate investment software or a spreadsheet, here’s what you want to keep in mind about your statement.

1) You are essentially looking to analyze the cash flow and other performance measures resulting from changes to such variables as income, operating expenses, and property value over some number of future years.

2) Because it consists of projected estimates, don’t rely solely upon a proforma income statement to make your investment decision.

3) Also, because it is speculative, you might not want to construct your proforma out further then ten years.

4) Always use income and operating expenses that are realistic to begin with and then use a reasonable percentage rate to inflate them annually. The same would be true with the projected selling price of the property.

To get a better idea about creating revenue projections for rental properties, you can see a completed sample proforma on my website. Here’s to your real estate investing success.

I have to digress a bit to property cover the next aspect of Small Business Wealth Creation. I want to show you the detrimental effects of loan amortization, how lenders benefit from it, and give you a strategy to “turn the tables” on your lender.

One of the greatest financial inventions is “compound interest.” Albert Einstein is said to have called compound interest: “The eighth wonder of the world! Those who understand it profit from those who do not.” I can not verify the source of the quote, but whoever it said it was dead right. Let’s examine amortization and how you can turn the tables on your lenders.

When the “Lowest Rate” Is More Expensive

You see, amortized loans were created by bankers and are structured so that the payments made in the early years (according to the amortization schedule) go primarily to pay interest. In the first year of a 25 or 30 year amortizing loan, approximately 3% of the monthly payment goes toward reducing the principal balance, depending upon interest rate. So for the first several years, your payments do nothing but go to your lender’s bottom line.

Thus, the typical repayment of a commercial mortgage with a 10 year call is only something like 20% to 23% of the original loan amount even though a 33% to 40% of the loan’s term has passed. So to emphasize the point, this means that the majority of that money you made in payments went into the lender’s pocket and you still have to pay back a large portion of the loan!

If you have ever taken the time to look at either an amortization schedule or a Reg “Z” Truth In Lending Disclosure, it is frightening just how much you end up paying the lender for the privilege of using his money. This is the “earning” power of amortization from the lender’s standpoint.

However, if you can pay one extra dollar in principal in the first month of a 25 year fully amortized loan at 7%, you save $141.49 in interest costs over the life of that loan! This can be verified using a simple present value calculation. (No wonder banks have their names at the top of the largest building in all of the major cities across the U.S.) So when evaluating the true cost of a loan, you need to look past the “rate” to amortization, points, and other fees. This concept is called “Total Loan Cost” and is the theory behind those Good Faith Estimates and Reg “Z” disclosures that you get when you borrow money on your home. However, typical of government intervention, almost no one short of a Ph.D. can understand the forms.

Using Debt To Save Money On Debt

There have been some recent advances in money management software that will allow you to “break the bank” when it comes to amortization. With proper money management, you can drastically reduce the lifetime cost of your loan with almost no impact on your current standard of living.

The traditional approach to reducing the overall cost of a loan is to add an additional payment per year (OK) or to add principal to the monthly payment (Better). This usually results in reducing the term of a loan by 25% to 33% depending upon the interest rate. The problems with these methods include:

1. The need for discipline in consistently paying more per year or per month.

2. Interest cost reduction is maximized in the early years of amortization, thus the gradual approach doesn’t take advantage of this aspect.

There is a company called United First Financial that offers a sophisticated web-based amortization management software program that is combined with a credit line to take extreme advantage of the amortization disparity of the early years. (In the interest of Full Disclosure, Excelsion Mortgage does represent the UFirst Money Management Account software for its clients). The program uses the credit line as a “reverse checking account” to allow you to make greater principal reductions in the early years of a real estate loan’s life without affecting your lifestyle.

The results are astounding in that most loans are paid off around years 7 to 11!

The principle is simple: The credit line is used to pay ALL of your bills, instead of your checking account. Income pays down the line, bills increase it. The software manages the timing of payments and income to increase principal reductions on the mortgage while minimizing interest expense on the LOC (line of credit). Since you can never have a negative balance on the LOC, the software tells you when it is safe to made additional payments to the mortgage based upon your spending pattern.

You can use a home equity line of credit, a business line of credit, or even a sophisticated credit card like those offered by American Express. As long as the credit line offers check writing capability with no extra fees, it will work with the Money Management Account software. You can see an example of how this program works on a $2,000,000 loan used in conjunction with a $150,000 LOC at our sister site: www.ExcelsionMortgage.com/MMA.

Now you no longer need to be the victim of Bank-orchestrated larceny! If you combine a fully amortizing loan with flexible pre-payment terms, sophisticated money management software, and a low-cost line of credit, you can be commercial loan debt free in a very short time, saving you literally hundreds of thousands to millions of dollars in interest expense. That money goes into your pocket, not the bank shareholder’s pockets. The pieces of the Small Business Wealth Creation Program are coming together. In the next article, I’ll discuss the steps that you can take to put this program together quickly and effectively.