Pro Forma in Commercial Real Estate Explained


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 real estate 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 real estate 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, the pro forma may be the primary document upon which they rely for an investment decision.

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Pro Forma in Commercial Real Estate Explained

When real estate investors search for property, they typically cast a wide net to find several potential investments that meet their general criteria. Once they have narrowed it down to a few properties, they will typically build out a pro forma for each. This is one of the most important parts of the due diligence process and is a key component when trying to assess the property value.

In this article, we explain what information a commercial real estate pro forma contains, what metrics can be calculated from a pro forma, and what to look for in the fine print of a real estate pro forma.

At First National Realty Partners, we specialize in the purchase and management of retail centers with grocery store anchor tenants. We build a pro forma for every property that we purchase as part of the due diligence process.  If you are an accredited investor and would like to learn more about our current commercial real estate investment opportunities, click here.

Real Estate Pro Forma Definition

A pro forma is a document that contains a property’s cash flow projection over a defined holding period and is one of the most critical components of a commercial real estate transaction. In most cases, a pro forma is created using a spreadsheet program (like MS Excel) and presented as part of an investment’s offering materials. The stakes are high when investing in a commercial property, so sophisticated investors tend to spend significant time and effort conducting market analysis and may even speak to others in the real estate industry to try to build the most accurate pro forma possible.

The Purpose of a Pro Forma

Using a series of inputs and assumptions, an investor builds a pro forma to help them gauge the market value of a property. Commercial properties are valued by applying a capitalization rate to the amount of annual net operating income generated by the property. The pro forma is the key tool that an investor uses to estimate the net operating income. Net operating income is the amount of gross rent revenue less all expenses, such as maintenance expenses, property taxes, and insurance.

Once a real estate investor understands the potential rental income that a property is expected to generate over the holding period, the investor can decide if they are comfortable pursuing the deal.

Why Investors Need to Understand Pro Forma in Real Estate

Commercial real estate investors, whether individuals or institutions, spend plenty of time and effort trying to find deals that meet their criteria. One of the key pieces of criteria that every investor has is buying a property at a good valuation. This is a simple idea, but in reality, it is more difficult to achieve.

One of the best ways for investors to understand what property is worth is to create a pro forma to model the total cash flow that the property can be expected to generate over the Period of time that the investor owns it. This allows the investor to come up with an estimated value for the property. It also helps the investor to think about different ways that they might be able to increase the amount of cash flow the property generates on a monthly basis, either by increasing revenue or decreasing costs.

Once the investor is comfortable with all of these variables, she can make an offer that has a high likelihood of getting a good return on her investment.

What Information Does a Real Estate 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 real estate pro forma can be broken down into three categories: income, operating expenses, and debt service.

1. Income

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.

2. Operating Expenses

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.

3. Debt Service​

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.

4. Property Taxes

One of the most important expenses that investors need to think about when performing due diligence on a property is the amount of property taxes that they will pay every year. Property taxes directly reduce the amount of net operating income that the investor is left with. Property taxes are also one of the few operating expenses that investors have little or no control over. The local municipality where the property is located will likely increase the amount of taxes due during the holding period, and investors need to be able to estimate this as part of the pro forma model before underwriting the deal.

What Metrics Can Be Calculated from a Real Estate 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 a real estate investment property.

1. Net Operating Income

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. NOI is calculated as a property’s Effective Gross Income (EGI) less its operating expenses. NOI 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.

2. Internal Rate of Return

The second metric that can be calculated from a pro forma 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 property’s original purchase price and the sale price. The formula used to calculate IRR can be complex, so a spreadsheet function is generally used instead.

3. Cash-On-Cash Return

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.

How to Build a Pro Forma for Commercial Real Estate

Building a pro forma for a commercial real estate investment requires the investor to input a few key pieces of information, including the historical rent roll, the amount of annual property taxes paid, an estimate of the annual insurance expense, historical maintenance expenses, and any other income and expenses that can be expected during the holding period.

Once the investor has this information, they can use it to calculate the net operating income for each year throughout the holding period. The way to do this is to start with gross rental income and subtract each expense that the property is expected to incur. The difference Is net operating income, which can be used to establish a valuation by dividing it by the cap rate. For more information on cap rates, see our article about it.

An Example of a Real Estate Pro Forma

Let’s take a look at an example to see how a real estate pro forma is created.

Let’s suppose that an investor is looking at a particular property to purchase. For simplicity, we’ll assume that the investor is only going to hold the property for four years. The property is leased up, so we have a good idea about what the gross rent revenue will look like over the next four years. The property also generates some ancillary revenue – laundry revenue for a multifamily property is a good example.

The property will also have expenses. Based on the historical maintenance schedule, we are able to estimate maintenance expenses for the holding period. Property taxes are known in year 1, and we can estimate what they will be in years two through four based on historical property tax increases. Insurance expenses are estimated in a similar way to property taxes.

These inputs leave us with the following pro forma table:

                               Year 1             Year 2             Year 3             Year 4

Gross Rent               150,000          153,000          156,000           159,000

Ancillary Income       10,000            11,000            12,000            13,000

Gross Revenue        160,000          164,000          168,000          172,000

Maintenance           25,000            17,000            21,000            19,000

Property Taxes           60,000            62,000            64,000            66,000

Insurance                   10,000            11,000            12,000            13,000

Total Expenses         95,000            90,000            97,000            98,000

NOI                         65,000         74,000            71,000            74,000

The investor can use the NOI figures with a market-based capitalization rate to estimate a value for the property. Using these figures we are able to calculate a valuation for the property using the following formula:

Property value = NOI / cap rate

Using the year 1 NOI and a cap rate of 7% gives us the following valuation:

$65,000 / 7% = $928,571

What to Look for in the Fine Print of a Pro Forma

Again, it must be stressed that a real estate 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 assumptions in a real estate pro forma are:

1. 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.

2. Occupancy Levels

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.

3. 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 the leases will renew. Lease renewal rates should be consistent with market rent on a per-square-foot basis.

4. Capital Expenditures

Commonly, a new owner will want to invest some capital to improve a property. This investment 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 real estate investors should read the pro forma 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 real estate pro forma:

  1. the income,
  2. the expenses, and
  3. 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, real estate 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.

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