As you embark on your entrepreneurial quest, you will have to make several real estate decisions along the way.
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The best way to evaluate these decisions, and make the correct decision, is to make a pro forma. A pro forma will help you to evaluate if you are making the most prudent financial decision for your company.
What Is A Pro Forma?
A pro forma is usually a spreadsheet that depicts the revenues, expenses, and returns that you can expect from a particular project. It is called a pro forma because it typically has some assumptions built into it. Whether you are dealing with revenues or expenses, often times you will not have real accurate data to rely on. Running a pro forma with some sensitivity analysis will help you make a good decision based on the best projections you can make.
The top few lines of your pro forma should constitute a revenue section. For a typical property you may wish to consider all of the following items:
Gross Rental Receipts This line item includes rent from leases and other contracted revenue.
Vacancy and Credit Loss Typically you will include a deduction here that accounts for the likelihood that some tenants will vacate before schedule and others will not pay on time or not pay at all. This item typically totals 5 to 10% of gross rental receipts in many office and multi-family properties.
Other Income This item could include interest on security deposits, profits from any other side businesses in the property such as vending machines or laundry machines, or payments from a cell phone provider who puts a cell tower on your property.
Expense recoveries If you recover expenses from tenants you may wish to account for it here in the revenue section. You could also account for it in the expense category as a negative number.
Revenue Adjustments as you create your assumption for the current year and subsequent years, you may want to include an adjustment for inflation, cost of living, or consumer price index adjustments.
Total Revenue will be equal to the sum of all the revenue lines above it.
A property can have any number of expenses. These can include, but are not limited to:
Basic operating expenses
Repair and maintenance supplies
Paint and wall covering
HVAC repair and maintenance
Property Manager overhead
Fire and life safety updates
Parking lot maintenance
General repairs and maintenance
A sum of all the items above will yield your total operating expense. Please note that these operating expenses include property tax but do not include income tax. This is especially relevant for situations when the property is owned by different individuals jointly. Income tax will always come below the line. In addition, debt service is not included as an expense.
Net Operating Income
Net operating income (NOI) is simply the revenues less the expenses. This number is a simple calculation, but is very important for determining the profitability of your project.
Below The Line Expenses
Once you figure out NOI you need to remember that leasing commissions, tenant improvements, capital reserves, debt service (both principal and interest), and other costs are below the line.
To get cash flow you take your net operating income and subtract all of your below-the-line expenses. Next, simply discount your cash flows back by your opportunity cost of capital to determine if your real estate project has a positive net present value (NPV). Keep in mind that this is still a before tax return.