The first task in any investment real estate decision is to develop and understand the workings of a pro forma. A pro forma in real estate represent a cash flow projection of a particular property. This page explains each components common to a pro forma which are used on a systematic basis by investors, developers, lenders, and appraisers to understand property valuation and long term cash flow. The following are general terms to gain better understanding of the analysis and how it comes into play in the real estate setting:
The Potential Gross Income (PGI) top line item in the pro forma that consists of income that is generated if a property were 100% leased. It is the maximum rental income possible without vacancies or credit losses. In calculating the PGI, the cash flow for each contractual lease in place in the rent roll is calculated each year in the holding period. This takes into account each tenant's specific lease terms. If there is any period of time that is not covered by a lease, the market rent is then forecasted to determine cash flow that could be generated. Determining the potential rental income involves accounting for assumption of renewal after a lease expires. This includes forecasting market leasing commissions, tenant improvements, any and necessary abatements and reimbursements.
Generally, a property will not be 100% leased at all times during a holding period. The vacancy allowance (or vacancy rate) line item on a real estate pro forma will account for any projected vacancies. The figure for a vacancy allowance can be calculated in several different ways: taking a simple percentage of the potential rental income or using a total dollar amount for each year during the holding period. In multi-tenant office, residential and retail setups, vacancy allowances normally range from 3% to 8%, with the most commonly used figure being around 5%.
Other income items typically show up on the real estate pro forma after the vacancy allowance. These line items usually aren’t part of the contractual lease, but still provide additional revenue for the property. Some examples of other income items include billboard, laundry, parking, or vending, or other income generally derived from common areas of a property.
The Effective Gross Income (EGI) is the amount of income actually received: the Potential Gross Rental Income (PGI) plus other income minus the vacancy allowance and credit costs of a property. The EGI becomes key in determining the value of a rental property and the true positive cash flow that it can produce. This is one of the more analyzed line items by a prospective investor or investment company during the property acquisition phase.
The Operating Expenses line item include all the expenses specific to a property. This includes property taxes, property insurance, property management service, and municipal utilities. Class A and National Credit tenants often have so-called net leases, where the tenant
pays all or most of the operating expenses. Otherwise, landlords will negotiate the reimbursements where the tenant is required to pay a portion of the recurring operating expenses.
The Net Operating Income (NOI) line item is calculated by subtracting all operating expenses from the Effective Gross Income for a specific property. The NOI is the most widely used indicator of cash flow of commercial real estate properties. It is important to note that NOI does not take into account expenses such as leasing commissions, tenant improvement allowances, and capital improvement expenditures. The actual accounting for these items in the Before Tax Cash Flow indicator
results in more accuracy.
The Cash Flow Before Taxes (CFBT) is the cash flow an investor or investment firms realizes after subtracting debt service and other expenses from the NOI, but not tax liability. This provides an investor a clear picture of free cash flow available to the owners of a property, before taxes.