How to Evaluate Investment Property Future Cash Flow Performance with a Proforma

A Proforma Income Statement (or proforma) is a proven way for real estate investors to evaluate the future cash flow performance of investment properties. Better than an APOD (which merely shows a property’s cash flow for the first year), proforma income statements enable investors to project-then-evaluate the investment real estate’s cash flow, tax benefit or losses, sales proceeds, and key returns out over a number of years.

The method is straightforward. The proforma starts with a property’s financial data in the first year then applies a set of variables to make projections for the second year, then repeats the process for the third year, again for the fourth year, and so on; in each case, always applying a variable (of your choice) to the previous year in order to compute the revenue projections for the following year.

For example, if last year’s income was $30,000, the operating expenses $12,000, and the net operating income $18,000 ($30,000 income – 12,000 operating expenses), 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 next year’s net operating income as follows:

*Revenue less Operating Expenses = Net Operating Income
*Revenue = $30,000 + (30,000 x .05) = $31,500
*Operating Expense = $12,000 + (12,000 x .04) = $12,480
*Net Operating Income = $31,500 – 12,480 = $19,020

The same would hold true if you expect the vacancy rate to change from one year to the next. Say, for example, that the gross scheduled income for the rental property is $40,000, the vacancy rate is 10% and the gross operating income is $36,000 ($40,000 gross scheduled income – 4,000), and you want to decrease the vacancy rate to 5% the following year. Then you would compute next year’s gross operating income as follows:

*Gross Scheduled Income less Vacancy Allowance = Gross Operating Income
*Gross Scheduled Income = $40,000
*Vacancy Allowance = $2,000 (40,000 x .05)
*Gross Operating Income = $40,000 – 2,000 = $38,000

This is 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 through EOY10). Specific variables are applied to this year’s data to recalculate the rental property’s financial performance for the next year. Including revenues, operating expenses, cash flows (before and after tax), tax liability, sale proceeds, and returns such as cap rate, net present value, and return on equity (depending on your particular proforma).

How do you create a proforma income statement?

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

2) You can use an Excel spreadsheet and manually create a Proforma Income Statement. Of course it helps to have some knowledge of Excel, and you should allow yourself plenty of time 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 project any number of future years, because it is speculative, you might not want to go out further then ten years (I wouldn’t).

4) Be sure to use realistic numbers. Start with the current income and expenses and apply reasonable variables. 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. Moreover, it makes a good presentation to other investors and lenders because it does peek into the future. You can see a sample Proforma on my website at www.proapod.com. Simply choose one of our three solutions and look at Proforma Income Statement under Reports.