The first task in any investment real estate decision is to build a real estate proforma, which is just a word that means cash flow projection. In this post we will look at a numerical example of a real estate proforma, and then explain each individual component common to all real estate proformas.
Real Estate Proforma Example
The following is a numerical example of a real estate proforma. This shows a ten year cash flow projection similar to what would be used on a regular basis by investors, developers, brokers, lenders, and appraisers.
Potential Gross Income (PGI)
The top line item in the proforma consists of the cash that could be generated if the property were 100% leased. Forecasting Potential Gross Income is a function of both contractual lease terms, as well as market rents. First, for all of the contractual leases in place on the rent roll, the cash flow for each lease is calculated for each year in the holding period. This takes into account the lease terms specific to each tenant.
Second, if there is any period of time in the holding period not covered by a contractual lease, market rent is forecasted to determine cash flow that could be generated given the then prevailing market conditions. Projecting out potential rental income will often involves accounting for renewal assumptions after a lease expires. This includes forecasting market leasing commissions, tenant improvements, abatement, reimbursements, etc.
Vacancy Allowance
Because it’s not realistic to assume a property will be 100% leased forever, the vacancy allowance line item on a real estate proforma accounts for expected vacancy of the property. Vacancy can be calculated in several different ways, including taking a simple percentage of the potential rental income, or using a total dollar amount for each year in the holding period. Other, more advanced ways of accounting for vacancy include calculating downtime between leases, and taking into account prevailing market conditions.
Other Income
Other income items typically show up on the real estate proforma after vacancy allowance. Other income items usually aren’t a part of contractual leases, but still provide additional revenue for the property. Examples of other income items include billboard, laundry, parking, or antenna income.
Effective Gross Income (EGI)
Subtracting the vacancy allowance from potential rental income for a property, and then adding in any other income items, results in what’s known as the Effective Rental Income.
Operating Expenses
The next major category on the real estate proforma is operating expenses. Common expense line items include property taxes, property insurance, property management fees, and utilities. Often Class A tenants will have so-called net leases, where the tenant pays all or most of the operating expenses. Other times, landlords will negotiate reimbursements where the tenant is required to pay a portion of the operating expenses each year.
Net Operating Income (NOI)
The Net Operating Income is derived by subtracting all operating expenses from the Effective Gross Income for a property. The NOI is perhaps the most widely used indicator of cash flow for commercial real estate. However, it is important to note that the NOI ignores irregular expenditures like leasing commissions, tenant improvement allowances, and some capital improvement expenditures. Accounting for these items in the Before Tax Cash Flow indicator results in more accuracy.
Other Expenditures
Other expense items associated with a property that are specific to the investor, or that don’t occur on a regular basis are included here. Examples include debt service, leasing commissions, tenant improvement allowances, reserves for replacement, and some capital expenditure items.
Before Tax Cash Flow (BTCF)
Netting out any other expenditures items from the Net Operating Income results in a Before Tax Cash Flow for the property. This gives a clear picture of free cash flow available to the owners of a property, before taxes.
Reversion Cash Flows
In addition to forecasting the operating cash flows using the above proforma line items, the reversion cash flow, or net sales proceeds, must also be taken into account on a real estate proforma. The reversion value can be estimated in a number of different ways, including taking a terminal cap rate and applying it to that year’s NOI, or applying a percentage of growth method to appreciate the property over the holding period. After a sales price is forecasted, any outstanding debt is netted out, as well as selling costs and taxes, to arrive at a net sales proceeds figure.
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Robert,
Thanks for the post. I thought the chart example was very easy to understand. I now have a better understanding of real-estate performa’s and will use this example to practice some of my own.
Cheers!
Chris
Excellent article and outline. Thank you for your contribution
Thanks for the article Robert.
On the (BTCF) section you stated – “This gives a clear picture of free cash flow available to the owners of a property, before debt service and taxes.”. But doesn’t the BTCF include debt-service?
Good catch, this has been updated.
Good article. You gave an effective definition of pro forma, stating that it just means cash flow projections. A good definition for people to “get it”, Pro forma is a Latin term that originally meant “for the sake of form”. Usage was updated somewhere along the way to “for the sake of reduction to writing”. In today’s world, it is mostly thought of just as you described it. Good job. This is just the anal part of me yakking.
So when we are doing DCF Analysis on a property, do we use the NOI as our cash flow or the BTCF as our cash flow?
Depends on what perspective you want to do for the analysis. NOI would be used at the property level (used for market value). BTCF or ATCF would be used at the owner/investor level (used for investment value) since it deducts owner specific expenses (mortgage, tax, etc.).
Interesting writing . Incidentally , if your company is interested a IL Power of Attorney for Property , my family discovered a sample version here
http://goo.gl/z0CgrbI understand each of the cross-references in the article and the sample sheet except for the BB&T. It’s a fairly large amount, and with BB&T being a financial institution of some size, I am thinking that this item is debt service. Can you confirm that for me please.
Yes, the BB&T line item is the bank loan.