What is a pro forma in real estate? How is it calculated?

If you’re interested in real estate investing, you should know what is a pro forma in real estate. This financial tool can help you project how much money you could make (or lose) from an investment property. Here’s a breakdown of what a pro forma is and why it’s so important in the real estate industry.

So, what is a pro forma in real estate?

Pro forma (from Latin) literally means “as a matter of form or formality.” In legal terms, it refers to the formal steps taken to keep the legal process moving. In business, it can describe either a pro forma process or a financial document (sometimes called a pro forma invoice) that predicts future income and expenses.

In real estate, a pro forma analysis helps you decide whether to invest in a property or not. It projects how it will perform financially over the long haul. That is to say, this document forecasts the future financial performance of a property. It includes estimates of income, expenses, and other key financial metrics. 

Think of it as a crystal ball that helps you see if an investment property will be profitable or not. Frivolities aside, a pro forma helps property investors make informed decisions and effectively manage their investments.

What are the main components to calculate a pro forma?

• Potential rental income (PRI): This is the total rent you’d collect if the property is fully rented out at market rates. Market rent is the amount you can realistically charge based on what similar properties are renting for.
• Vacancy rate: This is the percentage of the property that might be empty at any given time. It accounts for the periods when you’re between tenants.
• Effective gross income (EGI): It gives a more realistic idea of the rent you’ll actually collect. Take the potential rental income and subtract the expected vacancies. 
• Operating expenses: These are the costs of running the property. They include maintenance, property management fees, insurance, property taxes, and utilities.
• Net operating income (NOI): This is your income after covering operating expenses. It’s a key figure because it shows the property’s profitability before considering mortgage payments and taxes. Therefore, NOI = EGI − Operating expenses
• Debt service: This is your mortgage payment, including both principal amount and interest. It’s a crucial tool for understanding your cash flow.
• Cash flow projections: This estimates how much money you’ll have left after paying all expenses and mortgage payments. As the name suggests, a positive cash flow means you’re making money. And, a negative cash flow means you’re losing money.
• Capital expenditures (CapEx): These include big-ticket items such as a new roof or HVAC system. Of course, you need to budget for these to keep the property in good shape.
• Income and expenses: This includes a detailed list of all income (rent, laundry machines, parking fees) and all expenses. All these help you get a clear picture of the property’s financial health.

What are the other key metrics for real estate investors?

To figure out if an investment property is worth it, you need to also look at a few other key numbers.

• Cash on cash return: This measures your annual return based on the cash you’ve invested. It’s calculated by dividing your annual cash flow by your total cash investment. Cash on Cash Return = Annual Cash Flow​/Total Cash Investment
• Internal rate of return (IRR): IRR is a bit more complex. It measures the overall profitability of the investment over time, considering when you get cash inflows and when you make payments.
• Net present value (NPV): NPV looks at the value of money over time. It’s the difference between the present value of cash inflows and outflows. Positive NPV means you’re expected to make money; negative NPV means a loss.
• Debt service coverage ratio (DSCR): This measures if your property’s income can cover its mortgage payments. It’s calculated by dividing the NOI by the debt service. DSCR=NOI/Debt service. A DSCR above 1 means you’re in good shape; below 1, you’re not making enough to cover your mortgage.

Why is an accurate pro forma analysis important?

Getting your pro forma right is crucial for making smart real estate investment decisions. Here are some ways it helps real estate investors achieve long-term success. 

• Pro forma helps you see potential risks and manage them. By playing out different scenarios, you can understand how changes in market conditions, vacancy rates, or expenses might affect your investment.
• It shows a property’s financial feasibility – if it is likely to generate positive cash flow and meet your financial goals.
• Pro forma lets you compare multiple properties side by side, helping you pick the best one.
• Loan lenders often want to see a detailed pro forma before giving you a loan. A good pro forma increases your chances of getting financial aid.
• Pro forma aids in property management and operational efficiency. That is to say, it helps property managers plan and run the property more efficiently by understanding projected income and expenses.

How to calculate a real estate pro forma?

Creating a pro forma involves several steps. 

• Collect data on market rent, vacancy rates, operating expenses, and capital expenditures. Always, use reliable sources such as property records.
• Calculate the potential rent by multiplying market rent by the number of units and months in a year.
• Estimate the vacancy rate based on market trends. Subtract this from the potential rental income to get the effective gross income.
• List all operating expenses and total them up.
• Subtract operating expenses from the effective gross income to get the NOI.
• Estimate your debt service. Calculate your mortgage payments and subtract these from the NOI to get your pre-tax cash flow.
• Factor in capital expenditures and any other non-operating expenses. Subtract these from your pre-tax cash flow to get the net cash flow.
• Work out the cash-on-cash return, IRR, and DSCR to get a sense of the property’s financial health.
• Perform sensitivity analysis. Test different scenarios to see how changes in key assumptions affect the property’s performance.

Read more: What does cap rate mean in real estate?

What are some useful tips for long-term success in real estate investment?

To be successful in real estate over the long term, you need a solid strategy and careful planning. Here are some tips:

• Do your homework and due diligence before investing. Look at market conditions, property location, tenant demographics, and potential risks.
• Make sure your pro forma is based on reliable data and realistic assumptions.
• Spread your investments across different property types, locations, and markets to reduce risk.
• Work with experienced property managers to keep operations smooth and maximize rental income.
• Keep an eye on how your properties are performing. Update your pro forma and adjust your strategies as needed.
• Focus on sustainable growth, property appreciation, and consistent cash flow.

Last thoughts

In a nutshell, understanding what is a pro forma in real estate is key to making smart investment choices. A pro forma gives you a clear picture of the potential returns and risks of a property. It helps you make smart investment decisions, get financing, and manage the property better.

By accurately forecasting rental income, expenses, and key metrics, you can evaluate if a property is a good investment, manage risks, and build a profitable portfolio. You can then navigate the real estate market successfully and achieve your financial goals.

FAQs

Can a pro forma guarantee how a property will actually perform?

No, a pro forma can’t guarantee actual performance. Remember that it’s based on estimates and assumptions. And, these may change. But it’s a valuable tool for evaluating potential outcomes and risks.

How often should I update a pro forma? 

You should update your pro forma regularly. Especially, when there are big changes in market conditions, expenses, or after major repairs. Regular updates will keep your projections accurate and useful.

How do property managers use pro forma analysis?

Property managers use pro forma analysis to plan and run the property more efficiently. It helps them budget for expenses, schedule big repairs, set rental rates, and find ways to reduce vacancies and boost revenue.

Why do I need a pro forma to get financing?

Mortgage lenders want to see a detailed pro forma to understand the property’s potential and risk. Therefore, a well-done pro forma shows you know what you’re doing and makes it easier to get a loan.

Written by Ramona Sinha. July 17, 2024

Ramona is the Senior Content Writer for Kukun. This experienced blogger uses simple and succinct words to decipher the complex phenomenon called life. She has written articles covering a broad range of topics, such as real estate, lending and mortgage, finance, business, taxation, home designs, home improvement projects, decor concepts, and more. An avid traveler, she’s a digital nomad at heart and an animal lover from the depth of her soul.