ProAPOD®

Real Estate Investment Software Blog

There’s an ongoing debate amongst analysts and real estate investment software developers as to whether it’s better to use a 10-year or 20-year proforma income statement when analyzing investment real estate.

Fair enough. Some feel that the more data an individual investor has to make an investment decision the better while others would argue that any rental proforma assuming to present any semblance of correct data twenty years out can be dangerously misleading.

Let’s start at the beginning.

A proforma income statement is used in a real estate analysis to project a rental property’s revenues. The concept is straightforward. By looking at the financial performance of the rental property the year before and then using a variable to make projections into the future, a rental pro forma shows the cash flow that an individual investor who owns the property might receive on a year-to-year basis over time based upon those projections.

Here’s how it works.

Assume that a property currently produces $30,000 gross operating income and has operating expenses of $12,000, thus leaving a net operating of $18,000 (income less expenses). The analyst seeks to determine the following year’s net operating income based upon an educated guess for next year’s income and expenses.

For example, if the analyst speculates that the revenue above will annually increase 5% and the operating expenses 4%, then it follows that the net operating income at the end of next year will increase to $19,020.

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

And so it goes for each subsequent year extending out 10, 15, or 20 years until the rental income proforma is populated.

Of course, a pro forma is very helpful to an 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 realestate analysts and investors rely on a proforma for property evaluation and in turn, regularly rely on it to help them make their decision regarding an investment opportunity.

Okay, but here’s 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 realestate agent or individual investor in Los Angeles, Tampa, or De Moines.

Here’s the point.

Yes, analysts and realestate 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 for rental properties needful for investment decisions. But it’s this author’s opinion that a proforma, because it is conjecture, should not extend beyond ten years.

Real estate investing provides enough risk already.

[You can see our proforma income statement here...]