The success or failure of a real estate investment ultimately depends on the property’s ability to produce revenue. Therefore real estate investors are always interested in making cash flow projections on any investment property they are evaluating as a potential investment.
Okay, but let’s start at the top.
Rental properties are subject to a flow of funds whereby money comes in and money goes out. When more money comes in from the property than goes out the result is a “positive cash flow” that benefits the investor. Likewise when more money goes out than comes in the result is a “negative cash flow” that regrettably means the investor must “feed the property” with personal cash to make up the deficiency.
Understandably then, prudent real estate investors seek to know whether the property will produce enough cash to pay its bills over time. Even if the investor decides that the investment is worthwhile enough despite its negative flows (because they are brought front and center during the evaluation) they can be anticipated and therefore are less likely to blindside the investor later after the purchase.
The two reports investors commonly rely upon in their rental property analysis for cash flow projections are the APOD and Proforma Income Statement. Let’s consider the strengths and weaknesses of both.
An APOD (annual property operating data) is a mini income statement that is helpful to real estate investors because in a concise manner it reveals the income, expenses, and cash flow for the first year of ownership and therein acts as sort of a “first-glance-look” at the property’s financial condition for the investor.
The shortcoming of the APOD lays in the fact that it does, however, only project the cash flow for the first year of ownership and it does not account for tax shelter. As a result, you should only look at an APOD to provide you with a “snapshot” of the property’s cash flow and returns in order to help you to make an initial decision whether or not to look further into an investment opportunity. But don’t rely upon an APOD too heavily.
The Proforma Income Statement
A Proforma income statement, on the other hand, is a more robust way to project cash flows because it anticipates a property’s financial condition beyond the first year of ownership (commonly extended out over a period of ten years) and does account for tax shelter (at least those created by the better real estate investment software solutions).
The benefit of being able to make revenue projections over a number of years is self-explanatory. Whereas the fact that a pro forma considers cash after taxes is important to investors because they can anticipate what may or may not be left over after income taxes are paid on the property’s earnings.
The shortcoming, not unlike any projection, is that the numbers revealed in a Proforma income statement are projections subject to a lot of variables that can easily be skewed.
The Bottom Line
You should not depend on either an APOD or a Proforma Income Statement to provide you with enough information to make a sound investment; there is much more for you to consider. Nonetheless, for real estate investing purposes, these reports can provide you with cash flow projections you must consider before you make any real estate investment rental property so you don’t find yourself facing negative cash flows you didn’t anticipate (a prospect no real estate investor relishes).