Monday, January 4, 2016

Analyzing a Property's Cash Flow Statement & How to Create a Real Estate Pro Forma (part 1 of pro forma building series)


(Transamerica Building)
Here's a list of everything we've covered so far:

Part 1 - Overview on how to calculate down to the NOI line item.
Part 2 - Intro to lease structures and calculating the gross potential revenue line item.
Part 3 - A look at reimbursement methods and how to calculate reimbursement income.
Part 4 - How to calculate the other income line item and an intro to income adjustments.
Part 5 - Rent abatements overview and calculation example.
Part 6 - Absorption and turnover vacancy explanation and intro to tenant improvements.
Part 7 - General vacancy allowance explanation and calculation example.
Part 8 - Operating expenses explanation.
Part 9 - Constructing a sources and uses table.
Part 10 - Building a debt schedule.
Part 11 - Calculating levered IRR.
Part 12 - DCF analysis.
Part 13 - Loan sizing.

An asset has value because it generates cash for its owner, or will in the near future. Commercial real estate follows the same principle. A property has value because of its ability, or potential for generating cash for its owner.

The fist step to analyzing and valuing a property is to try and project the cash flow it will produce; creating what is often called a "pro forma." Below is an example of a simplified  pro forma you can download and use to follow along. In a series of posts we'll learn what each major section of the pro forma is and how to perform the necessary calculations.




Income


This section projects what the total amount of income a property could potentially generate in a given time period. The major income items are the rent that could be received from tenants, the expense reimbursements tenants pay (we'll cover this in much more detail later), and other income the property generates (parking, for example).

Income Adjustments


These are items that adjust the total potential income of a property downward.

Rent abatements are the number of months of free rent a tenant receives and the loss of income associated with them. A tenant will typically negotiate several months of free rent while negotiating lease terms.

Absorption and turnover vacancy is the loss of income associated with tenants vacating a suite and the downtime that occurs while trying to re-tenant the suite. For example, if a tenant vacates their suite and it takes 6 months to find a new tenant to fill the space, that's 6 months worth of income lost.

General vacancy allowance is an additional cushion baked into most pro formas. We'll go into more detail in future posts, but for now just understand that it is meant as an additional buffer to be conservative.

Effective Gross Income


This is the actual income the property is generating in the given time period.


Operating Expenses


These are the expenses associated with operating the property. Typically the largest operating expenses will be insurance, management fees, property taxes, repairs and maintenance, and utilities.


Think of all the expenses you incur owning a home. You have to make plumbing repairs, replace light bulbs, maintain the lawn, etc... Now imagine those type of expenses applied to a 100,000 SF building with a huge parking lot.

It's important to note that expenses above the net operating income line item are what it costs to run the property, irregardless of ownership decisions / strategy, meaning any ownership group would incur these expenses.


Net Operating Income


Net operating income (NOI) is probably the most important line item in the entire pro forma. NOI is the cash flow a property generates from its day-to-day operations, irrespective of management decisions / strategy. Those familiar with corporate finance can think of it as EBITDA.



Check back for detailed explanations on how to calculate each of these line items and begin building a functioning commercial real estate valuation model / pro forma.

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