How do you build a pro forma? A pro forma calculates return metrics with a discounted cash flow analysis. This analysis is usually a projection of cash flows the investor plans on receiving through the investment. These cash flows are then "discounted" by a rate. This discount rate measures what the investor must make on her or his investment adjusted for your riskiness of this investment. It is important to see that the cash flow analysis is very useful in valuing income producing properties, but may not be as useful in valuing real estate that does not produce income. Other real estate investments, for instance raw land, vacant buildings or new construction could possibly be best analyzed by using other methods of valuation, for instance comparables or replacement costs. To create the income streams of a pro forma, start with the net operating income of your revenue producing property. If you might be analyzing a hypothetical deal or do not have the actual income numbers you will have to use assumptions. This is alright, as assumptions are critical for a pro forma model. You should use assumptions to project cash flows in to the future. In the end, a pro forma model is often a guess at future cash flows. You can project your future cash flows making use of your current net operating income and multiplying by the growth rate. The rate of growth inside the model should align with all the inflation trends with your local market.
The next step is to after building out your cash flows is to calculate a sale value of your property. A common method to calculate this value is to apply a capitalization rate or cap rate. Very commonly used in the commercial real estate industry, the cap rate serves as a the annual return you anticipate from your real estate investment. It is determined by the property or asset you're buying and also the risk linked to that investment. Since you currently have projected the annual income of your building in the future, by assuming a future cap rate, you are then able to calculate the long run sale value of your building. Your building's future sale amount is the same as the future net operating income divided by the future cap rate.
With all future cash flows projected, included sale value, the real estate investor can calculate metrics, for example IRR. The IRR metric is incredibly common in to compare investments. IRR will be the average annual yield realized through the investor over a string of income flows and will be calculated utilizing the IRR function in Excel. IRR is the main result of the pro forma model and lets the investor ask and answer fundamental business questions with regards to real estate investing.For example, if two investments have equal risk and capital requirements, but one investment has an IRR of 10% while another investment comes with an IRR of 5%, then the investment that produces the higher IRR seems to function as the better investment. With an adequately constructed pro forma model, the investor can also easily alter the assumptions and see how her or his IRR changes.
Source: http://www.artipot.com/articles/765628/how-to-utilize-an-excel-pro-forma-to-evaluate-a-commercial-real-estate-investment.htm
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