The first task in any investment real estate decision is to develop and understand the workings of a a real estate pro forma. A pro forma in real estate is simply a cash flow projection of a particular property. This page explains each
of the components common to a pro forma. They are used on a regular basis by investors, developers, brokers, lenders, and appraisers to understand property valuation and long term cash flow projections. The following are the general terms in order to gain a better understanding of pro forma and how it comes into play in gaining a better idea of the numbers of a commercial property:
Cash on cash return — a.k.a. the equity dividend rate — is a property valuation formula that calculates the ratio of cash earned to cash invested (not including money borrowed to finance the purchase). In real estate, Cash-on-Cash return is the before tax cash flow (i.e. Cash Flow after Financing) of an investment in a given period divided by the equity invested (i.e. total equity capital invested) as of the end of that period. Cash-on-Cash return is a levered (after debt) metric, whereas the Free-and-Clear return is its unlevered equivalent. The metric used by real estate investors to assess potential real estate investments.
The IRR formula helps investors understand their yearly earnings. Its result is based on a percentage of the investor’s original investment and what they hope to one day sell the home for. Essentially, it’s a formula that helps investors realize what they’ll earn overtime on their investment. The result can be used to compare to see if they will earn more in a certain real estate investment versus putting their money in a more traditional investment or a different property.
The net present value (NPV) or net present worth applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount rate. NPV accounts for the time value of money. It provides a method for evaluating and comparing capital projects or financial products with cash flows spread over time, as in loans, investments, payouts from insurance contracts plus many other applications.
Return on investment is the ratio between the profits and costs of an investment. It measures how much money is made on investment as a percentage of the investment’s cost. Investors use ROI to evaluate profitability of an investment or in order to compare the profitability of different investments.
A property’s capitalization rate, or “cap rate”, is a snapshot in time of a commercial real estate asset’s return. Commercial real estate is an investment type, so the return is a reflection of the risk and the quality of the investment. The cap rate does not take into consideration a mortgage and is most useful in a market where sales occur often and prospective buyers can use the information from comparable sales of stabilized assets to determine if the price being offered is reasonable, relative to other sales.
