How to Project Rental Property Cash Flow

Using a proforma income statement to evaluate an investment property's future cash flow performance is a real benefit to individual investors because it computes the property's cash flow out over a number of years.

The concept is straightforward. By looking at the financial performance of the rental property the year before and then using a variable to make projections into the future, a rental pro forma shows the cash flow that an individual investor who owns the property might receive on a year-to-year basis over time based upon those projections.

Here's how it works.

Assume that a property currently produces $30,000 gross operating income and has operating expenses of $12,000, thus leaving a net operating of $18,000 (income less expenses). The analyst seeks to determine the following year's net operating income based upon an educated guess for next year's income and expenses.

For example, if the analyst speculates that the revenue above will annually increase 5% and the operating expenses 4%, then it follows that the net operating income at the end of next year will increase to $19,020.

Revenue (next year) = $30,000 + (30,000 x .05) = $31,500
Expense (next year) = $12,000 + (12,000 x .04) = $12,480
Net Operating Income (next year) = $31,500 – 12,480 = $19,020

And so it goes for each subsequent year extending out 10, 15, or 20 years until the rental income proforma is populated.

Anyone involved with real estate investing understands that real estate is not considered liquid and as such, a property's performance must be considered over the long run. This is the reason that realestate analysts and investors rely on a proforma for property evaluation and in turn, regularly rely on it to help them make their decision regarding an investment opportunity.

How do I create a pro forma income statement?

A pro forma is typically created in most real estate investment software solutions, although they might vary slightly or omit some features like tax shelter, sales proceeds after tax, or specific rates of return found in competitor applications. For the stouthearted, however, a proforma can be manually created with an Excel spreadsheet. In this case, if you have some knowledge of Excel, allow yourself enough free hours to create a good proforma income statement.

Whatever method you choose however, whether real estate investment software or a spreadsheet, here are a few important considerations to keep in mind.

1. Understand 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.

2. The pro forma is 100% assumptive (a guess). Do not rely solely upon a proforma income statement to make your investment decision.

3. Though a proforma can be constructed to project any number of future years, because a proforma is speculative, you might not want to go out further then ten years. I personally would not feel comfortable going out any further.

4. Be sure to use realistic numbers. Start with the current income and expenses and inflate them annually by a reasonable amount. Don't, for instance, increase the income 10% annually when 2-3% has been normal.

Finally, let me add that if you are serious about real estate investing then it is highly recommended that you make an investment in a good real estate software solution rather than spend the time trying to create one yourself. You'll get a professional-quality report and get a ton of other real estate analysis features that will benefit you as well.

You can preview a sample proforma at www.proapod.com.