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.
In order to start your pro forma, you will need to input or calculate your property's Net Operating Income (NOI), which is equal to operating income minus operating expenses. If you do not have exact figures for your property's operating income and expenses, which is the case for most real estate deals, you will need to estimate them using assumptions based on market information and standards. Solid, realistic assumptions are the building blocks of a good real estate pro forma. The most common assumptions you will need to generate NOI are rental rates, expenses rates and vacancy rates.
For rental rates and vacancy rates, you should use the industry average rental rate for similar buildings in your market area, usually quoted as dollars per net square foot for rental rates and a percentage for vacancy rates. For expense rates, you need to estimate the total annual operating expenses, usually in dollars per net square foot ($/NSF). These are expenses necessary to operate the exact property, for example; electric, water, landscaping, maintenance, etc., in addition to taxes and insurance. Each industry sector and lease deal can have different assumptions with this type of expense. For example, retail and industrial leases are generally triple net (NNN), meaning the tenant pays all operating expenses; therefore, the expense assumption for the landlord can be very low or even zero. In case your property is an office building, you must assume you will need to pay a percentage of the operating expenses.
When you have generated your property's current NOI, then you're able to use assumptions to project cash flows in the future. This is usually done while using the inflation assumption. Inflation is the assumed rate where a cash flow will grow as time passes. It is typical inside a property deal to assume inflation of NOI will probably be generally near the CPI (Consumer Price Index), or the general inflation or your overall market. If your inflation assumption is too high, the compound effect will greatly exaggerate your future cash flows and give you an incorrect valuation of your asset's future value. It is vital never to over-estimate your inflation assumption.
As soon as 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 completed by changing each assumption and understanding how those changes in each assumption affect your pro forma outputs, for instance IRR and NPV. Sensitivity analysis may help determine the assumptions that are critical to your pro forma.
In order to start your pro forma, you will need to input or calculate your property's Net Operating Income (NOI), which is equal to operating income minus operating expenses. If you do not have exact figures for your property's operating income and expenses, which is the case for most real estate deals, you will need to estimate them using assumptions based on market information and standards. Solid, realistic assumptions are the building blocks of a good real estate pro forma. The most common assumptions you will need to generate NOI are rental rates, expenses rates and vacancy rates.
For rental rates and vacancy rates, you should use the industry average rental rate for similar buildings in your market area, usually quoted as dollars per net square foot for rental rates and a percentage for vacancy rates. For expense rates, you need to estimate the total annual operating expenses, usually in dollars per net square foot ($/NSF). These are expenses necessary to operate the exact property, for example; electric, water, landscaping, maintenance, etc., in addition to taxes and insurance. Each industry sector and lease deal can have different assumptions with this type of expense. For example, retail and industrial leases are generally triple net (NNN), meaning the tenant pays all operating expenses; therefore, the expense assumption for the landlord can be very low or even zero. In case your property is an office building, you must assume you will need to pay a percentage of the operating expenses.
When you have generated your property's current NOI, then you're able to use assumptions to project cash flows in the future. This is usually done while using the inflation assumption. Inflation is the assumed rate where a cash flow will grow as time passes. It is typical inside a property deal to assume inflation of NOI will probably be generally near the CPI (Consumer Price Index), or the general inflation or your overall market. If your inflation assumption is too high, the compound effect will greatly exaggerate your future cash flows and give you an incorrect valuation of your asset's future value. It is vital never to over-estimate your inflation assumption.
As soon as 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 completed by changing each assumption and understanding how those changes in each assumption affect your pro forma outputs, for instance IRR and NPV. Sensitivity analysis may help determine the assumptions that are critical to your pro forma.
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For more advice and tips on building real estate pro forma models and templates, please see the Pro Forma GURU: Guide for Real Estate Investing at www.ProFormaGURU
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