This post originally appeared on Burt M. Polson's Real Estate Journal and is republished with permission. Find out how to syndicate your content with theBrokerList.
You will find several opinions regarding a proforma financial report for an investment property. Some descriptions used may be “working magic,” “pie in the sky,” and “using a bit of pixie dust,” to coin a few terms.
With accurate research, a proforma statement can be a valuable tool an investor can use in determining the viability of an investment.
What is proforma?
Proforma is a method applied to a financial analysis that can draw focus to a specific figure of current or future projections. A “method” is a loosely used term as some would consider this manipulation.
You will find a proforma analysis widely used when analyzing investment real estate. There are several types of metrics used over a five or ten-year period, for example, IRR, net present value, and many more.
One could consider the five or ten-year projection of an investment property’s income and expenses to be a proforma analysis.
When should a proforma be used?
Speaking from experience, I use a proforma analysis to fill in the “holes” of an underperforming investment. The property may be underperforming for several reasons.
We commonly call these types of investments “opportunistic” meaning the property may need rehabilitation and re-tenanting or have high vacancies and high expenses. The proforma report shows what the financial picture could be in the future with certain improvements, new tenants secured, and costs brought under control.
Real life example
I am representing a mixed-use property in Vallejo, California for sale at $800,000. It contains two small retail storefronts, three apartments and a 3,800 square feet warehouse.
Our example has only two studio apartments rented, and the storefront units need approximately $100,000 in improvements. The income an investment property creates is used to determine its value; however, there is value in the land and improvements.
The best way to value the investment is with a proforma evaluation. Using a conservative and comparable market rent for all the vacancies as well as an assumption of expenses a market value can be derived.
Next, the cost to improve and repair the property to bring it up to standards is factored in to come to a market price. Several other metrics can be used to confirm the price against other similar investments such as the capitalization (CAP) rate, price per square foot, internal rate of return (IRR) and different ratios.
After analyzing the data, the investment came back with a gross operating income (GOI) of $78,785 and operating expenses of $26,597 a year. The difference represents the net operation income (NOI) and equates to a CAP rate of 6.5 percent and an IRR of 11.7 percent. The good part is I underestimated the rent income and over-estimated the expenses so actual returns could be better.
There may be some instances where a proforma financial analysis you find is only magical pixie dust, but the well-informed investor that has a relationship with an experienced commercial broker can see right through the magic.
Burt M. Polson, CCIM, is an active commercial real estate broker. Reach him at 707-254-8000, or [email protected] Sign up for his email newsletter at BurtPolson.com.