Real Estate Investing
What is Pro Forma in Real Estate?
Belong on Sep 11, 2022
A real estate pro forma uses current or potential rental income and operating expenses to help potential investors understand the risks and benefits of purchasing a property. While there are different kinds of pro formas in various industries, they all present financial projections for a specific period of time in a standardized way.
It’s important to note that a 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. As such, a pro forma is a tool used to evaluate the risks or benefits of a potential rental property. However, you need to consider critical factors in calculating your pro forma. Most importantly, you must learn to spot a pro forma that inaccurately reflects a potential real estate investment.
What real estate investors need to know about pro forma reports for real estate
If you’re interested in purchasing a real estate investment, pro formas are essential to evaluate potential properties. A real estate pro forma report can indicate a property’s projected net income and possible cash flow projections.
An accurate pro forma report can help investors estimate and project the rate of return for a rental property. The pro forma outlines income, expenses, potential revenue, and the operating income of a property. This information is critical if you are new to investing in real estate, renting a home, or unfamiliar with the geographic area.
What included in a pro forma statement for rental property
While there are many different ways to present the information in a real estate pro forma, nearly all of these documents will include three main types of information. A pro forma will include a projection of a rental property's net operating income (NOI). The net operating income may also be called before-tax cash flow. The NOI is calculated by subtracting operating expenses from the effective gross income.
NOI = Effective Gross Income - Operating Expenses
While each pro forma will include slightly different information, you should see expenses, gross income, and the net operating income on each pro forma document.
How to calculate gross income for a pro forma
You can calculate the effective gross income using a simple formula. Take the total projected income, add any other income for the property, and subtract a vacancy allowance.
Gross income = (Total Projected Income + Other Income) - Vacancy Allowance
The projected gross income for a rental property should reflect the total rental income the property would generate if you leased it 100% of the time. The projected gross income should reflect the current rent if the property is rented. If the property is not leased, the gross income may be an estimate based on the current rental market.
Other income should include things such as late fees or pet fees. However, this additional income should not include security deposits.
The vacancy allowance for a rental property is an estimate that allows prospective rental property owners to account for any time when the property may not be rented. The vacancy allowance should include the time the property may be vacant between residents. It should also include any time you need between the purchase and when a new resident will move into the property.
How to calculate operating expenses for pro forma
Calculating the operating expenses for a real estate pro forma requires understanding the costs associated with managing and maintaining a rental property. These expenses fall into four categories: repairs and maintenance, property management costs, mortgage payments, and additional miscellaneous expenses.
Repairs and maintenance: If you are unfamiliar with maintaining a rental property, it’s helpful first to consider standard rental property maintenance costs. You should also consider a potential property's annual maintenance costs. If a potential property is older or less updated, you can expect there to be more maintenance and repairs. Similarly, it’s helpful to consider the age and condition of the major home systems like central air, water heaters, or the roof. Your estimate for maintenance also needs to include a reserve amount used for future maintenance or repairs.
Property management costs: Your real estate pro forma must include the property's management costs. If you plan to self-manage the property, you must account for all management expenses, including your own time. Most property management services will charge a percentage of the monthly rental value, typically between 6-12%. However, there are often additional costs and fees associated with traditional property management. So while an initial package may only cost 6% of your monthly rent, extra expenses can add up quickly.
Mortgage payment: If you will not own the property outright, you will need to include the principal, interest, and property taxes on the pro forma.
Expenses: Your real estate pro forma should include any additional expenses associated with the rental property. These expenses include utilities, insurance, legal fees, marketing, HOA fees, or any other costs you can estimate.
Why accurate pro forma calculations are important
An accurate pro forma will provide an essential financial snapshot of a rental property. A more precise pro forma will allow you to evaluate a potential real estate investment effectively.
Further, almost all real estate investment metrics/calculations (cap rate, cash-on-cash, and ROI) rely on accurately calculating NOI and cash flow:
- Capitalization Rate = Net Operating Income / Purchase Price
- Cash-on-Cash Return= Total Cash Invested/ Annual Pre-Tax Cash Flow
- ROI = (Gain on investment – Cost of investment) / Cost of Investment
Conversely, if a pro forma is incorrect or misrepresents a property, you may risk making poor financial decisions. An inaccurate pro forma can result in overpaying for a rental property or misjudging the potential success of a property. Poor financial projections might cause you to set the rent too high because you did not include all expenses in the initial pro forma. You may also miss out on a real estate investment opportunity because of miscalculations.
How to avoid misleading pro forma reports
Unfortunately, you may also encounter pro formas that present information in a way that either misrepresents a property, aims to emphasize optimistic financial projections, or downplays expenses.
An overly simple pro forma might only include the purchase price, gross annual rent, cash flow per month, and appreciation. In this case, the pro forma does not accurately capture the expenses associated with owning a rental property.
Similarly, overly complicated pro formas make it difficult to compare potential real estate investments accurately. Keep in mind that sellers are incentivized to provide an optimistic pro forma. It’s vital to avoid wishful thinking when you evaluate a real estate investment or pro forma.
In real estate investing, comparing properties using the same criteria and data points is best. Because of this, you should use the same pro forma calculations for each potential investment. We also recommend that you do not rely on a pro forma that the seller’s agent provides.
Pro forma rent
Carefully review any gross income data that a seller provides. Potential rental income or rent rate projections can widely differ from the current rental market. Always do your best to conduct your own calculations and ensure you have an accurate sense of what rental rates are in the area. For a precise pro forma, you’ll need to understand how much rent to charge and consider all rental pricing factors related to a potential rental property. It can be challenging to project rent, as pricing factors can fluctuate over short periods.
Belong makes pro forma calculations simple
Due to high costs and hidden fees, traditional property management companies can negatively impact your pro forma. However, Belong offers homeowners a modern alternative to property management that makes financial projections easy and straightforward.
Rental pricing: Belong's unique proprietary algorithm tells you exactly how much rent to charge, thanks to real-time data and insights about your individual property.
Guaranteed Rent: Did you know Belong homeowners get guaranteed rent, no matter when their residents pay? Estimating rental income couldn’t be easier thanks to steady and guaranteed payments with Belong.
Repairs and maintenance: Our team of Pros are full-time Belong employees who have been screened and vetted. Belong Pros provide long-term care and fix any issue in your home. They’re on call, take care of regular property maintenance, and can provide 24/7 emergency service.
Belong’s management fee is transparent (8%), capped (won’t exceed $599), and inclusive. We never charge markups or hidden fees.
A successful real estate investment strategy requires you to identify the ideal property and manage your investment effectively. Belong helps homeowners increase their profits and limit the hassles of owning an investment property.