Residual Pro Forma
The pro forma used to evaluate the residual/terminal value of a property. The residual pro forma seeks to forecast the net operating income a subsequent purchaser might use in valuing the subject property. This figure is often either the trailing twelve months (TTM) or the next twelve months from the sale date but can be altered to reflect a stabilized state at the time of sale.
Putting ‘Residual Pro Forma’ in Context
Horizon Equity Partners, a real estate private equity firm, is preparing to acquire Cedar Creek Apartments, a 200-unit garden-style apartment community located in a suburb of Nashville, Tennessee. As part of their financial analysis, the firm creates a residual pro forma to estimate the property’s terminal value at the end of a planned 7-year hold period.
Understanding the Residual Pro Forma
The residual pro forma forecasts the net operating income (NOI) that a subsequent purchaser might use to value the property at the time of sale. This NOI is typically based on a trailing twelve months (TTM) figure or projected stabilized NOI for the following twelve months. Horizon Equity Partners assumes the following for their residual pro forma:
- Effective Gross Income (Year 7): $4.35 million
- Operating Expenses (Year 7): $1.3 million
- Stabilized NOI: $3.05 million
- Exit Cap Rate: 5.75%
Calculating the Terminal Value
The terminal value is derived by applying the exit cap rate to the stabilized NOI from the residual pro forma:
- Terminal Value Formula: Terminal Value = Stabilized NOI ÷ Exit Cap Rate
- Calculation: $3,050,000 ÷ 0.0575 = $53,043,478 (rounded to $53.04 million)
Incorporating the Residual Pro Forma into Decision-Making
Horizon Equity Partners uses the residual pro forma to project key metrics such as:
- Equity Multiple: The multiple of the initial equity investment returned at sale, based on the terminal value and cash flows during the hold period
- Internal Rate of Return (IRR): The annualized return on the investment, incorporating the residual value
- Profit Margin: The difference between the terminal value and the total project cost, including acquisition and renovations
Conclusion
This hypothetical example illustrates the role of the residual pro forma in estimating a property’s terminal value. By projecting the stabilized NOI and applying an appropriate cap rate, Horizon Equity Partners can forecast the future value of Cedar Creek Apartments, enabling them to evaluate the potential profitability and viability of the investment.
Frequently Asked Questions about the Residual Pro Forma
What is a residual pro forma?
The residual pro forma is “the pro forma used to evaluate the residual/terminal value of a property.” It forecasts the net operating income (NOI) that a subsequent purchaser might use in valuing the property.
What timeframe does the residual pro forma typically use for NOI?
It is “typically based on a trailing twelve months (TTM) figure or projected stabilized NOI for the following twelve months.”
How is the terminal value calculated using the residual pro forma?
The terminal value is calculated using the formula:
Terminal Value = Stabilized NOI ÷ Exit Cap Rate
In the example, the calculation is: $3,050,000 ÷ 0.0575 = $53,043,478.
What assumptions did Horizon Equity Partners use in their residual pro forma?
They assumed the following for Year 7:
Effective Gross Income: $4.35 million
Operating Expenses: $1.3 million
Stabilized NOI: $3.05 million
Exit Cap Rate: 5.75%
Why is the residual pro forma important in investment decision-making?
It helps project key metrics such as:
Equity Multiple: Based on terminal value and cash flows
IRR (Internal Rate of Return): Annualized return including residual value
Profit Margin: Difference between terminal value and total project cost
This allows investors to evaluate the “potential profitability and viability of the investment.”
Can the residual pro forma reflect a stabilized state?
Yes. While often using TTM or next 12 months NOI, it “can be altered to reflect a stabilized state at the time of sale.”
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