Using a Proforma to Evaluate Investment Real Estate Future Performance

A proforma is a useful way for real estate investors to evaluate an investment property's future cash flow performance. Unlike an APOD, which merely gives a snap shot of the property's first year cash flow, proforma income statements look at revenue and expense projections typically up to ten years, enabling the investor to evaluate the investment real estate's cash flow, tax benefit (or loss), sales proceeds, and other financial projections.

Pro forma income statements are generated by looking at the financial performance of the rental property the year before and then using a variable to make projections into the future.

For example, if last year's income was $30,000, the operating expenses $12,000, and the net operating income was $18,000 ($30,000 - 12,000), and you would like to determine next year's net operating income in the event revenue increases 5% and operating expenses increases 4%, you would compute as follows:

Revenue (next year) less Expenses (next year) = Net Operating Income (next year)

Revenue (next year) = $30,000 + (30,000 x .05) = $31,500

Expense (next year) = $12,000 + (12,000 x .04) = $12,480

Net Operating Income (next year) = $31,500 - 12,480 = $19,020

In other words, now you know what net operating income (NOI) you can expect the property to generate in the event that next year, the property's rental income increases (inflates) 5% and its operating expenses increases (inflates) 4%.

This is the essentially the pattern for each year in the proforma, starting with the end of year one and extending out through the end of year ten (i.e., EOY1, EOY2, EOY3, and so on up through EOY10). This year's data is inflated by some variable to compute next year's data.

Moreover, its exactly the same way the computations are made each year for the other returns such as cash flow before tax (CFBT), cash flow after tax (CFAT), sale proceeds after tax (generally requires an inflation rate for property value), cap rate, return on equity, and other returns provided by your specific proforma. Rates of return are recalculated annually according to the changes made to the property's income, operating expenses, and resale value.

How do I create a proforma income statement?

1. Software You can invest in a real estate investment software that will automatically create a proforma income state for you. Bear in mind, however, that software solutions tend to vary and whereas one might include computations for tax shelter, another might not.

2. Manually You can use an Excel spreadsheet to create a Proforma Income Statement. In this case, it helps to have some knowledge of Excel, and you should allow yourself several hours to create a good proforma.

Whatever method you choose, though, real estate investment software or a spreadsheet, here are a few important considerations to keep in mind about your statement.

1. Consider what you are seeking to accomplish with the proforma. You want to analyze the cash flow and other performance measures resulting from changes to such variables as income, operating expenses, and property value over future years.

2. The pro forma is just an estimate (a guess). Do not rely solely upon a proforma income statement to make your investment decision.

3. Though a proforma can be constructed to reflect any number of future years, it is speculative, therefore you might not want to project out further then ten years (I normally don't).

4. Be sure to use realistic numbers. Start with the current income and expenses and inflate them annually by a reasonable amount. Don't inflate income 10%, for instance, when 2-3% has been normal for your market over the past several years.

As stated earlier, a proforma is a good way for a real estate investor or analysts to evaluate the future financial performance of investment real estate. Whats more, because it does look into the property's future performance, a pro forma makes a good report to present lenders.