Evaluating a Rental Property's Future Performance, Easy as 1, 2, 3

A Proforma Income Statement is a useful way for real estate investors and analysts to evaluate an investment property's future performance.

Unlike an Annual Property Operating Data (APOD), which gives a "snap shot" only of the property's first year cash flow, a proforma income statement projects the investment property's income and expenses typically out over a period of ten years.

The advantage of a proforma income statement, by giving the real estate investor or analyst a look at a rental property's long-term cash flow projections, makes it a popular report for those who want to evaluate the future financial performance of rental properties. Nonetheless, the proforma should be used cautiously when making real estate investment decisions.

A Proforma is a "projection", with speculated numbers. What the income, operating expenses, and future value of a rental property might be over the course of a ten-year period is, at best, just a guess.

For this reason, real estate analysts should create the proforma with projections that are more conservative rather then overly aggressive, and the investor should never make a buying or selling decision on the results of a Proforma alone.

Moreover, given that a Proforma Income Statement is speculative, it is probably better to opt for a ten-year proforma rather then a fifteen or twenty-year income statement.

Most real estate investment software solutions create a proforma income statement, though they will vary. Whereas, they would generally include projections for income, expenses, and cash flow, not all real estate investment software solutions include computations for such things as cash flow after tax, sales proceeds after tax, or time value of money returns like net present value.

If you decide to purchase a real estate investment software solution to create a proforma for your rental property analysis, be sure to look at a sample created by the software before you buy.

If you want, you can also create your own Proforma Income Statement. It will take some effort, several hours of your time, and some computer skill. Still, it can be done with a spreadsheet program such as Microsoft Excel.

To begin, bear in mind what you want to accomplish with the proforma. You want to analyze the cash flow and other performance measures resulting from changes to such variables as income, operating expenses, and property value over future years. In other words, given the assumption that rents, expenses, and value are going to increase over time, you want to see the outcome.

As such, include one column for labels (i.e., income, expenses, mortgage payment, cash flow, etc.) and ten additional columns (assuming it will be a ten-year proforma) for the calculations. Label each of the ten column headers as EOY (End of Year). This is because you want to determine the results at the end of each year, beginning with Year One.

Insert the income, operating expenses, and mortgage payment in the first year's column (EOY1, or End of Year One). In this case, you should use the rental property's current income and expenses and whatever loan payment is associated with the proposed financing. Next, decide upon a reasonable percentage rate that you assume income and expenses will inflate each year. Then grow the income and operating expenses by that percentage over each of the ten years, starting in Year Two.

For example, if the rental property has an income of $108,000, operating expenses of $40,000, plus a proposed annual mortgage payment of $36,326, your anticipated cash flow before taxes (CFBT) would be $31,674 at the end of Year One. If you assume an annual inflation of 3% for both the income and expenses, then the income becomes $111,240, operating expenses become $41,200, same mortgage payment of $36,326, and cash flow before taxes becomes $33,714 for the end of Year Two.

Continue this process for each of the following years through the end of Year Ten. If you created your Proforma Income Statement correctly, with all the necessary calculations, it should be ready for you to evaluate the rental property's future performance and long-term cash flow projections.