To properly develop a pro forma for an income producing property you simply must make assumptions. These assumptions will help to calculate your property’s cash flows in to the future. You may also need to use assumptions to build your property’s current operating budget since, if your potential target property is not on the market, you probably do not have exact budget numbers. Without knowing the current operating budget, you need to use assumptions to calculate your property’s cash flows today, after which, use more assumptions to project your property’s cash flows in the foreseeable future.
To be able to start your pro forma, you simply must input or calculate your property’s Net Operating Income (NOI), which is the property’s operating income minus operating expenses. If you do not have exact figures for the property’s operating income and expenses, which is the situation for many real estate property deals, you will have to estimate them using assumptions determined by market information and standards. Solid, realistic assumptions need to be the foundations of your good real estate pro forma. The most typical assumptions you will need to generate NOI are rental rates, expenses rates and vacancy rates.
For rental rates and vacancy rates, you should employ the average rental rate for similar buildings inside your market area, usually quoted as dollars per net square foot for rental rates and also a percentage for vacancy rates. For expense rates, you should estimate the entire annual operating expense, usually in dollars per net square foot. These are expenses important to operate the property, for instance; electric, water, landscaping, maintenance, etc., in addition to taxes and insurance. Each industry sector and lease deal can have different assumptions. For instance, retail and industrial leases are usually triple net (NNN), meaning the tenant pays all operating expenses; therefore, this assumption would be negligible for the landlord. In case your property is an apartment or office building, you must assume you will have to pay some in the operating expenses.
Once you have generated your property’s current NOI, you may then use assumptions to project cash flows in the future. This is commonly done by using inflation. Inflation is the assumed rate by which earnings will grow over a period of time. It is usual in a real-estate deal to assume inflation of NOI is going to be generally near to the CPI (Consumer Price Index), or general inflation or your existing market. If your inflation assumption is just too high, the compound effect will greatly exaggerate your future cash flows and provide an incorrect valuation of your respective property’s future value. It is vital to not over-estimate your inflation assumption.
Once your assumptions are input and your pro forma is created, it is important to run sensitivity analysis on all your pro forma assumptions. Sensitivity analysis is performed by changing each assumption (up and down) and understanding how those changes in each assumption affect your pro forma outputs, such as IRR and NPV. Sensitivity analysis can help to pinpoint the assumptions that are critical to your pro forma.
For more advice and tips on building real estate pro forma models and excel templates, please check out the Pro Forma GURU: Guide for Real Estate Investing at www.ProFormaGURU
