When real estate investors search for property, they typically begin with a broad universe of opportunities. After narrowing the field, they build a pro forma for each shortlisted asset. This step is one of the most important parts of the due diligence process.
In this article, we explain what information a commercial real estate pro forma contains, which metrics can be calculated from it, and what to look for in the fine print.
Real Estate Pro Forma Definition
A real estate pro forma is a financial model that projects a property’s cash flow over a defined holding period. It is one of the most critical components of a commercial real estate transaction and is typically prepared in spreadsheet form.
Because capital commitments are significant, investors often validate market rents, operating costs, and financing terms using third-party data and industry professionals.
The Purpose of a Pro Forma
The purpose of a commercial property pro forma is to estimate future Net Operating Income (NOI) and, by extension, market value. Commercial properties are commonly valued by applying a capitalization rate to stabilized NOI.
Why Investors Need to Understand Pro Forma in Real Estate
At its core, the business plan for commercial real estate is simple: acquire a property, lease it, collect rent, pay expenses and debt service, and distribute remaining cash flow.
What complicates the process is valuation. A pro forma allows investors to model cash flows, test assumptions, and assess whether pricing provides an adequate margin of safety.
What Information Does a Real Estate Pro Forma Contain?
A pro forma is only an estimate, and uncertainty increases the further projections extend into the future.
Income
Income projections are based on historical operating statements, rent rolls, and prevailing market rents.
Operating Expenses
Operating expenses include taxes, insurance, maintenance, utilities, management fees, and marketing costs.
Debt Service
Debt service depends on loan terms, interest rates, and amortization schedules.
Property Taxes
Property taxes require conservative modeling, as reassessments can materially impact NOI.
What Metrics Can Be Calculated from a Real Estate Pro Forma?
Net Operating Income (NOI)
NOI is cash flow from operations before debt service and capital expenditures.
Internal Rate of Return (IRR)
IRR measures the annualized return of projected cash flows over the holding period.
Cash-On-Cash Return
Cash-on-cash return measures annual pre-tax cash flow relative to equity invested.
An Example of a Real Estate Pro Forma
Assume an investor plans to hold a fully leased property for four years. Using known rents, ancillary income, and historical expenses, the following pro forma is created:
| 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 |
Using a 7% cap rate, the year 1 valuation is calculated as:
$65,000 ÷ 7% = $928,571
What to Look for in the Fine Print of a Pro Forma
- Income and expense growth rates
- Occupancy and vacancy assumptions
- Lease renewal rates
- Capital expenditure assumptions
- Exit cap rates and financing terms
Summary and Conclusion
A real estate pro forma brings together income, expenses, and financing assumptions to estimate future cash flow and value.
Investors should focus less on headline returns and more on the assumptions driving them. That discipline often separates strong investments from disappointing ones.
