June 15, 2023
Adam Hoeksema
If you are a real estate developer, investor or simply looking to get into the real estate business it won’t be too long before a potential lender or investor asks you for a real estate pro forma.
So in this article I am going to try to share everything you need to know about real estate pro formas. We will look at:
- What is a real estate pro forma?
- What are the key terms you need to know
- Example real estate pro forma
- How to create a real estate pro forma
- What investors and lenders want to see in your pro forma
Throughout the article we will be referencing our various real estate pro forma templates that are built for sophisticated real estate developers, investors, or individuals looking to acquire their first rental property.
Let’s dive in!
What is a real estate pro forma?
A real estate pro forma is a document that provides a projection of the financial returns that a real estate investment is expected to generate. It is often used by investors to analyze cash flow, return on investment, and to make decisions about whether to proceed with a specific real estate investment.
A pro forma typically includes detailed information about expected revenues (like rental income), operating expenses (such as maintenance, insurance, and property taxes), debt service if the property is financed, and capital expenditures for any planned improvements or repairs. These elements are used to calculate key metrics like Net Operating Income (NOI), Cash Flow, and Cap Rate, which help to assess the profitability of the investment.
However, it's important to remember that a pro forma is essentially a set of estimates or assumptions about future performance. While it is a useful tool in the decision-making process, the actual financial performance of a real estate investment could turn out to be different from what was projected in the pro forma.
What are the key terms you need to know
In the definition of real estate pro forma above I mentioned a bunch of other real estate related buzzwords that you may not be familiar with, so before I get too far I wanted to define some key terms that you will need to know to be able to “talk the real estate lingo” with investors and lenders.
What is Gross Potential Income (GPI)?
Gross Potential Income (GPI) refers to the total amount of income that a real estate property could generate if it was fully occupied and all rents were collected. It is an essential component in real estate pro forma analysis, which provides an estimate of potential earnings and cash flows. To calculate GPI, you simply multiply the potential rent for each unit by the number of units, and then by the number of periods (usually months in a year).
What does Vacancy and Credit Loss mean?
Vacancy and Credit Loss is a cost that accounts for potential loss of income due to vacancies (when units are unoccupied) and credit losses (when tenants do not pay their rent). This is typically expressed as a percentage of the Gross Potential Income. It is important to consider in pro forma analysis as it provides a more realistic estimate of the property’s income by accounting for these potential losses.
What does Effective Gross Income mean?
Effective Gross Income (EGI) is the total income generated by a property after accounting for vacancy and credit losses. It gives a more accurate representation of the actual income a property might generate. It is calculated by subtracting the Vacancy and Credit Loss from the Gross Potential Income. Other income streams, such as parking fees or laundry income, can also be added to the EGI.
What does Net Operating Income mean?
Net Operating Income (NOI) is the income generated from a real estate property after operating expenses are deducted but before deducting taxes and interest payments. Operating expenses may include costs like utilities, property management fees, repairs, maintenance, insurance, and property taxes. NOI is a key metric in real estate investment, as it provides insight into the profitability of a property after considering operating costs.
What is Pro Forma Net Operating Income?
Pro Forma Net Operating Income is an estimate or projection of the net operating income. It's a key component of real estate pro formas and is based on anticipated revenues and expenses. This figure is used by investors to understand potential profitability and cash flow from a property in the future.
What is a Cap Rate?
Cap Rate, or Capitalization Rate, is a real estate metric that measures the potential return on an investment property. It is calculated by dividing the Net Operating Income by the current market value of the property. A higher cap rate typically indicates a higher potential return, but also comes with higher risk.
What is a Pro Forma Cap Rate?
A Pro Forma Cap Rate is a projected or estimated capitalization rate based on a real estate pro forma. It uses the projected Net Operating Income and the estimated future value of the property. The Pro Forma Cap Rate can be used to evaluate and compare the potential return of various real estate investments. It's particularly useful for comparing properties in different markets or with different levels of risk and return.
Example Real Estate Pro Forma
You can see an example of a real estate pro forma below:
At a high level a real estate pro forma should include the following:
- Potential Gross Income
- Vacancy and Credit Losses
- Effective Gross Income
- Operating Expenses
- Net Operating Income
To see a full real estate pro forma example, you can watch our demo video for our Multifamily Developer Pro Forma Template.
How to create a real estate pro forma
Creating a pro forma involves several steps, each focused on a key aspect of the property’s financial performance.
Calculate Gross Potential Income
The Gross Potential Income (GPI) represents the maximum income a property can generate if it was fully rented at market rates and all rents were collected. Calculate the GPI by multiplying the potential rent for each unit by the number of units, and then by the number of periods (usually months in a year).
Estimate Vacancy and Credit Losses
Every property will have periods of vacancy and times when tenants do not pay their rent. Estimate these losses as a percentage of GPI based on market and historical data. Subtract this percentage from the GPI to get a more realistic revenue estimate.
Calculate Effective Gross Income
Effective Gross Income (EGI) is the actual income expected to be generated after accounting for vacancy and credit losses. Calculate the EGI by subtracting the vacancy and credit loss estimate from the GPI. Other income sources (e.g., parking, laundry) can be added to this number.
Forecast Operating Expenses
Operating expenses encompass all costs associated with operating and maintaining the property. These usually include:
- Maintenance and Repair: Regular upkeep and unexpected repair costs, including landscaping, HVAC, plumbing, electrical, etc.
- Property Management: If you hire a property management company, they'll typically charge a percentage of the EGI.
- Taxes and Insurance: Property taxes can be obtained from the local tax assessor's office, while insurance costs can be quoted by an insurance agent.
Add all these expenses together to get the total operating expense.
Calculate NOI
Net Operating Income (NOI) is the income left after all operating expenses have been paid. Calculate the NOI by subtracting the total operating expenses from the EGI.
Calculate Cash Flow
Cash flow is the NOI minus any debt service (mortgage payments). If you don't have a mortgage, the NOI equals your cash flow. If you do have a mortgage, subtract your annual debt service from the NOI to calculate your cash flow.
What investors and lenders want to see in your pro forma
Investors and lenders are going to want to see all of the buzzwords we have already talked about, but ultimately a lender wants to know that you can repay the loan and an investor wants to see that you can provide a strong return on their investment.
Lenders are going to want to look at your debt service coverage ratio to make sure that you can repay the loan.
Debt Service Coverage Ratio
DSCR is a financial ratio that measures a property’s ability to cover its debt obligations from its NOI. A DSCR of 1 means the NOI is equal to the annual debt service. A ratio greater than 1 indicates that the NOI is more than sufficient to cover the debt service. To calculate DSCR, divide the NOI by the annual debt service.
IRR on Real Estate
Investors are going to want to calculate the IRR on the project. Our real estate templates include an investor distribution tab that allows you to model distributions and ultimately the IRR of the investment based on your assumptions.
Conclusion
Ultimately, whether you are looking to buy your first Airbnb property or build a large commercial office building you owe it to yourself and your investors to create a well thought out real estate pro forma. I hope this article, our templates, and how to videos have been helpful in your process!
