There’s an ongoing debate amongst analysts and real estate investing software developers regarding proforma income statement projections.
Whereas some would argue that proformas should provide twenty-year financial projections, others claim that ten-year projections are sufficient – if not better because trying to project twenty years out can be dangerously misleading.
In this article, we’ll look at the proforma income statement and see which claim might be the most reasonable.
Definition
A proforma income statement is used in a real estate analysis to project a rental property’s revenues. The concept is straightforward.
Based upon the financial performance of the rental property and then using a variable to make projections into the future, a proforma income statement shows the real estate investor what amount of cash flow and rates of return might result on a year-to-year basis over time based upon those variables.
Illustration
Source: ProAPOD Real Estate Investment Software
Example
Assume that a property currently produces $30,000 gross operating income, operating expenses of $12,000, and a net operating of $18,000 (income less expenses). In this case, the analyst seeks to determine the following year’s net operating income based upon an educated guess for next year’s income and expenses.
We’ll say the analyst speculates that income revenue will annually increase 5% and the operating expenses 4%. Here’s the calculation required for the investor to arrive at the net operating income at the end of 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
This is the procedure used for each subsequent year extending out 10, 15, or 20 years until the rental income proforma is populated. The real estate investor simply creates a projection of the rental property’s financial performance according to the variables (i.e., vacancy allowance, income, operating expenses) that he or she desires.
Benefit
Of course, a pro forma is very helpful to a real estate investor. Anyone involved with real estate investing understands that real estate is not considered liquid and as such, a property’s performance must be considered over the long run.
This is the reason that analysts and investors create a proforma income statement for rental property evaluation and in turn rely on it to help them make their real estate investment decision.
The Catch
A proforma income statement is 100% assumptive.
It merely assumes what the income, vacancy rate, operating expenses, and future selling price produced by a property might be over time. The long-term cash flows, rates of return and sales proceeds available to the property’s owner in the future are conjecture because no one really knows what the future holds.
Who, for example, could have predicted the slide that real estate has taken over the past several years? If the brightest and smartest on Wall Street or Washington couldn’t, then how could a real estate agent or individual investor in Los Angeles, Tampa, or De Moines know what the future holds?
Here’s the point.
Yes, analysts and real estate investors should rely on the proforma income statement to evaluate a rental property’s future financial performance because it does provide a concise revenue projection needful for real estate investment decisions.
But it’s this author’s opinion that a proforma – because it is conjecture – should not extend beyond ten years. After all, real estate investing provides enough risk already without adding even more risk.
