The Real Estate Pro Forma: What Every Investor Should Know
June 7, 2022
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A real estate pro forma can be an excellent way for buyers and sellers to get information about a property's potential cash flow. Based on effective gross income and operating expenses, real estate investors can determine if a property is worth a chance or if they should look elsewhere.
What Is Real Estate Pro Forma
Real estate pro forma is a statement or document that breaks down a real estate investment's current and estimated income and expenses. It's one of the main factors used in determining an investment property's worthiness and if the cash flow projections are high enough.
A real estate pro forma includes the following information:
- Property's projected income if it had a 0% vacancy rate
- An allowance for vacancies when in between tenants
- Miscellaneous income charged for parking spot rentals, coin-operated laundry, or late fees
- Cost of repairs (regular maintenance and unexpected repairs)
- Property management fees
- Total mortgage payment
- Any recurring and one-time expenses
The pro forma statement deducts the total expenses from the gross rental income to come up with the net operating income, which is used to calculate other financial metrics such as the cap rate and ROI.
Why Buyers and Sellers Use Pro Formas
The pro forma is useful for both buyers and sellers. They both use it to predict certain scenarios or play 'what if.' This often helps them decide if buying or selling makes sense given the projected scenarios.
Sellers use the pro forma statement to show how the potential rental income and cash flow to help potential buyers see the value in investing in the property.
They may also use it to determine if certain property upgrades are worth it. In other words, would they make a higher profit by investing more money in the property? Sellers also use it to help buyers understand their net operating income and cap rate with and without property management fees.
Buyers use the pro forma statement to determine if a property is worth investing in, given its current condition or potential vacancy rate. Buyers can play with the numbers and see what it would take to earn the necessary NOI to make the investment property worthwhile.
NOI & Cash Flow Projections
The real estate pro forma report gives buyers and sellers net operating income and cash flow estimates. The form allows buyers and sellers to play around with figures, such as rental income, operating expenses, and vacancy rates.
Playing with the numbers lets real estate investors see the best and worst-case scenarios for a property they own or one they are considering buying. For example, investors can change vacancy rates, rents charged, and operating expenses, both higher and lower, to see the different scenarios.
Another reason investors may use a real estate pro forma is to decide whether to hire a property manager or manage the property themselves. However, investors investing remotely or long-distance must include property management fees in their pro form as they can't manage a property remotely.
Real Estate Pro Forma Example
Here's a quick example of a real estate pro forma on an annual basis.
Purchase price $200,000
Projected gross income $14,000
Vacancy loss of 5% $700
Effective gross income $13,300
Repairs 10% $2,000
Property management fees 7% $980
Property taxes, insurance, and miscellaneous expenses $3,500
Net operating income $6,820
As you can see, real estate investors can play around with the numbers to see different scenarios, including higher or lower vacancy rates, different repairs or renovations, DIY property management versus hiring, and higher or lower property taxes.
Calculating Pro Forma in Real Estate
To calculate pro forma in real estate, you'll need some specific information, including:
- Projected gross income
If you don't already own the property or aren't yet renting it out, you'll need a good estimate of how much you could, given the market rent.
- Potential vacancy rate
Find out the average vacancy rate in the area to use an accurate percentage of vacancy loss, aka rent you wouldn't earn because tenants were not in the property.
- Estimated repair costs
If you can get a good idea of the home's condition and its average annual repair cost, you can use that in your pro forma, or you can use the average repair cost for the area for estimated tenant improvements.
- Estimated property management fees
Include the cost of hiring a property manager versus doing it yourself. Don't forget to compensate yourself for managing the property, though. Time is money, so it should be a factor.
- Property taxes and homeowner's insurance
You'll likely know the property's property taxes and can include actual numbers and the homeowner's insurance. If not, find the average cost in the area to include in your calculations.
- Mortgage payment
If you're leveraging your investment with a mortgage, include the cost of principal and interest payments.
With this information, you can figure out the effective gross income and net operating income based on the estimates or actual numbers you collect.
How to Create a Real Estate Pro Forma
To create a real estate pro forma, you'll need the best estimates for these categories. Because they are estimates, you can play around with the numbers to see how they would affect your bottom line.
Income is the rental income you earn from your tenants. You'll subtract the vacancy rate from this number, which will vary by area. It's always best to estimate high when considering investing in a property so you can see the worst-case scenario regarding your cash flow.
Operating expenses are all the expenses you'll incur to maintain and operate the property. This includes mortgage payments, real estate taxes, homeowner's insurance, property maintenance and repair, property management fees, and any other expenses you incur owning and running the property.
Net Operating Income
The net operating income is the difference between the effective gross income and operating expenses. It's this number that will help you calculate further metrics to decide if a property is a good investment.
The Fine Print
Keep in mind, that a pro forma is an estimate. Buyers' and sellers' pro formas often don't match. This doesn't mean one is right and one is wrong. They are both estimates.
The numbers used are based on assumptions and estimates but are better off when actual data is used. In other words, relying on a pro forma alone probably isn't the best idea, but it can help you figure out if the rental income is enough to offset the cost of an investment property.
Pro Forma vs Actual
A pro forma is an estimate of the cash flow a property is capable of, whereas actual is based on real data and showcases the property's actual returns. A pro forma is good for determining the net operating income, but actual data should be considered from there.
Other Important Calculations
The cash flow projections from the pro forma are just the start. It helps real estate investors understand the property's potential rental income and cash flow, but the following calculations give an even better idea. Don't forget about after and before tax cash flow.
The cap rate is the expected return on a property. It's a comparison of the net operating income to the property's sales price.
The lower the cap rate is, the less risky the investment is, and the higher it is, the higher the risk. On average, real estate investment properties should have a 4% - 10% cap rate.
Return on Investment (ROI)
The return on investment is the profit you might make on a property. It considers the profit earned minus the overall cost. Here's the formula:
Profit - Property cost/Property cost
Cash-on-cash return is the cash yield on a property based on the cash invested (the down payment, unless you paid all cash).
Its formula is:
Annual cash flow/Total cash invested
Why Do Sellers Use Pro Forma Statements?
Sellers use pro forma statements to entice buyers with the property's cash flow and net operating income. Because the numbers are estimates, buyers should use their own pro forma based on their research to make buying decisions.
When Would a Buyer Use a Pro Forma?
Buyers use pro formas to make sure a property is worth investing in. Using their own figures, buyers can determine if a selling price is inflated or if the seller's pro forma figures are higher than the figures the buyer found.
Are All Pro Formas Accurate?
Pro formas are estimates; they are not actual numbers. Can they be accurate?
But it's always worth doing your own due diligence and creating your own pro forma to ensure your capital expenditures and income are where you intended.
Who Would Be Interested Using in Pro Forma Statements?
All real estate investors use pro forma statements. They help with buying, selling, or investing more money in a property. Having as much help as possible with investment decisions is the key to making wise investments.
The Bottom Line
A real estate pro form shouldn't be the only information buyers, and sellers use to make investment decisions, but it can be a good start.
Real estate investors can use estimated or actual data to determine if a property is worth investing in and can determine a property's cash flow, base rental income, operating expenses, and overall metrics. Learn more by signing up and visiting our blog.
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