The Importance of a Real Estate Pro Forma
The best crystal ball you’ll ever have as a real estate investor
Wouldn’t it be great if you were able to predict the exact amount of income an investment property would yield year over year? If you could instantly know that a property you’re interested in would add value to your portfolio and provide ongoing passive income? Or if you could instantly know if a property would bring a variety of headaches and be a money pit you should walk away from?
With a real estate pro forma, you almost can.
Simply put, a real estate pro forma allows you to use three primary financials to calculate a property’s predictability to deliver a desired income:
What is the potential rental income from this property?
What are the anticipated operating expenses, whether they are ongoing maintenance expenses or capital improvements?
What is the debt service on the property such as a mortgage, hard money loan, etc.?
In addition to those financial categories, you’ll want to consider the following items to get closer to a property’s income potential:
NOI Net Operating Income—calculated when you take your gross rental income and subtract your operating expenses
IRR Internal Rate of Return—used to predict the potential yield over a hold period and can use complex calculating formulas best suited for Excel®
CoCR Cash-on-Cash Return—the return on capital investments in the property and is calculated by taking your annual NOI and dividing it by your total cash investment
IRR can also be confused with capitalization rate (“cap” rate) but is slightly different. The main difference is the calculation is done based on the first year’s predicted performance (cap rate) versus the entire hold period predicted performance, (IRR) which could be many years. When making a choice whether or not to purchase an investment property, your pro forma may be the best crystal ball on the investment’s potential.
There are many ways to build or buy pro forma models whether it’s a powerful Excel spreadsheet with formulas or a commercial software service you pay monthly to enter and store your property’s data. We advise our investors to always begin with a simple spreadsheet that is customized to the types of investments you purchase and how you want to grow your investment portfolio. Each property will have its own unique criteria, however, all pro formas should be able to calculate important financials so you can more easily predict a property’s income value.
Easily missed items in pro formas
But a pro forma is not all that straightforward and if every factor is not considered, you could end up falling victim to a bad deal. A pro forma will need to include financials and note other factors unique to each investor and/or property, such as:
Capital expenses (installing a new roof, boiler system, mitigating hazards, etc.)
Occupancy rates and your ability to raise rents
Adjusted NOI
Vacancy loss rates
Property taxes
Time frames for hard money loan repayment
Tenant improvements
Leasing commissions
Property management fees
Property maintenance fees (landscaping care, snow removal, etc.)
Utilities (if covered by the landlord)
Cash on reserve
Insurance, legal fees and other administrative costs
Anticipated hold period
Market and economic/inflationary impacts on rent rates and tenant quality
Rental competition/new construction/buy vs rent
Expense reimbursements
Tenant incentives
Lease terms
Absorption and tenancy turnover expenses
Cash flow to equity investors
Exit cap rates
Property emergencies where clean up and an insurance deductible will need to be used (fire, flood, sewer backup)
There can be many more, so make sure you’re considering as many potential expenses and impacts as possible to be able to predict whether or not a particular property meets the income criteria you seek.
Using a well-formulated pro forma spreadsheet is a powerful tool in your investor toolbox. You can also use your past pro formas to measure and compare a future property’s income-generating potential, especially if you’re focusing on a regional market you already own investment property in and are familiar with the rental market.
Key points and pro forma best practices
Track your investment over time after you purchase on your pro forma so you can make adjustments and improve your formulas
Build your own pro forma - don’t trust a seller’s pro forma especially if it’s overcomplicated
Account for the “J-curve” when assessing your pro forma
Strike the perfect balance of data without overcomplicating your pro forma
Customize your pro forma to fit your investment preferences and the marketplace
Note that the further your pro forma goes into the future, the less accurate it is
Double check your formulas—one simple miscalculation can throw off the entire spreadsheet
Do your own due diligence—get accurate data from tax records, insurance, contractors, property managers and other direct sources
Make your pro forma appealing to others, such as a potential future buyer when you’re ready to sell your investment property
Make sure you’re well versed in investment and financial fundamentals such as NOI, cash flow, cap rate, etc.
A pro forma can also help you predict when you can recover capital investments based on your ability to increase rents after that improvement
Above all, remember that a pro forma is a powerful tool, but it’s just that—a tool. It serves as a prediction of as many scenarios as you enter into the tool, but in the end, what eventually happens with your investment over time is a challenge to precisely predict. A pro forma will equip you as best as possible, and the more you grow your investments, the better prepared you’ll be at realizing a property’s income potential with a well-oiled pro forma.
Ready to calculate your own investment? Start by downloading Jennifer’s Cash Flow Analysis spreadsheet here: (using Microsoft Excel)