Understanding Real Estate Investment Financial Statements
One of the first steps to making any investment decision is doing your homework and performing basic due diligence. Commercial real estate offerings often come with a variety of documents, such as financial statements and pro formas, that help to explain the investment opportunity. Those documents can be complex and confusing. Here are some basic tips to help better understand and navigate those documents.
What is a pro forma?
The term pro forma is commonly used to describe cash flow projections. It is typically a detailed spreadsheet that provides information on income and expenses of a property, such as an office building or shopping mall. A pro forma helps paint an overall picture of income and expenses. What money is being generated and how is that money being spent? And at the end of the day, how much of that net gain (or loss) is returned to investors in the terms of an annualized and total return over the life of an investment?
One important point to note about a pro forma is that financial data is forward-looking based on assumptions of how the property will perform over the term for that investment hold, such as the five, seven or 10-year period. A second important point is to look at a pro forma in the context of the business plan for the strategy for that investment property.
For example, if the investment property is a Class A high-rise apartment building in Manhattan, the pro forma will likely show very stable income, expenses, cash flow, and returns. However, if the investment property is for a new apartment development in Manhattan, the first two years might show negative cash flow due to construction costs with no income coming in to offset those expenses. Once the property is complete and begins to fill up with renters, the income, cash flow, and returns should surge, while expenses for the new property will likely drop.
Key Terms to Recognize
Cash flow refers to any and all income a property generates. The main source of income for most properties is the rent tenants are paying. However, properties also can generate other sources of income, such as from parking or on-site advertising. It also is important to look at how the investment is structured related to what happens to cash flow. Some sponsors will structure investments in a way that allows them to reinvest cash flow back into a property, such as to pay for property improvements or upgrades. Other sponsors may structure a deal so that cash flow is paid out to investors as dividends.
Cash-on-cash yield is an annual rate of return that calculates the income earned on the capital invested in a property. For example, if an investor puts $100,000 into an investment that pays out $8,000 per year in total income, then the cash-on-cash return is 8%.
Internal Rate of Return (IRR) gives the investor a “big picture” number on overall profitability. Ultimately, the IRR is an estimate of the value an investment generates over the life of that investment. That is an important consideration for real estate, which often involves a long-term hold of 5, 7, or 10 years or more.
Stabilization refers to new development projects, redevelopment, renovation or projects that are otherwise in transition. Pre-stabilization is the period where construction or renovation is underway. The building may be completely empty or partially occupied by tenants. Stabilization is the point where the property achieves sufficient occupancy so that it is at break-even or positive cash flow.
What Can You Learn from a Pro Forma?
The pro forma helps to paint a picture of the financials of a commercial real estate investment. It is important to look at financial documents along with other key factors, such as the overall business plan and strategy. Does the forecast of income and expenses fit with the business plan? Red flags to watch out for that might warrant more questions for the sponsor, might be a sudden jump in expenses, or a sudden drop in income. That might signal a change ahead at the property, such as a costly roof replacement or the loss of a major tenant, that will impact the property’s net operating income and total return for investors.
It also is important to note that a pro forma is only as good as the data and analysis that goes into creating it. So, it is wise to look at the pro forma and investment financials in context with the strength and experience of the sponsor who created it. What is their experience and track record in being able to execute the business plan and deliver results to investors?