An important part of real estate investing is understanding how to determine a property's potential income, or pro forma. You will surely come across pro forma projections as you analyze investment opportunities, and knowing how to verify and calculate a pro forma can help you avoid buying a property for more than it's worth. Learn what pro forma is in real estate, how to calculate it, and when it's used in real estate investing.
What is pro forma in real estate?
Pro forma is a term used in real estate investing that relates to an investment property's projected income potential. It's a forecast of the property's cash flow using its future potential income and expenses to show how a property could perform if certain adjustments were made like raising rents, decreasing vacancies, making capital improvements, and developing or expanding.
How is pro forma calculated?
Pro forma is a future projection of a property's cash flow or net operating income (NOI). Here's how to calculate it:
- Estimate the property's potential gross rental income.
- Estimate the vacancy rate.
- Estimate all future expenses.
- Subtract the projected future expenses from the property's gross rental income minus vacancy rate.
Income and expenses should be based on realistic projections. Learn how to analyze and determine a true, fair rental rate for the property based on its location, condition, or future condition, and take into consideration the average vacancy rate for your property type in that market.
Keep in mind that some of the property's current expenses will stay relatively the same, but it's fairly common for expenses to increase or decrease. You may manage the property more efficiently or have a higher cost because you hire a third-party management company. Property insurance may be higher than the policy the current owner has in place, and property taxes may increase after the time of sale or shortly thereafter. Know how to estimate expenses and base them off realistic numbers for your property type and market.
|ACTUAL/CURRENT PERFORMANCE||PRO FORMA|
|GROSS RENTAL INCOME||$38,000||$68,000|
|VACANCY RATE||-$5,700 (15%)||-$8,200 (12%)|
|REPAIRS & MAINTENANCE||$2,100||$6,800 (saving 10% of gross income)|
|PROPERTY MANAGEMENT||$10,500||$6,800 (their fee is 10% of gross income)|
|PROFESSIONAL SERVICES (like legal fees)||$200||$1,500|
|NET OPERATING INCOME (NOI)||$8,607||$28,730|
When is pro forma used in real estate?
Pro forma is typically used in commercial real estate (CRE) when an investment property is being offered for sale and is most often used to determine a property's cap rate to take it to market. It can also be used to help prospective buyers determine a property's potential return on investment.
If a property is being sold with a commercial broker, the broker will analyze the property's current performance and compare it to market standards, determining where the property's income or expenses could be improved or reduced to create a pro forma. Most brokers will then list the property for sale based on the pro forma projections according to the going cap rate for that CRE type in that market.
If the property is being sold without a broker, an experienced investor should be able to provide pro forma projections, but ultimately, the prospective buyer needs to be able to determine their own pro forma for the property. It's up to the investor to verify that the property can, in fact, perform according to the provided pro forma. Many times the rental rates or expenses provided by the seller or broker will be inflated or deflated to boost the property's projections.
Pro forma in summary
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.
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