The Investment Pro Forma That Doesn't Add Up
A client, Ms. Roy, is considering a four-unit residential building listed at $1.85 million. The listing's pro forma shows: gross rents $96,000 per year, vacancy 3%, operating expenses $24,000, and a 'cap rate' of 5.2%. Ms. Roy plans a 65% loan-to-value mortgage at 6.2% interest, 25-year amortization. She will use $200,000 of her own cash and needs the property to cover its debt service from rents. The listing's expenses exclude property taxes of $14,000 and a management fee of 4% of gross rents. Ms. Roy asks her agent, Theo, whether 'the numbers work.'
1. Rebuild the income analysis using the listing figures plus the omitted expenses, and calculate net operating income and the cap rate on the asking price.
Read the worked answer
Start from the listing and correct it.
Gross potential rent: $96,000 Vacancy allowance (3%): $2,880 Effective gross income: $96,000 − $2,880 = $93,120
Operating expenses:
- Listing expenses: $24,000
- Property taxes omitted: $14,000
- Management fee 4% of gross rents: 0.04 × $96,000 = $3,840
- Corrected total: $24,000 + $14,000 + $3,840 = $41,840
Net operating income (NOI): $93,120 − $41,840 = $51,280
Cap rate on asking price: $51,280 ÷ $1,850,000 = 2.77%
The listing's 5.2% is not supportable. Working backward, a 5.2% cap on $1.85 million implies NOI of about $96,200, which is close to gross rent and impossible after expenses. The listing likely used gross rent or omitted taxes and management. Theo must tell Ms. Roy the advertised cap rate is wrong and show the corrected math.
Note on what cap rate means. Cap rate is NOI divided by price (or value). It is an unlevered measure and ignores financing. Comparing the 2.77% to market cap rates for similar four-plexes (say 4% to 5%) suggests the asking price is high relative to income, or the rents are below market and could be raised.
2. Calculate annual debt service on the proposed mortgage and determine whether the property covers it from rents.
Read the worked answer
Loan amount: 65% of $1,850,000 = $1,202,500 Rate: 6.2% per year, 25-year amortization, monthly payments.
Monthly payment using the amortization formula P × [i(1+i)^n] ÷ [(1+i)^n − 1], where i = 0.062 ÷ 12 = 0.0051667 and n = 300:
- (1+i)^300 ≈ 4.694
- Payment ≈ $1,202,500 × [0.0051667 × 4.694] ÷ [4.694 − 1]
- ≈ $1,202,500 × 0.024252 ÷ 3.694
- ≈ $1,202,500 × 0.006565
- ≈ $7,895 per month
Annual debt service: about $94,740.
Coverage from rents: NOI is $51,280. Debt service is $94,740. NOI covers only about 54% of debt service. The property does not come close to covering its mortgage from rents; Ms. Roy would have to fund roughly $43,460 per year from other income.
Debt service coverage ratio: $51,280 ÷ $94,740 ≈ 0.54. Lenders typically want 1.20 or higher. On these numbers the lender will likely decline or require a much larger down payment.
Cash flow after debt service: $51,280 − $94,740 = −$43,460 per year before tax. On $200,000 of equity, that is a negative cash-on-cash return of about −21.7%.
Conclusion. The property does not meet Ms. Roy's stated requirement that rents cover debt service. Theo must say so plainly. Options include a lower price, a larger down payment, higher rents, or a different property. Ms. Roy should also stress-test at a higher interest rate and a higher vacancy rate.