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.

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.

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