Pro Forma In Real Estate: What Is It?

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New construction development projects, whether large, small, infill, or otherwise, all start with a pro forma. Putting together the pro forma document is an essential step for all property investors. A well-calculated pro forma will ensure your cash flow projections are accurate and will have a positive effect on your ROIs. This article will help you learn how to read a pro forma correctly – and how to put together your own real estate pro forma as an investor.

What is a Pro Forma in Real Estate?

What is a pro forma? A pro forma is Latin for “for the sake of form,” is a financial model that’s an essential tool in a real estate developer’s toolbox and can supplement GAAP reporting.

Real estate pro forma statements are financial documents based on assumptions and hypotheticals, not on reality. Businesses use them to make and showcase financial decisions. They may or may not include a balance sheet or other financial statements that summarize the future status of the business.

Why Understanding Pro Forma in Real Estate is Crucial for Investors

If you’re thinking about building any new construction project or acquisition/rehab, be it anything from a single-tenant industrial property to a 100-acre master-planned mixed-use community, building your pro forma is one of the first steps you’ll take. Developers use pro formas to help negotiate with equity partners, structure financing with potential lenders, and create project specs with architects and engineers. Better yet, developers use pro formas to decide how big (or small) and how fancy (or simple) a specific project will be.

Like an architect communicating their design through blueprints, the developer communicates internally and externally through their pro forma. Your pro forma, by analyzing different scenarios, gives you the best way to maximize your real estate investment. For example, which is a better use of your capital, rental or condo? Should it be 100 units or 150 units? These decisions, which can have enormous impacts on your financial bottom line, are analyzed with your pro forma before any shovel hits the ground.

Here are a few important things to consider when creating a pro forma.

What Information Does a Real Estate Pro Forma Contain?

Here is what you can find in a typical real estate pro forma:

Income

A pro forma will look at a property’s past performance, including rent payments over the last year or two. It will also include information about current rent payments from all tenants. Current rental market conditions (e.g. average rents in the area) will also be listed. Cumulatively, this information will give an investor a sense of how much rental income they expect the property to make.

Operating Expenses

A pro forma will list all the expenses associated with running the property, from utility bills to insurance, taxes, and property management fees if you use a property management service, which will typically cost between 8 and 10% of the rent. Taxes will be one of the biggest expenses on this list and the investor will need to thoroughly research how much they’ll need to pay in property taxes in their location. They’ll also need to be aware that property taxes increase during the holding period.

Debt Service

The debt service section of a real estate pro forma details the mortgage terms of the current loan, including the length of the loan, the outstanding loan amount, and the interest rate on the loan. Calculating the debt service can be trickier on properties with a variable interest rate mortgage as these will change over time.

Repairs

Every property investor has to budget for necessary repairs on their investment property. Generally, it’s understood that setting aside 5% of the rent is enough for a property in good condition/newly built property. If you are investing in an older home, you will need a bigger repair budget. 

Vacancy Loss

Vacancy loss should be counted as an expense, and likely the biggest one the investor will have. All rental properties stand vacant from time to time and you will have to budget for the income loss from these periods. The time periods between tenancies when cleaning and repairs are undertaken should also be taken into account. 

What Metrics Can Be Calculated from a Real Estate Pro Forma?

So, what can you do with all this information? What insights can it give you about the performance of your investment property?

Net Operating Income

Probably the single most important real estate metric, net operating income is calculated by subtracting the total property expenses from its gross income. That’s why calculating your expenses accurately is so important. 

Return on investment (ROI)

The ROI is another crucial metric and is calculated by dividing the profit made from an investment by the cost of the investment.

Internal Rate of Return

The Internal Rate of Return (IRR) is linked to the property’s annual cash flows as stated on the pro forma. It takes into account the property’s original purchase price and its sale price.  

Cash-On-Cash Return

Cash-on-cash return is calculated by dividing the pre-tax cash flow by the initial amount invested in the property. It’s calculated annually for each year of the holding period.  

Cap rate

The cap rate is calculated by dividing a property’s net operating income by the current market value. Cap rates are used to compare the rates of return from multiple residential or commercial investment properties.

How to Build a Pro Forma for Commercial Real Estate

Building an investment-grade development pro forma is a major undertaking. It’s something that’s built in stages, torn apart, built again, torn apart again, and built again. Yet it doesn’t have to seem so daunting because of one major point:

Every pro forma starts somewhere—usually with a blank page.

There are a few strategies for starting and building a development pro forma:

• Build from scratch
• Reuse an existing pro forma
• Use a hybrid model

Building a real estate pro forma from scratch is time-intensive, but is an excellent method for understanding the ins and outs of a potential project in intimate detail. Don’t get overwhelmed by the need to get everything in place right away. Start with what you know, and expand from there.

Get what you already know in the “assumptions tab,” like site size and zoning. Then, estimate a rough development and construction schedule and create a preliminary building scope.

To reuse an existing pro forma, follow a template built by another person or company and customize it for your project. This strategy can backfire when you have to spend more time fixing and patching the template than it would take to build one from scratch.

Pro forma templates usually have the most value when they teach you how to build your own model. To do this, use the pro forma template as a reference, but build one of your own from scratch—a hybrid model.

The best way to implement this strategy is to find a quality, well-built pro forma, and keep it minimized in the background. When you hit a roadblock and need guidance, open the template to understand how and why certain inputs or formulas were used. Over time you start to recognize patterns, methods, tricks, and styles that you can then graft into your own model-building tool kit.

The most important thing to understand with financial models is that they aren’t built overnight. It can be intimidating to want to develop a project, but not know how to properly underwrite it. Since development is a high-risk venture, pro formas are essential to getting the process started and mitigating risk. So if you’re stuck on getting your pro forma off the ground, give one of the strategies above a try and jump in.

How to Recognize and Avoid Misleading Real Estate Pro Formas

How do you know that you can trust a pro forma you’ve been given? The truth is that often you can’t. Because there is no standardized way of building them, some pro formas contain too much information – others, too little. Here’s how to recognize a pro forma that will not give you accurate return projections:

• Overly simple pro formas: any pro forma that just gives you a purchase price, rent, and cash flow, and completely omits expenses, is to be avoided.
• Overly complex pro formas: too much information isn’t good either. Avoid pro formas that include monthly expenses (these are too difficult to predict accurately for investment properties) or give you dubious IRR figures. IRR is a complex calculation and you need to know how it was made; if it’s just listed willy-nilly, it may not be accurate.
• Pro formas that give you low maintenance expense projections: A pro forma that gives you a 3% maintenance expense allocation? We don’t think so. Remember: expenses will hugely affect your final returns, so they should never be downplayed.

Seller’s Pro Forma vs. Buyer’s Pro Forma

The basic rule here is: if you’re an investor buying a property, build your own pro forma. Do not rely on the seller’s pro forma; sellers often downplay expenses in order to make a property look more profitable than it may be. 

Pro Forma vs. Real Rents and Expenses

Every investor needs to remember that a pro forma, however, well-put-together, is still only an estimate. It can give you an idea of how much rent you can charge or what your expenses are likely to be, but your actual financing should always be based on the true income and expenses incurred.

What to Look for in the Fine Print of a Pro Forma

Pro formas in real estate are essentially models that show us what we think will happen in the future. They are based on many assumptions that are unknown at the start. As a project develops, these assumptions get more and more refined. Understanding the typical assumptions that underlay a pro forma is in essence reading the fine print of a pro forma. Here are typical types of assumptions that drive a pro forma.

Income / Expense Growth

A pro forma will typically give projected annual income and expense growth adjustments for inflation. These predictions shouldn’t be more than around 3% annually.

Occupancy Levels

No property will be occupied all of the time, and the pro forma will make assumptions about the projected vacancy periods. These shouldn’t be more than 5-7% of a holding period.

Lease Renewal Rates

This is an assumption about the rate at which rental leases will renew, as it’s unlikely that a tenant lease will cover the entire holding period. Lease renewal rates should correspond with market rent per square foot.

Capital Expenditures

Planning on refurbishing a property before renting it out? The expense of doing this should be included in the pro forma as it will affect the rents you will charge to recoup these expenditures.

Conclusion

Will a pro forma give you a 100% accurate prediction of your returns and expenses? No – only real numbers can give you that. Is a thoroughly built pro forma an important document that can reduce the margin of error when making an investment? Yes, absolutely, so taking the time and effort to build your own real estate pro forma is definitely worth it.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.