RE5003 Chap.5 Building the Property Cash Flow Pro-forma
Building the Property Cash Flow Pro-forma
What an investor actually buys
The fourth lecture starts from a simple statement: a real estate investment, direct or indirect, buys the right to a stream of future cash flows. The price depends on how much will be received, when, and with what confidence, along with the investor's tolerance for risk.
The lecture also separates investment value, which is a property's worth to one owner, from the most probable selling price and from market value at a valuation date.
A pro-forma built on one buyer's assumptions estimates investment value.
The ladder from rent to net operating income
The unleveraged pro-forma begins with potential gross income at full occupancy, deducts vacancy and collection loss, adds other income such as parking and signage to reach effective gross income, and deducts operating expenses to reach net operating income.
Debt service is excluded so that the property's own performance is seen before financing. Each rung carries a judgement. Potential income uses contract rent where long leases bind and market rent where leases roll. Vacancy draws on history, competing buildings and the natural vacancy rate.
Expenses split into fixed items, such as insurance and property tax, and variable items, such as utilities and maintenance.
Leases and reviews
The lecture lists four lease shapes: straight, stepped, indexed to inflation and percentage of sales.
In the office acquisition case used for the practice task, rents are reviewed every three years while service charges grow every year, so income steps up at each review and drifts between them.
The reversion
The final year adds the sale. The lecture gives two ways to estimate the terminal value: grow the purchase price at a constant rate, or divide the following year's income by a going-out capitalisation rate.
Selling costs such as brokerage and legal fees come off either result to give net sale proceeds. Because the reversion is usually the largest single cash flow, the exit method can matter more than any year of rent.
What this chapter covers
- 01
Amount, timing and confidence as the drivers of price
- 02
Investment value, most probable selling price and market value
- 03
From potential gross income to net operating income
- 04
Contract rent, market rent and the four lease shapes
- 05
Rent reviews and the stepped income profile
- 06
Terminal value by price growth or a going-out cap rate
Worked example · free
One year of a pro-forma
- 1Compute potential gross income.
- 2Deduct vacancy and add other income.
- 2Deduct service costs and property tax.
Key terms
- Potential Gross Income
- Rental income assuming every unit is let for the whole period.
- Vacancy Allowance
- A deduction from potential income for empty space and unpaid rent.
- Effective Gross Income
- Potential income less vacancy and collection loss, plus other income.
- Operating Expenses
- Regular costs of keeping a property running, split into fixed and variable items.
- Contract Rent
- The rent tenants actually pay under their current leases.
- Market Rent
- The rent a space would most likely fetch if offered for lease on the open market today.
- Reversionary Value
- The estimated value of a property at the end of the holding period.
- Investment Value
- A property's worth to a particular owner or buyer, which may differ from its market value.
Building the Property Cash Flow Pro-forma FAQ
Why is the pro-forma built without debt?
The unleveraged version shows how the property itself performs before financing changes the picture. Debt service is a choice of the investor, not a feature of the building, so it is added later when equity returns are analysed.
Which rent should a projection use, the lease rent or the open-market rent?
Use contract rent while long leases bind, because that is what tenants must pay. Switch to market rent as leases expire and are renegotiated, which is why rent reviews create steps in the projection.
What belongs in operating expenses?
Ordinary, regular costs of keeping the property competitive: fixed items such as insurance and property tax, and variable items such as utilities, maintenance, supplies and service contracts. Mortgage payments and major capital works do not.
Why are there two ways to estimate terminal value?
One grows today's price at a constant rate; the other capitalises the next year's income at a going-out rate. They encode different beliefs about how buyers will price an older building, and the analyst should test both.
How large is the reversion relative to the income stream?
In a five-year hold the sale usually carries most of the undiscounted inflows, often well over half. That is why a small change in the exit assumption can move the decision more than any single year of rent.
Assessment move
Build the ladder once by hand for a single year, then in a spreadsheet for six years. Label every percentage with its base and every rent with its review date, and add the exit both ways before you look at any decision measure.
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