Summary: In this article, you will learn pro forma real estate definitions, what a pro forma should include, how to recognize and avoid misleading pro formas, and why investors should consider using our REAL Property™ Pro Formas to better compare properties and estimate returns.
Article Quick Links
- What is a Pro Forma in Real Estate?
- What a Pro Forma Should Include
- How to Recognize and Avoid Misleading Pro Formas
- Seller’s Pro Forma vs. Buyer’s Pro Forma
- Pro Forma vs. Actual Rents and Expenses
- What is a REAL Pro Forma™?
- Calculating Projected Returns Using a Pro Forma
- Free Pro Forma Spreadsheet Download
A pro forma in real estate is an important document for sellers to know and understand. Putting together the most accurate estimates of expenses on your pro forma could mean the difference between negative and positive cash flow. A carefully calculated pro forma is an essential tool for all real estate investors looking to buy property. Utilizing the right pro forma will allow you to compare investment properties and avoid making a poor investment.
What is a Pro Forma in Real Estate?
A pro forma is a Latin term meaning, “for the sake of form”. In the investing world, it describes a method of calculating financial results in order to emphasize either current or projected figures.
A property’s pro forma in real estate are essentially its cash flow projections. These projections will help determine the home’s anticipated monthly cash flow, as well as expenses, including taxes and expected ROI.
What a Pro Forma Should Include
There are four important items that must be included in a buyer’s pro forma. The four items include, repairs, vacancy loss, property management, and miscellaneous.
- Repairs. Even if the property you are buying has been newly renovated, expect to set aside money every month for repairs and maintenance. Typically, putting away 5% of the rent every month will cover any necessary expenses. However, if you are purchasing an older property, buyers may want to consider more than 5%.
- Vacancy loss. This is typically the highest expense on your pro forma sheet. Buyers will need to consider the length of their lease and the amount of time the property may be vacant in between tenants. Also, after a tenant moves out there will be a period of time where cleaning, painting and repairs will take place prior to the next tenant moving in.
- Property Management or PM. This is often left off a pro forma when a buyer expects to manage the property themselves. Even if you are planning on managing your own property, make sure this line is included because you will want to be compensated for your time and any related expenses. If you don’t plan on taking any compensation for managing the property, it’s still important to include because the property’s financial merit is based on all related expenses. If you are planning on hiring a property manager, they typically cost between 8% and 10%.
- Misc. This line on the pro forma can be used for any other expense. We like to include projected insurance costs. However, expenses like legal fees, advertising costs, and taxes can be included under this category.
How to Recognize and Avoid Misleading Pro Formas
It’s very common to see several different versions of pro formas from turn-key companies, real estate agents, brokers, and sellers. Some are overly simple, while others are complex and confusing. Rarely do we come across a pro forma that tells the truth.
Buyers should be aware of this and extremely cautious when analyzing a seller’s pro forma. Best practice is to find a pro forma that fits your needs and use that, instead of the seller’s.
Misleading Pro Forma Examples
One example of an overly simple pro forma from a turn-key property provider’s website includes the following: Purchase price, Gross annual rent, Cash flow per month, and Appreciation. This particular pro forma assumes there will be no expenses whatsoever, which is impossible. It also includes appreciation in the cash flow return, which no one can actually predict.
Another example of a misleading pro forma is one that is too confusing and complex. An overly complex pro forma includes item lines like: Monthly taxes, Insurance/HOA, Maintenance expenses (3%), Vacancy rate, Monthly net cash flow, Yearly net cash flow, Principal reduction, Cumulative cash return, and IRR, etc.
While this pro forma includes maintenance and vacancy, it doesn’t add actual expenses to these lines. Not only that, 3% is way too low for estimated maintenance expenses. It also adds principal reduction as part of the IRR. Many real estate investors don’t know what IRR means. Plus, what if you were paying cash for the property? The numbers would look very different and doesn’t help investors compare properties in the same way.
Many sellers or turnkey property companies will unnecessary items to their pro forma to either confuse the buyer or make the investment property look more profitable than it actually is. Next we will discuss the difference between what a seller’s pro forma may look like and what a buyer’s pro forma should look.
Seller’s Pro Forma vs. Buyer’s Pro Forma
If you are at all familiar with pro formas, it is very clear that the seller’s projected expenses will look very different than the buyer’s. The seller wants to sell the property, so their goal is to make the pro forma look as cash flowing as possible. Just like the overly simple pro forma we discussed above, many key expenses may be left off the form. This is why it’s so important for a buyer to have their own pro forma, to make accurate estimations and projections on expenses and cash flow.
Pro Forma vs. Actual Rents and Expenses
The value of residential properties are calculated based on comps or comparative sales of what other properties in the area have sold for. This information is useful because it gives buyers a good idea of how much a property may be worth. Keeping this in mind, no one property is the same as another, so comps can provide an idea of the property’s value, but it can’t really be predicted.
The key takeaway here, is for buyers to not base their financing on the pro forma, especially if it’s the sellers. Financing should be based on actual income and expenses, not the pro forma. Remember, a pro forma is simply your best guess on projected expenses.
Pro Forma Rents
Pro Forma Expenses
Sellers can’t make up the amount of money spent on property expenses. However, they often try and control expenses for several months, or up to a year before listing the property for sale.
That way they can make an argument for listing a lower amount of expenses, thus making the property appear more profitable than it actually is.
The best way to get a more accurate idea of expenses for the property is to look at a month-to-month breakdown for at least the last 12 months, ideally 2 years.
If you are not able to get a month-to-month expense breakdown, (which is common), one option is to get estimates from a property management company. You can also compare it, either to other similar properties you own, or use certain rules of thumb, like the 50% rule. (The 50% rule is a simple assumption that 50% of your rental income will go toward operating expenses).
Whatever you decide to do, DO NOT assume the seller’s pro forma is an accurate indication of expenses versus cash flow potential. Once again, use your own pro forma and do the fact-checking yourself.
What is a REAL Pro Forma™?
Sellers in income property can be very creative in their methods of calculating returns. After all, they can sell a lot more when their returns appear to be higher than others. Learn how to spot misleading pro formas, and avoid making a bad investment.
RealWealth is setting the standard by defining the REAL Property Pro Forma™, so that investors can better estimate returns and compare properties.
We use “Projected Taxes” as properties are sometimes reassessed after purchase and amounts can fluctuate either up or down.
Property Management Fees: 8%
Property Management or PM fees can vary, but a standard rate is between 8% and 10% of rents each month.
Projected Maintenance: 5%
We use 5% for projected maintenance and vacancy reserves. This number should be higher if the property is old, in C class neighborhoods or has not yet been renovated. Walking through the property will give the buyer a better idea of how much maintenance expenses and repair costs will be. As with any real estate investment, this should be a part of your due diligence.
Projected Vacancy Rate: 5%
Sellers will often leave off maintenance and vacancy reserves from their pro formas because they are not actual expenses. They are simply estimates of potential repairs and vacancies that the investor should budget for future expenses. Experienced investors always add these numbers to their pro formas.
Some experienced investors also add more line items including re-lease fees, accounting and make-ready costs. This is really up to you on how detailed and conservative you want to be in your own pro forma.
Projected Cash Flow
Calculating Projected Returns Using a Pro Forma
Using the above pro forma real estate template, let’s walk through how to calculate our projected returns.
For instance, let’s say you paid $77,000 cash for the property, including closing costs.
The monthly net cash flow of $610 would be $7,320 annualized.
Divide the projected annual net cash flow by the initial cash invested to calculate the cash on cash return: $7,320 divided by $77,000 = .09 or a 9% return.
Now, let’s say instead of buying the property with cash, you choose to finance. If you were to finance the property with 20% down at 5% interest, your cash in would be $17,000 (down payment plus closing costs) and your monthly mortgage payment would be $322.
Subtract $322 from the $610 monthly cash flow and your net cash flow with financing would be $288 per month or $3,456 annualized.
$3,456 divided by $17,000 = .20 or a 20% return.
Note: This is a rather old pro forma example. It is very unlikely to find $77,000 properties in today’s market.
Add Additional Expenses to Your Pro Forma as Necessary
Bonus: Free Pro Forma Spreadsheet Download
Hopefully, after reading this article, you have learned the pro forma real estate definition, how to spot a misleading pro forma, how to estimate expenses accurately, and which pro forma is right for you. As you are analyzing and comparing potential real estate investments, take advantage of our simple, easy-to-understand pro forma spreadsheet to make better estimates on returns and avoid making a bad investment.
If you would like a copy of our REAL Estate Pro Forma excel template to help calculate real returns, simply join the Network by clicking the link below. The best part, becoming a member of RealWealth is free and gives investors access to all of our educational resources, including our free pro forma worksheet.