A successful real estate pro forma is a financial projection of rental income and expenses, not an actual report. A pro forma highlights what a rental property could, should, or would gross in revenue. Think of it as a budget for your investment.
A pro forma is a tool used to evaluate the risks or benefits of a potential rental property. Numerous rental property financial metrics such as cap rate, cash-on-cash return, and ROI (return on investment) depend on calculating accurate NOI (net operating income) and cash flow. This article shows a step-by-step model on how to adequately structure a rental pro forma and key items to consideration.
1.) Setting up a Basic Pro Forma for Real Estate
Property Purchase Price = $200,000 (A duplex with no common area and tenant pays utilities)
Loan $160,000
Projected gross rental income = $3,000
Vacancy loss at 10% = $300
Repairs & Maintenance at 5% = $150
Real Estate Taxes= $450
Insurance= $125
Projected monthly cash flow or NOI = $1,975
After calculating the NOI (Net Operating Income), next add in your monthly mortgage expense to determine your before-tax cash flow:
NOI = $1,975
Mortgage expense debt service = $1,600 (principal & interest only)
Before tax cash flow = $375 per month
*All numbers in the model are examples
2.) Conditions to Consider
The above example is a very basic model. There are several other considerations when constructing an accurate pro forma:
Management fees: Property management fees are generally around 10% of your gross income. If you hire out the managing aspect of the property, this must be included in your pro forma equation.
Single family vs. apartment: Single family rentals are generally less capital intensive for the investor than apartment buildings. Apartment buildings usually require additional maintenance expenses such as common area cleaning, landscaping, snow plowing & dumpsters. Your repair & maintenance ratio must be adjusted accordingly.
Condition of the property: This is a good indicator of how much maintenance expense to budget. A property with old mechanical equipment will require a higher repair & maintenance ratio than that of a newly renovated unit.
Utilities: Who is responsible for utilities? Owner paid utilities raise the ratio, tenant paid utilities lowers the ratio needed for an accurate estimate. Are there common area utilities? The best way to counter these additional expenses is to adjust the rental price accordingly.
Vacancy rate: A standard vacancy rate is 10%, which covers a month of vacancy and general turnover costs. This can vary depending on the location, rate of turnover in the area, tenant base, etc. Make sure you understand the tenant profile of your investment's area. (Example: Student housing areas have a much lower vacancy rate because of their proximity to universities. The demand for these areas is high and eviction is low.)
Short term rentals: If you are operating as a short-term rental, you will need to account for extra cleaning and turnover costs, higher utilities and additional amenities that remain in the owner's name. Again, the best way to counter these additional expenses it to adjust the rental price accordingly.
Real estate taxes: Make sure you know the tax rate of your municipality, the frequency and schedule of when assessments are performed and if the county adjusts the tax rate up to the purchase price of the property. Your real estate taxes may not stay the same as at the time of purchase and they are a varying expense.
3.) When to Use a Pro Forma
Purchasing a property: Creating your own pro forma is important. The job of the seller is to make the property look the very best to the investor. Sometime this means leaving out expense elements and presenting a very basic pro forma that may leave out important considerations. A good pro forma will help you know how much to offer on a property.
Valuing a property: Pro formas help investors determine the value of a property using an income approach- converting an income stream to a value on an asset. If your investment is long-term, you need to look at it through different lenses than a short-term investment that relies heavily on determining an asset value based on comparables.
When seeking financing: A lender will also perform similar pro forma tasks in determining the value of an asset and ultimately the LTV (loan to value) ratio. Don't waste your time and money on lender applications on a property that doesn't pencil out.
Side by side comparison: There are times throughout the course of your investment you will want to compare the property's current cash flow to its potential cash flow. Scenarios that come to mind are:
Rental increases
Expense increase
Best course of action for a needed repair (replace or patch)
Refinancing
Selling a property: To get the best ROI, you will want to take a good assessment of your pro forma to help determine the best list price.
As you can see, a rental proforma is useful throughout the investment cycle.
The takeaway- be honest with the numbers. Using the wrong information in a pro forma could lead to overpaying for a property that underperforms, missing out on a great opportunity to purchase a property, or being vulnerable to the terrible implications that come from not being able to keep up with the expense of the property. This exercise is for your benefit. If the deal doesn't pencil out, step aside and look for the next deal.
Spring Valley offers real estate lending products designed for the investor. Call us today to discuss our commercial real estate lending options, 513-761-6688.