What is pro forma in real estate and how can real estate investors use pro forma calculations to analyze potential deals.
The term “pro forma” is of Latin origin and literally translates to “as a matter of form or formality”. In real estate, pro forma analysis refers to the process of assigning accurate current estimates and future projections to key property valuations in order to calculate the potential net operating income and value of a property.
It can help guide both buying and selling decisions by projecting the long-term financial performance of a property. In this article, we take a closer look at what this actually means and how you can use pro forma in real estate to analyze potential deals.
Pro forma in real estate investing relates to a property’s projected potential. With it, you can forecast a property’s cash flow or net operating income (NOI) using future potential income and expenses.
You can assess the current performance of the property and then see how various adjustments to aspects such as vacancy rate, rent raises, capital improvements will impact the NOI. Using this method you can formulate strategies to increase revenue and profitability of a property – as well as identify those deals which will not realistically perform well enough to make them a good investment.
This is an important concept to understand as a real estate investor as it allows investors to ensure their projections and current assessment of a property are as accurate as possible.
The pro forma statement contains two important pieces of data: Cash flow projections and net operating income (NOI). Both of these metrics are used in other key investment property formulas such as ROI (return on investment), cash-on-cash return, and cap rate.
If the pro forma is wrong, these other important metrics could be wrong too which could easily lead to an investor overpaying for an underperforming property. Alternatively, it could result in the investor walking away from a great deal because they didn’t think it could perform.
Pro forma is a future projection of a property’s cash flow or net operating income (NOI). Here’s how to calculate it:
Subtract the projected future expenses and the property’s vacancy rate from the property’s gross rental income.
Pro Forma NOI = GRI – Vacancy expenses (Vacancy rate x GRI) – All other expenses
When estimating income and expenses you need to be realistic. As such you need to be able to analyze and determine the fair rent value of property dependent on things like square footage, location, condition, number of bedrooms, etc. Additionally, you need to take into consideration the average vacancy rate for your property type in that market.
Many of the property’s expenses will stay relatively the same, but it’s fairly common for some expenses such as property management fees and maintenance costs to either increase or decrease. For example, you might self-manage your properties allowing you to reduce your management fees from 10% of the monthly income to next to nothing. Additionally, after doing a market analysis you might decide the property is currently being rented for less than the current market rate and calculate the pro forma gross income based on a realistic rent increase. Know how to estimate expenses and base them on realistic numbers for your property type and market.
A seller might use pro forma to inflate the property value. For example, by reducing some of the actual operating expenses and increasing the rent amount they will be able to attract more buyers with a more attractive investment opportunity.
They have a singe-family property that has an actual current NOI of $1000 per month and other similar properties have a cap rate of around 7%.
Using these metrics they would calculate the market value of the house using the cap rate formula below:
Cap rate = NOI / Market value
Market value = NOI / cap rate
Market value = ($1,000×12) / 7% = $171,429
However, the seller might think that the current rent rate is too low and so decide to inflate the income to a pro forma value of $1200. The calculator would now look like this:
Market value = ($1,200×12) / 7% = $205,714
An increase in the market value of $34,285 or around 20% just by assuming a slightly different NOI.
For buyers, it’s important to always do your own pro forma calculations. Not doing so could result in you taking the seller’s word and potentially overpaying for a property.
For example, if we take the example from above. You might agree that that would be a fair rent increase based on the current market, however, this large jump in the rent amount is likely to cause the current tenants to move out leading to a vacancy period.
In this scenario, the buyer would want to calculate the pro forma NOI taking into account the lost rent due to vacancy and increased expenditures involved with finding a tenant.
The buyers market value calculation then would look something like this:
Rental Income = ($1,200×12) – $2,400 (vacancy loss of 2 months) = $12,000
Market value = $12,000 / 7% = $171,429
By not doing their own pro forma calculations they could end up overpaying for the property by nearly 20%.
Alternatively, this calculation could be used to identify a great deal, maybe the seller doesn’t know the fair market rent for example, and as such estimates the fair market value of their property too low. By investing in this property and increasing the rent the investor would immediately block equity and increase the cap rate of the property.
When buying real estate, always calculate your own pro forma. Pro forma plays a very important role in real estate, helping prospective buyers identify the potential growth of a property, but it is and always will be an estimate. Projections can be dramatically off, and a property that looks like it can perform well in the future may not because there are many factors that simply can’t be predicted.