Real Estate Pro Forma: Definitions
The mathematics of a pro forma is not particularly complicated.
Most of the calculations are simple addition, subtraction,
multiplication, and division. Like most accounting tools,
the difficulty comes in understanding the precise meaning of
each term and the order in which each acts on the others. The
following definitions are discussed according to the three
categories discussed in the Description section: expenses,
income, and feasibility ratios.
Expense Items:
Expenses can be divided into three sub-categories, capital costs,
lending costs, and operating costs. Technically, "lending
costs" should be allocated to capital or operating
costs, whichever is appropriate. They are not discussed separately
because the same definitions apply to both subcategories.
There are three types of capital costs:
- ACQUISITION COSTS: The cost of obtaining land and existing
buildings. May be expressed as a lump sum or as a price per
square foot.
- IMPROVEMENT COSTS: The cost of demolishing unwanted structures,
improving existing structures, and constructing new structures.
Improvement costs are usually expressed as a cost per square foot.
- INDIRECT COSTS: Costs of a project which are assigned on a
project, rather than square footage, basis. Indirect costs include
architect and engineering fees, legal and accounting fees, leasing
fees, and expenses associated with the construction loan.
There are four types of lending costs:
- CONSTRUCTION/PERMANENT LOAN: Construction loans are (relatively)
short-term loans to cover the cost of construction while a project
is being developed. Usually only the interest on the loan is
due until the project is completed. Upon completion, the entire
construction loan comes due and the project is either sold or
refinanced with a permanent loan. This loan usually carries
a lower interest rate than the construction loan, and it
allows the owner to retire the debt over a long period of time,
usually with small, equal-amount payments.
- LOAN/COST RATIO: Mortgage bankers will not lend the full
value of a project; they want to see the owner taking some
of the risk for the project, too. The bank will want the owner
to put some money into the project from the beginning. The proportion
of project cost lent by the bank will depend on a variety of
factors: the availability of money, the soundness of the project,
the expected life of the project, among others. These days
loan/cost ratios of 0.80 are not uncommon. The remaining
investment (e.g., 0.20) must come from the owner (or from
others) and is called "owner's equity," or "equity,"
for short.
- ORIGINATION FEE: Frequently, the lending institution will
charge administrative costs for handling a loan. This
is called an "origination fee," and is expressed
as a percentage of the value of the loan.
- DEBT SERVICE CONSTANT (DSC): The debt service constant
is the annual payment necessary to retire the principal and
the accumulated interest on a loan. It is defined as the ratio
of the present value of the loan to the annual payments on that
value. The derivation of the formula is fairly tortuous; the
interested reader is referred to Chapter 3 of Kleeman's Handbook
of Real Estate Mathematics (1978). The calculating formula
is
- DEBT SERVICE CONSTANT = Interest Rate / (1-[1/{1+Interest
Rate}**n])
- where "n" is the number of years to repayment
The DSC returns an index number which, when multiplied by the
principal, calculates the annual interest and principal repayment
for the loan.
If these costs are incurred for a construction loan, they
are counted as indirect capital expenses. If they are incurred
for a permanent loan, they are counted as operating costs.
There are two types of operating costs:
- OPERATING EXPENSES: Operating expenses are costs incurred
to receive a rent from a property. These include utilities (heat,
lights, etc.), cleaning and maintenance, leasing fees, and
normal repairs, among others.
- PROPERTY TAXES: Property taxes are an expense which is incurred
whether or not the property is generating a flow of income, and
it is an item which normally is beyond the control of the developer.
It is often entered as an expense separate from other operating
expenses.
Income Items:
Income is usually divided into two categories, potential income
and effective income.
Three items are included under potential income:
- GROSS POTENTIAL INCOME (GPI): Gross potential income is the
income a property could produce if it were rented to full
capacity. It is usually calculated by multiplying the anticipated
rent per square foot by the net leasable space. In detailed
analyses, different rents may be derived for different spaces
in the project.
- INVESTMENT TAX CREDIT: The investment tax credit is an
income-tax credit for rehabilitating certain kinds of income-producing
property. The purchase of property is not eligible for
an investment tax credit; however, the cost of rehabilitating
old structures (at least 30 years old) is eligible for
an investment credit under certain conditions. The credit is
10 - 20 per cent of the cost (depending on the age and
historic designation of the structure). Refer to the IRS publication,
Investment Credit, for full details. The investment tax credit
produces a flow of income through its effect on the owner's
taxes in the first year of the project.
- DEPRECIATION: Tax codes allow a property owner to balance
the cost of property depreciation against the flow of income
produced by a property. Since the direct costs of repair
and maintenance are also charged against income for tax purposes,
depreciation is a fictional, or "paper," cost which,
in effect, is translated into income at tax time. The amount
of depreciation one can claim is considered to be an equal
amount for each year of the property's usable life. Most residential
property will be depreciated over 27 years, most commercial
property over 31 years. The Accelerated Cost Recovery System
of depreciation, used before 1987, is not allowed for property
purchased after 1986. Refer to the IRS publication, Depreciation,
for full details.
There are two terms which describe effective income:
- GROSS EFFECTIVE INCOME: Gross effective income is the total
annual receipts expected from rents. It is the gross potential
income less expected vacancies.
- NET OPERATING INCOME (NOI): Net operating income is the
income a property produces after operating expenses are paid.
It is the gross expected income less operating costs. Different
approaches will treat operating costs differently; normally,
operating costs will include debt service, although an income-analysis
approach ("back-door" approach) will keep debt service
separate from the other operating costs. Net operating income
is the "bottom line" of a real estate project; it
is what is left over for profit (repayment on owner's equity).
Feasibility Ratios:
There are five feasibility ratios which are commonly used to
evaluate the cash flow of a real estate project.
- RETURN ON INVESTMENT (ROI): ROI is a ratio which is commonly
used to evaluate an investor's gain (return) from an investment.
In the case of a real estate project, ROI is the net operating
income divided by the total cost of the project. For real
estate transactions, ROI is somewhat misleading since, at the
beginning, most of the investment is held by the mortgage
lender (who is not paid out of NOI, but is guaranteed a
fix ROI through the rate of interest charged to the mortgage).
- RETURN ON EQUITY (ROE): ROE is the more commonly used ratio
for real estate projects. It is the ratio of net operating
income to owner's equity. This is also sometimes called
"cash-on-cash return" (the annual cash return which
comes back to cash investors).
- DEBT COVERAGE RATIO: Debt coverage ratio is the lender's
primary tool for evaluating the security of a project. It is
the ratio of net operating income before debt service to the
debt service:
- DEBT COVERAGE RATIO = NOI before Debt Service / Debt Service
In effect, it tells the lender how much of a buffer there
is in the project to protect the lender's interest (since
the mortgage is paid before owner's equity, if times are hard
the project owners get nothing until the lender is paid).
What is considered an "acceptable" debt coverage
ratio varies with the type of project and the state of the
economy.
- DEFAULT RATIO: The default ratio is similar to debt coverage,
but it is calculated from the owner's point of view. It
is the ratio between operating costs (including debt service)
and effective income (potential income adjusted for expected
vacancies):
- DEFAULT RATIO = Operating Costs / Gross Effective Income
- INTERNAL RATE OF RETURN: The internal rate of return is the
return on equity over the life of the project, plus the "reversion
income" which accrues upon sale of the project:
- INTERNAL RATE OF RETURN = Sum (ROE) + REVERSION
"Reversion" is any profit made at the time of sale,
less the capital gains tax on the profit. Calculating the
internal rate of return entails making assumptions about the
length of time the project will be held and the likely sales
price upon sale. The internal rate of return allows investors
to compare the long-term benefits of one investment to the long-term
benefits of other investments.
© 1996 A.J.Filipovitch
Revised 29 October 96