Key Takeaways

  • A commercial real estate pro forma is a projection of a property’s cash flow over a defined holding period.
  • A typical pro forma contains three sections: income, expenses, and debt service. Each is estimated by using a combination of historical operating data, growth assumptions, and current market information.
  • The cash flow projected by a pro forma is used to calculate key operating metrics like Net Operating Income and key return metrics like Internal Rate of Return and Cash on Cash Return.
  • There are no “right” numbers that result from a pro forma projection. In fact, it is common for a buyer and a seller to have their own versions in a purchase/sale transaction. However, it is important that a pro forma be created using conservative assumptions and market data.
  • Investors in a commercial real estate transaction should review the pro forma, and the assumptions used to create it, to ensure that it is reasonable. In many cases, this may be the primary document upon which they rely for an investment decision.

A pro forma is one of the most critical components of a commercial real estate transaction. It is a document that contains a property’s cash flow projection over a defined holding period. In most cases, it is created using a spreadsheet program (like MS Excel) and presented as part of an investment’s offering materials.

What Information Does a Pro Forma Contain?

The most important thing to remember about a pro forma is that it is just an estimate—and this estimate tends to be less accurate the further out into the future it goes. For example, the numbers in years 1 and 2 of a 10-year pro forma may be reasonably accurate because they are informed by recent operating history. On the other hand, the numbers in years 9 and 10 are likely to be less accurate because they rely on a series of assumptions that may or may not turn out to be true. Generally, the information in a pro forma can be broken down into three categories: income, operating expenses, and debt service.

There are three sources of information used to estimate a commercial property’s income. The first is historical performance, meaning an investor or analyst may look at a property’s historical operating statements to see how it has performed in the previous 12 to 24 months. Second is the current rent roll, which is a listing of all tenants and the respective rents that they are responsible for paying. Third is the current state of the rental market. Considering these three factors, a property’s rental income can be estimated for the planned holding period.

Operating expenses represent the cost of running the property on a day-to-day basis. They include line items such as property taxes, insurance, maintenance, utilities, property management fees, and advertising. Cost estimates for operating expenses can also be obtained from three sources. First is the property’s historical performance. Second is the actual bills for each cost category. Third is a comparison of similar costs for comparable properties in the same market. Considering these three factors, a property’s operating expenses can be estimated for the planned holding period.

Finally, a property’s debt service is based on its loan amount, interest rate, and the amortization period over which its payments are calculated. If the loan has a fixed interest rate, projecting the debt service over a multiyear time horizon is relatively simple because it will be the same every year. However, if the loan has a variable interest rate, projecting debt service can be a bit more difficult because it requires an assumption about interest rate changes over the holding period.

What Metrics Can Be Calculated From a Pro Forma?

From the pro forma, there are three metrics that can be calculated, all of which are key when measuring the potential return for an investment property.

The first metric is known as Net Operating Income (NOI), and it represents the amount of cash that a property produces from its normal day-to-day operations. It is calculated as a property’s Effective Gross Income (EGI) less its operating expenses. This is one of the most important metrics in real estate investing and it serves as an input in a property’s estimated valuation. In the final year of the holding period, a “cap rate” is applied to the projected NOI to estimate the sales price.

The second metric is known as the Internal Rate of Return (IRR), and it represents the annual return produced by the pro forma cash flows. This calculation is inclusive of the original purchase price and the sale price. The formula used to calculate IRR can be complex, so a spreadsheet function is generally used instead.

Finally, a third metric is known as the cash-on-cash return, and it is calculated by dividing the pre-tax cash flow by the original investment in each year of the holding period. While IRR is representative of the annual return earned over the entire holding period, the cash-on-cash return represents the return on investment in any given year.

Real estate investors should review these metrics to determine if the advertised returns meet their individual investment objectives.

What to Look for In The Fine Print of a Pro Forma

Again, it must be stressed that a pro forma is just an estimate. In a commercial real estate (CRE) purchase/sale transaction, it is not uncommon for a buyer to have his or her own version of a pro forma, and for sellers to have theirs, which may or may not be similar. While the methodology used to make the pro formas tends to be the same, the differences tend to occur in the assumptions, which can be found in the fine print.

For real estate investors reviewing a pro forma, the key to determining how accurate it may or may not be is to review the assumptions. Nearly all pro formas contain a set of assumptions that drive the numbers in future years. The most important ones are:

  • Income / Expense Growth: Due to inflation, it is logical for a pro forma to assume that the property’s income and expenses will grow slowly over time. These growth assumptions drive pro forma numbers and should not be more than 1.5% to 3% annually.
  • Occupancy: A property is not 100% occupied all the time. Thus, a pro forma must make an assumption about the property’s vacancy rate over the holding period. On a stabilized basis, it should not be less than 5% to 7% in a multi-tenant rental property.
  • Lease Renewal Rates: It is unlikely that tenant leases will last for the entire holding period. Thus, assumptions must be made about the rate at which they will renew. These rates should be consistent with market rent on a per-square-foot basis.
  • Capital Expenditures: Commonly, a new owner will want to invest some capital to improve a property. This could include things like new paint, needed repairs, and tenant improvements. These funds must be accounted for in the pro forma, and they should result in increased rent and/or occupancy. 

Whether it is the buyer’s pro forma or the seller’s pro forma, there is no “right” answer. However, there is a pro forma that is supported by data and conservative assumptions, and one that is not. Potential investors should read a pro forma’s fine print carefully to determine whether this is the case.

Summary and Conclusion 

In a real estate investment, a pro forma is one of the most critical documents that must be created and considered carefully prior to committing funds to a deal.

There are three main components to a pro forma: the income, the expenses, and the debt service. Each is created using a combination of historical data, growth assumptions, and market information.

To determine how accurate a pro forma may be, investors should read the fine print carefully to determine whether or not key assumptions are reasonable and supported by data.

Interested In Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.

If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or for more information.

Learn & Invest


The Ultimate Guide To Investing In Private CRE

The Comprehensive A-Z Guide Every Accredited Investor Should Read Before Investing in Private CRE Deals. Instant eBook Download. Updated for Q1 2021.

Download Ebook

The Art of Commercial Real Estate

Learn from private equity fund managers how to become a top CRE operator and investor. True success requires an "it" factor. Find out if you have "it".


Get Access to Our CRE Deal Flow

Get instant access to all of our current and past commercial real estate deals. Sign-up for deal-launch webinars, schedule one-on-one deal-preview calls, or just browse.

access our deals