As a real estate investor, you need to know how to make a cash-flow projection for a property. A cash flow projection shows the likely financial performance of a property and allows you to analyze and compare properties.
Cash flow is computed by subtracting operating costs from income to produce what is called net operating income, or NOI. This is the cash flow as if the property had no debt, and it is the basis for determining a property's value by the income method. If there is debt, the debt payment is subtracted from NOI to obtain the cash flow.
With a cash flow projection in hand, you can do all kinds of analyses. You can change the income or expenses to see how that changes cash flow. You can project what the property will sell for in the future based on the projected NOI. You can calculate such financial analyses as the present value or internal rate of return, and you can compare them with different cash flow projections to see the effect.
You can do these analyses for different properties to see how their performances compare.
But to get accurate information you need to compute the cash flow correctly.
Computer programs are available to do this, such as Excel or other spreadsheet software.
Start by forecasting future annual rental income for each year of the forecast assuming the building is fully leased. For commercial buildings, do this based on the square-foot area of each tenant and the lease rate. For the years after the lease expires, use your best guess of what lease rates will be at that time.
For apartments, use the rental rate for each type of unit, such as one-bedroom, two-bedroom, and so forth. Be sure to include any additional income such as parking or laundry. This income is called "scheduled income."
You have to take into consideration vacancy and rent not collected, called "vacancy and credit loss." For a typical property, figure you'll have a vacancy -- no rent -- 5 percent of the time, but this will vary depending on the property. Subtract this vacancy factor from the "scheduled income" to get what is called "effective income."
Now do another subtraction: the property's operating costs. This can be as simple as using the total cost amount, or you can show each cost item in as much detail as you want. The easiest way to do this is to take the current year's operating costs and increase them by a percentage for each year in your forecast. Typically this is your forecast of inflation, so something like 2 percent or 3 percent per year is probably about right. But make adjustments for exceptions. This is a before-tax forecast, so do not include interest or depreciation.
As described above, the result from subtracting operating costs from income is called net operating income, and it shows the cash flow without debt.
But most properties have debt, and to get the cash flow after loan payments, just subtract the annual loan payment from the NOI.
Remember, this is a forecast and, like a weather forecast, the further into the future it goes, the less likely it is to be accurate.
But it can provide you with a good idea of what your investment's future performance is likely to be. And if you use consistent basic assumptions, cash flow projections can be very accurate in comparing different properties' likely financial performance.
Chris Stephens, CCIM, is a local associate broker specializing in commercial and investment real estate. His opinion column appears every month in the Anchorage Daily News.