Proforma Real Estate Guide

By PropertyClub Team
Jul 7th 2022
Anyone interested in getting into real estate investing should research what is called a pro forma statement. A pro forma is a critical process and financial statement that will tell you everything you need to know about the earning potential of a property. Here is a closer look at the concept of a pro forma in real estate.

hash-markWhat is Pro Forma in Real Estate?

A pro forma is a method of calculating the financial projections of a business or income-producing asset such as real estate. 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.  

hash-markWhat Should a Pro Forma Include?

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. 

2. Repairs

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. 

3. Vacancies

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. 

hash-markHow to Calculate Pro Forma

Calculating a pro forma can get complex, although it's probably not as intense as you think. 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. Here are the steps you should take to create a pro forma statement.

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). 

hash-markHow to Recognize and Avoid Misleading Pro Formas

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.

hash-markSeller's Pro Forma vs. Buyer's Pro Forma 

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.  

hash-markPro Forma Spreadsheet Example 

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

Total: $2000

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.