A pro forma is a financial projection that estimates the performance of an income-producing asset such as an investment property. In real estate, a pro forma calculates the cash flow and net operating income (NOI) of a property and compiles it into a simple statement.
This is done by calculating the total expenses of managing and operating the property alongside its total gross income. A pro forma gives an investor an accurate assessment of the property's cash flow projections and essential metrics such as expenses and expected ROI.
- Projected Rental Income
- Property Management
- Mortgage Payment
- Taxes and Insurance
- Miscellaneous Fees
1. Projected Rental Income
The pro forma should include a projection of the building's gross rental income. Even if the property is currently vacant, the pro forma statement should show how much revenue the facility would generate when filled to capacity with tenants paying market-value rents.
Repairs are an unavoidable expense when managing a rental property. So, the pro forma statement should show how much it should cost to repair the building each year, including preventative and reactive maintenance. Investors should set aside cash reserves to prepare for repairs, using a pro forma as a guide.
The pro forma should also include projected vacancy rates. Every building has turnover, and it's impossible to keep it filled at all times. So, the pro forma statement should include an estimated vacancy rate and how often its likely to occur.
4. Property Management
Property management fees should also be accounted for on a pro forma statement. This includes any fees paid to a property manager or super intendant. Plus, it may include any other expenses related to managing the property, such as rent collection software.
5. Mortgage Payment
If you plan on using a mortgage to finance the property, the pro forma should include this expense. The statement should list how much you will pay each month to your lender and any other costs related to the financing.
6. Taxes and Insurance
The pro forma should also include a projected estimate of any additional costs related to property ownership, such as taxes and insurance. How much is your yearly tax bill, and how much should you pay monthly? Also, consider any insurance premiums and how the costs will impact your bottom line.
7. Miscellaneous Fees
Your pro forma should include any additional expenses that may not fit neatly into these categories. These fees include the costs of marketing and leasing units, paying legal fees, paying utilities, hiring an accountant, or any other expenses related to running the business.
- Estimated Gross Rental Income
- Calculate Vacancy Loss
- Determine Rough Repair Costs
- Add Up Property Management Fees
- Add Up All Other Expenses
- Calculate Your Monthly Mortgage Payment
- Determine Your Pre-Tax Cash Flow
1. Estimate Gross Rental Income
The first step is calculating gross rental income. Take the number of units in the building and multiply it by the average market rent of each unit. So, if the building has four units that each rent for $1500, your gross rental income would be $6000.
2. Calculate Vacancy Loss
Next, you should calculate the average vacancy loss. This will tell you how much money you're expected to lose while a unit is vacant. Suppose that each one of your units is vacant for about two weeks out of every year. That would give you a vacancy rate of about 3.8%.
3. Determine Rough Repair Costs
You should estimate how much you expect to spend repairing the building each year. You should generally expect to pay $1 per square foot in maintenance costs. So, if each of your four units is 1,000 square feet, you should expect to pay about $4,000 per year for repairing and maintaining the units.
4. Add Up Property Management Fees
Don't forget to include your property management fees. Most professional property managers charge 8-12% of the monthly rent. So, if you pay a property manager 10%, expect to pay around $600 (6000 x 10%). If you self-manage the property, you'll need to calculate all the expenses you will incur from managing the property on your own.
5. Add Up All Other Expenses
Next, you should go ahead and tally up any additional expenses related to maintaining the property, including taxes, insurance, utilities, broker fees, legal fees, and anything else you think may be relevant. It may be tough to get an exact number for some of these costs but do your best to determine a ballpark estimate.
6. Calculate Your Monthly Mortgage Payment
Last, if you are financing the purchase, you should calculate your monthly mortgage payment. If you already included estimated taxes and insurance payments, you should only have the interest and principal in this section.
7. Determine Your Pre-Tax Cash Flow
Finally, once you've counted up all your expenses, you can subtract that from your gross rental income to determine your pre-tax cash flow. Say, for instance, your costs for the 4-bedroom unit are $5,200 per month. That would leave you with a pre-tax cash flow of $800 (or $200 per unit).
Let's take a look at an example of a pro forma statement. First, you'd determine the property's price and gross rental income. We'll use the above example of a multifamily property with four 1,000-square-foot units.
Property price: $600,000
Market rent per unit: $1500
Number of units: 4
Gross Rental Income: $6,000
Next, you'll want to calculate the vacancy rate and subtract it from your gross income:
Vacancy loss (4%) = $240
That would bring your effective gross income to $5,760
Next, you'll want to add up all your monthly expenses:
Repairs (5%) = $300
Property Management Fees (10%) = $600
Taxes and Insurance: $600
Miscellaneous expenses: $500
Subtract your expenses from your effective gross income to find the NOI:
$5,760 - $2000 = $3,760
Finally, calculate your monthly mortgage payment (interest and principal only) and subtract it from that figure to determine your pre-tax cash flow.
Mortgage = $2,960 per month
NOI – Mortgage Debt = $3,760 - $2,960 = $800
This would give you a monthly cash flow of $800 or $200 per unit.
Unscrupulous brokers or sellers may use a misleading pro forma to entice you to invest in the property, regardless of whether the statement is entirely accurate. So, it's essential to know how to spot any deceptive information.
An excellent way to spot a potentially misleading pro forma is to determine if it seems overly simple or complex. For instance, a statement that only highlights the potential earnings but doesn't include critical expenses like maintenance and vacancy rates. This may indicate that whoever drafted the statement is overestimating the profits.
Another sign is if the pro forma seems needlessly complex. If they're itemizing specific expenses that seem unnecessary rather than giving a rough estimate, it may be a sign that they're trying to confuse you. It always helps to consult a broker or financial advisor if you receive a pro forma that seems too good to be true or overly complicated.
A pro forma can be helpful to both a buyer and a seller, but they may look slightly different. A seller will use a pro forma to attract potential buyers, so they are more likely to make it look like the property has the highest NOI possible. Even if they aren't trying to be intentionally deceptive, it's only natural to try to downplay the costs and highlight the returns.
On the other hand, a buyer may use a pro forma to determine when they will turn a profit on the investment. For example, say the property requires significant renovation. The buyer can use a pro forma to estimate how much rental income they can expect after the renovation and how long it would take to recoup their initial investment.
A real estate pro forma can provide important insight into the projected performance of an investment property. If you're thinking of investing in real estate, it's important to know how to use a pro forma to calculate expected cash flows. All you need to do is estimate the gross rental income, add up all your expenses and subtract the latter from the former to determine your pre-tax cash flow. This process will be simple if the property is already cash-flow positive. But even if it's newly built or still in development, it's just a matter of pulling market data and analyzing other comparable properties to get the needed information.