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.