When it comes to real estate investments, few documents are more important than a Pro Forma real estate sheet. This valuable document helps real estate investors assess a rental property’s income potential. As a matter of fact, an accurate Pro Forma can be the determining factor between positive monthly cash flow and negative cash flow. In this article, we will demystify Pro Forma documents and outline their importance in regard to comparing investment properties.
What Does Pro Forma Mean in Real Estate?
The concept of Pro Forma comes from the world of finance. It denotes a simple method of estimating the current or projected financial results of a particular asset. In a similar fashion, Pro Forma in real estate serves as a property’s cash flow projection. Besides cash flow estimates, a Pro Forma real estate document gives the buyer an estimate of expenses as well as the expected return on investment. Think of it as a combined income statement and cash flow statement for a property.
The Essential Components
A Pro Forma real estate document needs to be well-structured and should contain all the elements that pertain to revenue and expenses. This includes everything from the base rental income to all the potential costs that are associated with investment properties. Simply put, a Pro Forma gives you a rough estimate of the potential revenue as well as the expected deductions and adjustments that you have to make. Below is a more detailed breakdown of the essential items of a Pro Forma real estate document
The first half of the Pro Forma real estate document is always reserved for revenue items. The main ones are base rental income, loss of vacancy, concessions, credit loss, and expense reimbursements.
- Base rental income: This is an estimation of rental income in its simplest form. This figure posits that tenants are paying market rates.
- Vacancy loss: This is one of the highest figures on a Pro Forma real estate sheet. It represents the lost income that occurs between tenants. It’s important to note that this is classified as a loss of potential revenue rather than an expense.
- Concessions: This refers to the incentives that landlords give to new tenants. Generally speaking, this tends to be in the form of a few months of free rent.
- Credit loss: Also known as bad debt. This is a projection of non-paid rent and other types of revenue. It is usually around 2% of the expected gross income.
- Expense reimbursements: This represents the expenses that the tenant handles. This can include property taxes, insurance, and utilities. This item will vary depending on the type of lease agreement between the two parties.
The sum of the above gives you the net rent that the property can generate. To calculate total income, you will have to add some of the following revenue items:
- Application fees
- Cleaning and damages
- Late Fees
- NSF charge
The expense section of a Pro Forma real estate document is quite straightforward. It contains most of the rental property expenses that you are familiar with. This includes operating expenses, property management fees, and real estate taxes.
- Operating expenses: These expenses consist of a wide array of costs that are inherent in managing a rental property. Some of these include maintenance and repairs, utilities, and other various expenses such as trash disposal. Repair and maintenance expenses, in particular, can be quite significant. Even if you invest in a well-maintained property, a portion of the rental income will have to be put away in order to cover any potential repairs.
- Property management fees: The majority of real estate investors hire management companies. These companies handle collecting rent as well as repair and maintenance. The cost of hiring professional property management is around 3% to 8% of the property’s rental income.
- Real estate and property taxes: All types of property are subject to local and government taxes. In most cases, these taxes consist of a small percentage of the overall value of the property. In addition, these taxes tend to increase each year as the value of the property appreciates.
What to Watch Out for When Analyzing a Pro Forma Real Estate Document
It is not uncommon to come across a Pro Forma real estate sheet that does not reflect the reality of the investment property. In fact, some unethical sellers, agents, and brokers may make use of underhanded tactics to mislead buyers. Here are two red flags that every beginner real estate investor should be aware of:
- An incomplete Pro Forma: This might seem very basic, but some property sellers simply choose to omit a number of critical items. The target audience for this type of Pro Forma is unsophisticated or novice investors. An example of this is a Pro Forma that showcases rental income and appreciation without including expenses. Needless to say, making an accurate cash flow analysis without factoring in expenses is not feasible.
- An overly complex Pro Forma: A Pro Forma real estate sheet should be simple and easy to analyze. Yet many sellers and agents make a concerted effort to make their Pro Formas as complex as possible. The aim of this tactic is to confuse the buyer and blur the line between revenue and expenses.
Be sure to do your own cash flow analysis using online real estate investment tools like Mashvisor’s Investment Property Calculator. This tool conveniently gathers data on rental income and expense estimates to ensure you accurately calculate the return on investment when buying an investment property.
The Difference Between a Buyer’s Pro Forma and a Seller’s Pro Forma
The goal of the property seller is different than that of the property buyer. The seller is trying to sell the property at the highest possible price whereas the buyer is looking for a lucrative investment property. As a consequence, the Pro Forma that the seller produces will invariably gloss over some significant expenses. This is the reason why buyers should have their own Pro Forma. Accurate estimations and projections are only possible if the document incorporates all expenses.
As it is the case with any financial projection tool, a Pro Forma does not offer a fail-proof look into the future. In fact, several unforeseen factors can sour an investment property that looks perfect on paper. Having said that, an accurate Pro Forma document can go a long way in helping you find a profitable investment property.