In its most basic form, the business plan for a commercial real estate asset is to purchase a property and lease the space in it to individuals and businesses. The resulting rental income is used to pay for the property’s operating expenses (including debt service), and anything left over is distributed to the property owner(s).
When an investor, whether they are a professional firm (like FNRP) or an individual, is considering the purchase of a commercial property, one of their most important tasks is to create a proforma financial projection. In this article, we’ll outline six of the most important assumptions to look for in a proforma.
Six Important Assumptions to Look for in a Proforma
The purpose of the proforma is to estimate the property’s income and expenses over time. But, creating a proforma can be difficult because the investor may not have all of the information they need at the time they are constructing it. As such, the investor needs to make a series of assumptions to fill the gaps. While seemingly small, a proforma’s assumptions can make or break an investment, and they must be considered carefully before committing capital to a project.
1. Income Growth Rate
One of the reasons that investors like this type of investment because commercial real estate is a good hedge against inflation. As the costs to operate a property rise over time so does its income. But, by how much? This is a critical assumption.
In most cases, an income growth rate assumption of 2% – 3% is fairly standard. But, this is just a general rule of thumb. For it to carry some weight, it must be fully supported by data unique to the local market. In some cases 2% – 3% may be too high. In cases it may not be enough. To determine this, an investor should review the data and make adjustments as necessary.
Property income is driven by multiple factors: changes in market rents, changes to “other income” line items like application fees and late fees, property location, and broad macroeconomic factors like interest rates and GDP. Property owners have control over some of these and have no control over others. As such, it is in their best interest to be conservative with their income growth rate assumptions.
2. Expense Growth Rate
The idea behind the expense growth rate assumption is the same as the income growth rate. It needs to reflect inflationary trends. In general, a typical expense growth rate assumption is 1.75% – 2.50%. However, it is important to consider the relationship between assumptions for income growth and expense growth. For example, if the income growth assumption is 2% and the expense growth assumption is 2.5%, the net is negative and this is not preferable.
Like income, property owners have control over some expense categories and no control over others. For example, they could renegotiate contracts for things like property management fees or landscaping to save money. But, they have no control over property taxes and utilities. To make the assumption as accurate as possible, it can be helpful to review historic operating statements and to use that information to inform future predictions.
3. Vacancy Rate
A vacant space in a commercial property is not producing income for the owner, which means it should be minimized to the extent possible. But, a property’s vacancy rate can be difficult to estimate because tenants will come and go and it is always uncertain how long it will take to re-lease the space.
As a general best practice, a standard proforma vacancy estimate is 5% – 7% of the leasable space (93% – 95% occupancy). But, it should also be considered within the context of historical trends, property size, and lease expirations.
If the property has historically run at 3% vacancy, maybe a lower vacancy rate can be justified. Conversely, if the property has a small number of units, it may need to be higher. For example, if a multifamily property has 10 units, just one vacant unit equals 10% vacancy.
Further, lease expirations needed to be carefully studied to determine if there will be periods of higher vacancy than others. For example, if three leases expire around the same time, it can make sense to temporarily increase the vacancy assumption while they are re-leased.
4. Purchase Price / Sales Price
Perhaps more than any other assumption, the estimated purchase and sale price(s) have the biggest potential impact on investment returns.
The purchase price assumption is a relatively simple one because the asking price can be used as a guide. For example, if the property has an asking price of $1M, a purchase price assumption of $950k is easily defended.
The sales price assumption is much more difficult because it may not occur until 5 or 10 years into the future. Often it involves applying a capitalization rate or “cap rate” to the final year of the property’s cash flow. But the choice of a cap rate in real estate is difficult because there is no telling what it could be several years into the future. The most conservative assumption is to keep it the same as the entry cap rate. If it is appreciably different, it should be fully supported by data and historical transactions.
5. Capital Expenditures
Often, real estate investors will purchase a property with the intent of making repairs and renovations to justify higher rental rates. These costs are referred to as “capital expenditures” or “CapEx” and they can have a material impact on a property’s annual cash flow.
CapEx themselves are relatively easy to estimate because they can be tied to a specific, quoted cost. The relationship between CapEx and rental increases is a little bit more difficult. It must be fully supported by market data.
6. Financing Assumptions
Finally, a property’s loan amount, interest rate, payment, and debt maturity are critical components of the pro forma. If the loan is relatively straightforward with a fixed interest rate and payment, it is a fairly simple pro forma input. But, this isn’t always the case.
Some loans have variable interest rates and they may be refinanced at some point during the investment period. When this is the case, the assumptions become a bit more difficult because they rely on interest rate projections that may turn out to be materially different.
Why Assumptions Matter for Creating a Proforma
Creating a proforma is part science and part art. But, it is critical because the cash flow projections or Net Operating Income (NOI) are the necessary inputs into the following investment return metrics:
- Discounted Cash Flow (DCF): A method used to value a potential investment based on the amount of cash flow it produces. Future cash flows are “discounted” back to the present time to determine if the planned purchase price is reasonable. DCF is calculated on both a levered (with the loan) and unlevered (without the loan). basis
- Internal Rate of Return (IRR): IRR is the return earned on each dollar invested for each time period it is invested in. Equity investors demand this metric as an indication of their potential return and it is calculated using the property’s pro forma cash flows.
- Cash on Cash Return: The Cash on Cash Return measures an investor’s return on the cash invested.
- Equity Multiple: This is a variation of the cash on cash return and it is measured as a ratio of the total cash received, divided by the total cash invested.
Depending on a proforma’s assumptions, these metrics can appear to be higher or lower than they realistically have a chance of being. To have the best chance of achieving the proforma return metrics, it is important for assumptions to be reasonable, conservative, and fully supported by as much data as possible.
Interested in Learning More?
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