- As part of the pre-purchase due diligence process, investors ask the seller for a variety of financial documents and use them to create a proforma projection of the property’s income and expenses.
- The output from the proforma is used to calculate potential return metrics, property valuation, and to pitch potential investors. As such, it is critical that it be as accurate as possible.
- To ensure accuracy, each proforma line item should be compared and validated against known historical or market data.
When considering a commercial real estate investment, one of the first things that an investor will do is to ask the seller (or their representatives) for a series of documents. Typically, these documents include: prior year financial statements, property tax bill, utility bills, a rent roll, property management contracts, and insurance policies.
Once received, the documents are used to create a proforma projection of the property’s potential income, operating expenses, cash flow, and net operating income. Usually, this is completed in a spreadsheet program like MS Excel or some other equivalent.
But, the proforma creation process is inherently flawed. It is just a projection and it gets less accurate the further into the future it goes. For this reason, it is necessary for potential investors to verify the accuracy of each individual line item. This can be a time consuming and tedious process, but it is critical to the success of the investment.
Proforma Line Items Defined
Each proforma is slightly different, but they all contain the same general line items, which are defined below:
- Rental Income: Rental income represents the money that is generated by renting space to individuals or businesses.
- “Other” Income: Non-rental income is generated from things like late fees, application fees, expense reimbursements, and parking.
- Vacancy: The amount of income lost due to vacant space. It is typically expressed as a negative number.
- Gross Income: A calculation equal to the property’s total income, less vacancy.
- Property Taxes: Fees charged by local governments for the use of community services like roads.
- Property Insurance: Premium paid to protect the property against unexpected loss.
- Management Fees: Money paid to a third-party property manager to oversee the day to day operations of the property.
- Utilities: Costs paid to providers for services like water, electricity, and trash removal.
- Repairs and Maintenance: Costs associated with routine repairs and maintenance activities like painting, landscaping, HVAC/air conditioning, janitorial, and other common area maintenance activities.
- Net Operating Income (NOI): A calculation equal to the property’s Gross Income less operating expenses.
This last line item, Net Operating Income, is the key number in the proforma. It drives the value of the property so it must be as accurate as possible. To ensure that it is, commercial property investors should take extra steps to validate and verify each individual line item.
NOTE: The lines items above are for operating expenses only and do not include one-off expenses like capital expenditures, tenant improvements, capital improvements, or leasing commissions.
How to Verify Each Line Item
A proforma typically covers a multi-year time period, but it is only necessary to validate the year 1 values. Future values are informed by a series of assumptions that drive their calculation. The following bullet points describe the typical methodology used to validate each of the lines items listed above:
- Rental Income: Rental income in the proforma should foot to the property’s rent roll, which is a listing of all tenants and the amount of market rent they are required to pay. For example, if the rent roll shows $500,000 in annual income, proforma rental income should be approximately the same. Further validation can be performed by reviewing deposits into the property’s bank account.
- Other Income: Other income should foot back to the property’s income statement, which should differentiate between rental income and other income.
- Vacancy: Vacancy should also foot to the property’s rent roll. It is often expressed as a percentage of rental income, which is then translated into a dollar amount.
- Gross Income: This calculation should foot to the income statement for the trailing 12 months. It doesn’t necessarily have to be exact, but it should be close.
- Property Taxes: As part of the due diligence process, a copy of the most recent property tax bill should be obtained. The corresponding proforma line item should be consistent and any adjustments should be made for changes in the assessed value after purchase.
- Property Insurance: The property insurance line item cost should correspond to the invoices for the most recent year.
- Management Fees: Property management services typically run on multi-year service contracts. The cost for this line item should foot to the expense outlined in the contract.
- Utilities: There can be several types of utilities like water, trash, and electricity. The invoices should be obtained for each and the associated line item in the proforma should match.
- Repairs and Maintenance: This line item can be a little bit tricky since it can be variable from one year to another. But, it should foot to the corresponding line item in the income statement.
- Net Operating Income: This is a calculated value that may not foot to any specific document or report. However, it should be in the neighborhood of 45% – 50% of Gross income as a general rule of thumb.
Why Verification Matters
The income and expenses outlined in the proforma are the basis for calculating the investment’s potential return, the property’s potential valuation, and other key metrics like income taxes. It is also the basis for the pitch to potential real estate investors when raising capital and to potential lenders when seeking debt. There are many parties that rely on these projections so it is important that they are as accurate as possible.
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 email@example.com for more information.
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