Analyzing Pro Forma Data Years Out

Business school prepares you well to do complicated analysis of projects with cash flow patterns that are irregular. Fancy tools like the internal rate of return (IRR) are often used to decide where to optimally park real estate investment funds. Investors have different time horizons, risk profiles, required returns, etc. and will thus analyze projects competing for limited resources differently. Different valuations are healthy and are what make for a market.

Many investors buy and hold real estate projects and have a very lengthy time horizon. Other investors are interested in picking up projects that show some sign of distress, correcting the problem, and capitalizing “opportunistically” on the upside from forced appreciation. Investors at both of these extremes bid on the same assets using drastically different exit strategies and thus come up with big differences in value based on their required equity returns, tolerance for risk, etc. Values diverge appreciably when the time horizon for the investors is different and the pro formas past a few years are introduced. Use of more years in the underwriting to determine a project’s value introduces noise and reduces the certainty of those values in the final valuation. Buy and hold investors generally use these extraneous years while opportunistic investors don’t.

One of the popular BiggerPockets contributors is fond of saying pro forma equals pre-tend. This commentary stems mainly from the fantasy world pro forma profit and loss (P&L) statements circulated by brokers eager to obtain the maximum price for their clients while listing a property. I share this frustration about brokers trying to trade assets on number projections; albeit for what I feel is a different reason. Neils Bohr once said that, “Prediction is difficult, especially about the future.” Predictions about the future are necessary to perform a proper investment analysis.

How does any investor predict how an asset will perform a number of years in the future with any degree of certainty when there are so many variables that can influence the analysis?

My argument would be that it can’t be done and that trying to do so is an exercise in futility. Buy and hold investors should cast aside their modeling pride and fancy models and simply value projects in a manner close to what opportunistic investors use.

Analyzing the dominant factors that drive valuation is the best one can hope to do in an analysis of investments. Vacancy rates and rent escalators are big drivers of value in almost any real estate investment I have analyzed. The significance of cash flows past year 5 diminishes very quickly and is noise compared with getting these two assumptions as close to correct as possible. The uncertainty associated with forecasting these two variables alone is enough to discard other items regardless of how long your time horizon extends. A reversion cash flow in year 5 is useful in underwriting a project quickly and does not cause a meaningful change in valuation in most cases. Trying to predict the minutiae may make for a fancy model, but it seldom adds significantly to determining what an investor should pay for a cash flow stream produced by a project.

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.