How to Create Revenue Projections to Determine Rental Property Profitability

When a real estate investor or analyst wants to determine whether a rental property is profitable and might offer a good investment opportunity or should be dismissed, they commonly evaluate the property's projected future revenues.

The idea is to estimate the cash flows and rates of return a rental property may produce for future years by projecting its income, operating expenses, and loan payment out for maybe ten years based upon some assumptions.

The concept is straightforward. Increase the income and operating expenses annually by some estimated percentage rate to arrive at a net operating income (income less expenses), then deduct the mortgage balance owed for that particular year to compute the property's cash flow and subsequent rates of return. The proforma income statement (or proforma) is generally the report used to project these revenues, and in this article, we'll discuss some simple basics to give you the idea. Please feel free to visit my website if you would like to see a sample proforma.

How to Create a Proforma You can choose one of two methods. You can use a spreadsheet or you can invest in a real estate investment software solution that provides the forms and will create a proforma income statement for you.

In any case, the important thing is to start the proforma with numbers that accurately reflect the property's current financial position, i.e., income, operating expenses, and loan payment. This will represent year one.

Next, make an estimate as to how much you think income and expenses will increase annually (use separate percentage rates for each if you wish) and multiply your starting numbers by these rates to calculate for year two, year two's numbers again for year three, and so on out as many years as you deem necessary (ten years is typical). Be sure to include the loan repayment for each of those years.

Finally, for each year, subtract the operating expenses from the income to determine the rental property's net operating income then subtract the loan payment to arrive at the cash flow (or more specifically, cash flow before taxes).

For a more elaborate income statement that shows cash flow after taxes, sale proceeds, cap rate, return on equity and so on, you will need to include tax information such as depreciation, mortgage interest, amortized loan points and the investor's marginal tax rate, a projected selling price for each of the years, and a round of additional computations for the rates of return.

Start with year one and then add each of the figures to the following years. You can inflate a sales price in exactly the same manner you did for income and expenses or select another way to project a sales price such as with a cap rate, gross rent multiplier, or set dollar amount. The depreciation rate depends on whether the rental property is residential (a home rental or apartments), or non-residential (commercial use). The loan will also have to be amortized so you can determine the amount of interest paid during each year.

You can find information regarding the depreciation schedules online if you're planning to construct your own proforma, otherwise a good real estate investment software solution will have it built in to the program and you will just have to fill in the forms.

Whether you choose to use real estate investment software or a spreadsheet, here's what you want to keep in mind about your statement.

1) You are essentially looking to analyze the cash flow and other performance measures resulting from changes to such variables as income, operating expenses, and property value over some number of future years.

2) Because it consists of projected estimates, don't rely solely upon a proforma income statement to make your investment decision.

3) Also, because it is speculative, you might not want to construct your proforma out further then ten years.

4) Always use income and operating expenses that are realistic to begin with and then use a reasonable percentage rate to inflate them annually. The same would be true with the projected selling price of the property.

To get a better idea about creating revenue projections for rental properties, you can see a completed sample proforma on my website. Here's to your real estate investing success.