What Is a Pro Forma In Real Estate?
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.
What Should a Pro Forma Include?
- Projected Rental Income
- Operating Expenses
- Mortgage Payments
- Miscellaneous Fees
- Return Metrics
1. Projected Rental Income
- Gross Potential Rent (GPR): The total rental income if the property is 100% leased at market rental rates.
- Vacancy Allowance: Estimated percentage of the GPR that will not be collected due to vacancies. 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.
- Effective Gross Income (EGI): The GPR minus the vacancy allowance, plus any additional income (e.g., parking fees, laundry facilities).
2. Operating Expenses
- Property Management Fees: Costs associated with managing the property. Property managers charge either a fixed fee or a percentage of the rent.
- Maintenance and Repairs: Regular upkeep and unexpected repairs.
- Utilities: Costs of water, electricity, gas, etc.
- Property Taxes: Annual taxes levied by local governments.
- Insurance: Property insurance premiums.
- Other Expenses: Miscellaneous costs such as legal fees, advertising, and accounting.
3. Mortgage Payments
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.
4. 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.
5. Return Metrics
- Cap Rate: The cap rate is equal to the NOI divided by the property’s purchase price, expressed as a percentage. Indicates the return on investment.
- Cash-on-Cash Return: Cash-on-cash return is the before-tax cash flow divided by the total cash invested. Measures the annual return on the investor's out-of-pocket cash.
- Internal Rate of Return (IRR): IRR is another important metric to consider. It is the discount rate at which the net present value (NPV) of all cash flows (both incoming and outgoing) from a property equals zero. Provides a comprehensive measure of investment performance over time.
How To Calculate Pro Forma
- 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. 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).
Pro Forma Spreadsheet Example
| Item | Annual Amount |
|---|---|
| Income | |
| Gross Potential Rent (GPR) | $120,000 |
| Vacancy Allowance (5%) | -$6,000 |
| Additional Income | $4,000 |
| Effective Gross Income (EGI) | $118,000 |
| Operating Expenses | |
| Property Management Fees | $6,000 |
| Maintenance and Repairs | $5,000 |
| Utilities | $3,000 |
| Property Taxes | $10,000 |
| Insurance | $2,000 |
| Other Expenses | $1,000 |
| Total Operating Expenses | $27,000 |
| Net Operating Income (NOI) | $91,000 |
| Financing Costs | |
| Debt Service | $40,000 |
| Cash Flow Projections | |
| Before-Tax Cash Flow | $51,000 |
How 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.
Seller'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.
Proforma Real Estate Bottom Line
A real estate proforma is an essential tool for evaluating an investment property's potential financial performance. By projecting income, expenses, and cash flows, investors can make informed decisions about the viability and profitability of a real estate investment. 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.