Real Estate Pro Forma: Interpretation

There is no fixed way to interpret a financial statement. The feasibility ratios are guideposts; a range of values is usually acceptable; often the pattern of the ratios is more important than any single value.

There are a few (general) rules of thumb for interpreting the feasibility ratios. Traditionally, banks have looked for a debt coverage ratio between 1.25 and 1.50, depending on the type of project. Walk-up apartments and shopping centers are considered a more secure investment, and can carry a lower debt coverage ratio. Hotels and motels carry a higher ratio. In the recent economy, lenders have eased their debt-coverage requirements; many now accept ratios as low as 1.10 to 1.15.

Investors traditionally expect a rate of return around 15 - 20 per cent. Real estate gives a higher rate of return than many investments because it is more risky. Part of the return from real estate is the "reversion," or profit from sale of the property. This means that the annual return on equity may be lower since there is a promise of a large return at the end of the project. Because of the tax advantages from real estate, the pre-tax rate of return can also be lower than it would be for other investments. A real estate investment protects some of the money it returns from taxes, and in some cases can carry a paper loss to protect other regular income as well. Traditionally, investors would accept a pre-tax rate of return of 8 - 12 per cent.

Finally, bear in mind that after-tax returns cannot operate a project. A project must generate a default ratio and a debt coverage ratio that are low enough to convince lenders to underwrite the project. Tax benefits all go to the investors; lenders get their money from the effective income of the project.

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