I’m sure you’ve seen it, especially in this hot market – current rents are at $800 per month but the listing agent is advertising it as potentially have a monthly rent of $1,300…once all the upgrades are complete.
They are trying to get you to pay top dollar for a property based on its pro forma rent rather than the actual rents.
But, what is a pro forma and when should we use it?
Real Estate Pro Forma – Defined
The real estate pro forma is a detailed breakdown of the income and expenses of a rental property once it is fully stabilized and operating at peak efficiency. This means that it has the market rents, income, vacancy rates, and operating costs that are comparable to other properties with a similar class and age in that market.
Often, pro forma rents are calculated based on comparable rentals, and once any planned renovations or upgrades are completed. Similarly, pro forma expenses are based on the cost to operate a fully stabilized property and does not include any major upgrades or expenses.
Pro Forma vs Actual Rents and Expenses
Do not be confused, the pro forma is not how the property is operating today. Often, the sellers will inflate the income and reduce costs to have a favorable net operating income and entice offers.
Remember, a commercial property’s value is determined based on the Net Operating Income and the Capitalization Rates in that market for that class of property. Alternately, residential property values are calculated based on comparative sales.
So, your financing will be based on the actual income and expenses and not based on the pro forma. If you want to make an offer based on the pro forma rents and expenses, then you’ll likely end up having to make a larger down payment to cover the difference in value.
Create Your Own Pro Forma
When I’m looking for a deal, I’ll generally take the broker’s pro forma and plug it into my calculator.
I do this as a screening tool. My thought is – if the deal doesn’t work with their amazingly aggressive income and expense assumptions, then there is no way it will work with my more conservative numbers!
5-Step Investing System
We have spent years developing this process that has literally generated millions of dollars in value and a stable yearly revenue for investors.
If it doesn’t look like a killer deal with their numbers, I immediately toss it. If it looks great on paper, then I move on to the next step and give it a deeper look.
Part of that deeper look is to create your own pro forma.
Pro Forma Rents
The first step is to see if the pro forma rents are based in reality or not. You do this by comparing them to the actual rents.
Let’s say for a simple example that you are analyzing a 10 unit deal and all of the units are 2 bedrooms.
The broker is telling you the rents could be $1,000 per month, but the average rent is only $797. There is a big discrepancy, so let’s see if it’s realistic or not by taking a look at the rent roll. Here is an example of the rents you might see:
You might think it’s kind of weird for the rents to vary so much, but it’s quite normal. The tenant that has lived there for 10 years will usually pay less than the one who moved in last month.
Also, some units might have additional amenities that are worth more. Ground floor apartments might have a yard. Others might have a washer/dryer hookup for example.
Here, I want to see how many units are rented at or near $1,000 since that is what the broker is saying the rents should be. In this example we see only 1 unit rented at that level and one more at $950 and one at $925.
Most of the rest are in the $800 range with one outlier at $700.
Without knowing why the one unit is getting $1,000, I’d have to assume it’s an outlier since there is only 1 unit at that rate.
There are 2 units at $875, 1 at $925, and 1 at $950. So I’d feel quite comfortable listing my pro forma rents at $925 because 4 of the 10 units are right around that number.
If I wanted to make a very aggressive offer (for example, I LOVE the area) I would underwrite it at $935 or $940.
Pro Forma Expenses
This is a bit different. Brokers know they can’t explain away he actual expenses they provide you. So, they can’t just make up the pro forma expenses.
Instead, they will make sure the seller is controlling the expenses for 3-6 months before listing the property. Smart sellers will control their expenses for a full year before listing their property for sale.
That way the listing agent can make a compelling argument to use a lower set of expenses.
On larger deals you’ll get to see a break down of the expenses month by month, so this trend can be discovered by annualizing the expenses over the last 3 months and comparing it to the expenses for the last 12 months. If they are dramatically different, you know they are artificially pushing costs down.
For smaller deals, you’ll be lucky to just get the expenses they put on last year’s taxes, never mind a month to month breakdown. So, the only way to compare is to look 2 years back, which probably isn’t going to happen either.
The only thing you can do is get estimates from a property management company, compare it to other properties you own, or compare it to some rules of thumb, such as the 50% rule.
Putting It All Together
Once you have your actual income and expenses and your pro forma rents and expenses, it’s time to compare the two and analyze your deal.
Let’s take a look at this example of a 3 unit building. On the right, under T12 actuals, that is the information the seller has provided. So, punch it into the calculator.
As you can see, the seller doesn’t provide a lot of information. Without a good breakdown of all the expenses, it’s easy to forget what expenses should be there or shouldn’t be. Things like make ready or admin costs (for eviction, attorneys, accountants, etc), and reserves are often forgotten.
Now that we have realistic expectations for rent and a good budget, it’s time to put it all together.
From Actual to Pro Forma
The last thing to do is to estimate how long it will take you to move from actual rents and expenses to the pro forma projections.
If it will take 18 months, then you need to account for the increased vacancy, turnover, and other costs to get you there over that time frame.
I’ve built this into my calculator to make it easier, but if your calculator doesn’t have it, you can jack up the vacancy rate, or build it into the rent growth assumptions, or any number of ways to work around the limitations of the software.
You can see at the bottom, I assumed for this specific project it would take 12 months to finish and bring all rents to the full, stabilized level.
Since this was a hypothetical I’m going to stop the analysis there. But, you can take the information and use it on any deal you find.
How Do You Analyze Your Deals?
Do you use a pro forma when running your numbers, or do you just look at the actuals?