Posted over 1 year ago

How Pro Forma Works In Real Estate Investments

The first thing an investor must consider when looking at any potential real estate investment property is the cash flow projection. This is done through a Real Estate Pro Forma, which allows an investor to evaluate the overall profitability of a property.

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

To state the obvious, the seller of a property wants you to buy that property, so he or she will frame the pro forma to make the cash flow look as positive as possible, which often means that several key considerations may be missing or oversimplified. As such, the decision to purchase a property should be based off of a buyer’s pro forma using true (or as close to true as possible) estimations and calculations.

How to Read and Understand a Pro Forma

You’ll need to fully understand how to interpret and read a pro forma with each real estate investment you consider. Let’s take a look at one example.

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(source)

The above example shows a ten year cash flow projection similar to what many real estate investors will build and study when evaluating any potential investment opportunity. This pro forma table includes the following:

  • Potential Gross Income (PGI)
  • Vacancy Allowance
  • Other Income
  • Effective Gross Income (EGI)
  • Operating Expenses
  • Net Operating Income (NOI)
  • Other Expenditures
  • Before Tax Cash Flow (BTCF)
  • Reversion Cash Flows

You can find an in-depth explanation of each of the above items here.

What to Include in Your Pro Forma

There are 4 key line item considerations that should be included in every buyer’s pro forma: repairs, vacancy loss, property management, and miscellaneous.

  • Repairs. It is often stated that the property you are looking at has been renovated or perhaps a new property so there will not be any repairs. This may be true for a while but eventually something will need a repair. Depending on the age and condition of the property the amount of money you want to earmark for this line item is discretionary. I typically will use 5% of the rent as a benchmark. There is no right or wrong number to put in here. It is more of an estimation to future expenses. Putting this money aside each month will keep your returns more accurate.
  • Vacancy loss. The most expensive line item we have is vacancy loss. Even a property that is fully rented for a year will eventually experience some loss. When a tenant moves out, you have a short period of time where you are cleaning, painting or simply waiting for the next tenant to arrive. 1 week worth of vacancy in this example will cost you 1/4th of month’s rent. Again, no right or wrong number to put in here but you should consider listing something.
  • Property management. This is typically left off the pro forma as it is assumed you may elect to manage your own property. Even if you do you should be compensated for it. You want to consider the fact that the properties financial merit is based on all expenses. Whether you take compensation or not the merit of the property should support a payment for this line item. If you manage it yourself your cash flow should be that much greater.
  • Misc. This is more of a place holder, you may or may not have added expenses, but if you look deep you usually encounter something like advertising costs, a fee to pay the property manager to fill the vacancy, perhaps a legal fee.
  • (Thanks to HowToBuyUSARealEstate for the description of these four items. Read the full article here.)

    Moving From Pro Forma to Actual Data

    You’ll want to transition from examining cash flow projections to studying real life data as you advance through the real estate investment evaluation phase. You should ask the seller to provide you with the following: previous years’ tax returns, property tax bills, maintenance records, etc. This concrete data will give you a much more accurate picture than the estimated projections.

    According to BiggerPockets.com, you’ll want to examine the following sources to gather this information and make you an informed real estate investor:

    • Property Details: This information should be available from the seller, but more comprehensive and detailed information can also be obtained from your local County Records Office
    • Purchase Information: Obviously the seller is going to name a purchase price (which will likely be negotiable, of course), but the more important information here will be any upfront maintenance or improvement work that needs to be completed to ensure that the property can (or continue to) meet its income potential. While there may be no extra cost here for properties in good condition, it’s worth having the property inspected by a professional building inspector to ensure that there are no hidden issues or problems
    • Financing Details: You’ll want to talk to your lender or mortgage broker to get an idea (or better yet a letter of approval) about the cost of the loan and the necessary down payment
    • Income: Details about income should come directly from the seller, but as mentioned above, don’t rely on pro-forma data for final analysis. You can also talk to the property management company currently running the property (if there is one) to get this information
    • Expenses: Similar to income, details about expenses should come directly from the seller (last warning not to trust pro-forma data!) or the property management company currently running the property. This is another place where a building inspector could help warn you about any major repairs that may be coming due in the near future (new roof, new heating/AC, etc)

    As you continue exploring and evaluating possible real estate investments, this Quick Proforma tool might come in handy for your projections. And when you’re ready to make the jump into building your global real estate investment portfolio, check out my real estate crowdfunding platform, Durise.


    Comments (1)

    1. A lender I'm working with to acquire a residential portfolio of 3 condo units (commercial loan) asked for pro formas of each unit... is this something for the Seller to provide, or am I supposed to create these?