Removing 'Rose Colored Glasses' When Evaluating Cash Flow Pro Forma in Commercial Real Estate Investment
The commercial inventory status and changing requirements of the modern investor’s portfolio demands that the Commercial Realtor® have the skills to perform more sophisticated due diligence of future gains, and a thorough analysis of the deal.
By: Justine Synder, 2019 president, Realtors® Commercial Alliance of Massachusetts
Currently in Massachusetts there is a glut of inventory and available commercial space, very much the opposite of the residential side. The commercial inventory status and changing requirements of the modern investor’s portfolio demands that the Commercial Realtor® have the skills to perform more sophisticated due diligence of future gains, and a thorough analysis of the deal.
In commercial real estate, there are three major market-types and they all interact and impact each other.
The Space Market which is the market for the occupancy and usage of build space or the rental market;
The Development Market where new space is built using investor capital; and
The Asset Market, this is the market dealing with the selling and buying of owned real estate assets as investments by investors, and this asset market is the focus of this article.
Investment properties are usually purchased one property at a time and the price is negotiated between the buyer and the seller for a unique property. One of the significant factors in determining the purchase price is the cash flow that it will generate. A key question to ask is “how much is this property worth?” Almost any property purchased at a low enough price would seem to be a good investment, but even a really well-priced property could be a bad investment if it cannot generate cash flow in the long run. The best solution is to produce an accurate cash flow Pro Forma.
Cash Flow Pro Forma
The cash flow pro forma is the basic analytical tool that investors use to quantify the expected net cash flow from investment. Using this tool an investor can forecast the future net cash flow stream that the property will provide. A standardized framework exists in the accounting world based on financial accounting rules, which is then customized for the property itself.
Cash flow Pro Formas are actually a lot more complex when performed with accuracy for most properties. Sometimes, these are performed without a whole lot of thought put into them. I’ve seen them made up on the spot by the owner or reviewed where the numbers don’t make any sense at all.
If you want to know what you are truly looking at for an investment property, consider these rules of engagement.
For a cash flow performer in real estate to be done correctly you will need these following standard terminologies (as defined by the MIT School of Architecture and Planning, a lecture on Cash Flow Proformas Module 3 - 2018):
Estimate of the market value (MV) of the property- The market price the property will most likely sell for.
Estimate of the investment value (IV) of the property - This differs from investor to investor, but it is how much the investor would be willing to pay for the property and could be different from the market value.
Sensitivity analysis is a projection on how the future investment may perform differently from the current expectation. This is the “what if” analysis and can help an investor to quantify the magnitude of the risk involved in the purchase and its future performance. It is also used by lenders who are thinking of committing capital to the project or loaning money on whether to grant the money or not. Lenders are conservative in the possibilities of negative outcomes in the investment. Cash flow pro forma is the basic tool for conducting the sensitivity analysis. Sometimes this is referred to as the “crash testing” pro forma. Other times it is coined “the hair cut”.
Conduct an ex ante performance attribution: this process lets the investor review the expected internal rate of review (IRR) before purchase. The investor can evaluate components that add up to the total projected IRR. This can help investors compare the purchase with other potential purchases i.e. which property might have a bigger yield versus those which might have higher growth to match their portfolio requirements.
Conduct an ex post analysis. This looks at the realized results. At this point an investor knows the actual history of the investment’s cash flow from when the property was bought. Using the actual pro forma an investor can determine the actual IRR base on the true operating expenses ratio to gross rental income and vacancy losses. It is a great tool to analyze and compare property managers and to improve performance.
Biases and wishful thinking can be very damaging when purchasing investment property and lead to disappointing and even portfolio threatening results. It is important to be accurate, forthright, and use scrupulous figures in creating an unbiased projection of cash flow on an investment property. Human nature has a part in generating numbers that are hopeful and “rose- colored”. It may even be unintentional from parties wanting to make the deal.
Commercial Realtors® can help their clients remove the “rose colored glasses” and avoid such mistakes.
For more information on joining the Realtors® Commercial Alliance of Massachusetts (RCMA) or questions about commercial real estate, contact Justine Snyder, 2019 RCMA President at firstname.lastname@example.org.