Real Estate Investing: How to Read a Pro Forma Statement

by FI Fighter on February 17, 2014

in Real Estate Thoughts

new_house

When getting started with any new job, hobby, sport, investment, etc., there are always new terminology and acronyms we must learn. This is no different when it comes to real estate investing. And although the final equation (make lots of money) is easy for almost anyone to grasp, we still must learn how to navigate from A to Z.

Learning to read a Pro Forma statement may seem daunting at first, but it’s actually pretty easy to digest once you know what all the terms mean. In this article, we will use an example to try and break down every line item, one by one.

To get started, here is my own personal favorite equation (simple is good):

Pro Forma Statement

A typical Pro Forma statement might look something like this, for a 16 unit commercial apartment building:

proforma_2 proforma

Lots of numbers being thrown around there, right? Let’s see if we can breakdown what each line actually means. For this 16 unit, $1,175,000 apartment, we have the following:

Scheduled Rent

The scheduled rent is the gross rental income you would expect to collect for all of your units over a full year. Plugging in the number from the table above, we get:

Scheduled_Rent

Assuming each of the 16 units rents for the same amount, we can back track to determine how much rent each unit generates per month. Back calculating isn’t always necessary, but in the event the Pro Forma statement doesn’t provide individual unit information, we can still easily calculate to find out.

Take the annual Scheduled Rent and divide that by 16 units to get the gross annual rent per unit:

Gross_Annual_Rent

Once we know the gross annual rent per unit, we can divide that number by 12 to get the gross monthly rent per unit:

Gross_Rent

Other Income

Commercial apartments oftentimes have coin operated laundry facilities that actually help generate additional income. Further, if the unit charges fees for parking, or has a vending machine, you can count this additional income and group it under the Other Income section. In this example, the section is titled “Laundry/Other Income”.

Other_Income

Scheduled Gross Income

The Scheduled Gross Income the sum of the Scheduled Rent and the Other Income. It is commonly used in most Pro Forma statements and is the total annual gross income the investment is expected to generate, assuming full occupancy (0% vacancy rate).

Scheduled_Gross_Income2

Less Vacancy

Because actual vacancy rates cannot be accurately predicted, almost always, a fixed percentage assumption will be used. Most sellers, or marketers will underestimate the actual vacancy numbers in an attempt to “juice” the return on investment to entice potential buyers. In this example, 5% vacancy is assumed.

Less_Vacancy

For the conservative investor, it is always a good idea to budget an even higher number, say 10%. Also, any costs associated with filling a vacancy need to be accounted for in this section. For instance, any fees associated with listing the property, lease up, lease renewals, background check, open house showings, etc.

However, be wary of any Pro Forma statements where the seller is already baking in vacancy rates of higher than 10%. This may be a red flag that the prospective property has difficulty retaining quality tenants. The only way to get a close approximation of actual vacancy rates for a property is to insist upon the seller to release to you the rent roll for the last few years. In this example, the vacancy assumption falls under the “Less Est. Vacancy Loss”.

Effective Gross Income

The Effective Gross Income is calculated by taking the Scheduled Gross Income and subtracting out the Less Vacancy assumption. You can think of it as the annual gross income you would realistically expect to generate. In the real world, vacancy is unavoidable and must be accounted for.

Effective_Gross_Income2

Operating Expenses

Operating expenses are all the bills associated with your investment property. These will include items such as, but not limited to:

  • Property Taxes
  • Insurance
  • Landscaping/HOA
  • Property Management/On-Site Manager Accommodations
  • Staff
  • Repairs and Maintenance
  • Capital Equipment/Materials
  • Payroll/Accounting/Marketing
  • Utilities/Electric/Gas
  • Garbage/Sewage
  • Pest Control
  • Pool/Gym Services

In this example, the sum of all the expenses is:

Operating_Expenses2

The operating expenses appears in the “Less Est. Expenses” row.

Net Operating Income

Net Operating Income is the yearly cash flow (before taxes) received from all units over a given year. It does not factor in any debt service. To calculate Net Operating Income, take the Effective Gross Income and subtract the Operating Expenses.

Net_Operating_Income

Capitalization Rate

One of the first equations you will come across in real estate is Capitalization Rate (CAP Rate). The gross CAP Rate is a measure of the potential return of the investment. The higher the percentage, the larger your return. In its simplest form, it looks at the ratio of gross yearly income generated divided by the Purchase Price:

CAP_Rate

The use of CAP Rate implies that the property is being purchased all cash without the use of financing. Debt service is not accounted for in the CAP Rate equation.

Effective Capitalization Rate

If the CAP Rate looks too good to be true, it typically is. The “true” CAP Rate, known as the Effective CAP Rate, looks at the complete picture, and also accounts for operating expenses (property taxes, insurance, property management, landscaping, utilities, etc.). The numerator, “Scheduled Gross Income” is replaced with “Net Operating Income”.

The Effective CAP Rate is your yearly return for an all cash purchase, and like CAP Rate, does not take into account any Debt Service:

Effective_CAP_Rate

Often times, an honest Pro Forma statement will simply provide the Effective CAP Rate in absence of the gross CAP Rate. However, never take for granted that the CAP Rate number advertised is indeed the Effective CAP Rate. Sellers will often times try to make their numbers look better than reality by only providing the gross CAP Rate. You must double check to make sure the Cap Rate provided is indeed the Effective CAP Rate which accounts for Operating Expenses.

Debt Service

The use of Debt Service implies that financing will be used to purchase the property. To calculate the annual Debt Service, we first need to know the terms of the loan.

From the Pro Forma, we know that the Downpayment was 25% of the purchase price:

Downpayment

If neither the monthly mortgage payment or interest rate is explicitly stated (this is typically not the case and this information is usually provided in a Pro Forma), we can use a mortgage calculator to figure out the exact terms. Using trial and error, the terms of the loan are calculated to be:

Debt_Service_Fix

Note: Since this is a commercial building, the terms of the debt service using a commercial loan are not as straight-forward as they would be for a residential loan (fixed 15 year or 30 year rate). In this example, a 1st loan of $881,250 (75% of Purchase Price) is obtained at 3.70% financing fixed for the first 5 years, amortized over 30 years due in 30 years. The Debt Service numbers shown above would be valid for use in Year 1, but would have to be updated after 5 years to reflect the new interest rate.

Cash Flow

The Net Operating Income is the annual net Cash Flow (before taxes) for an all cash purchase. If financing is used, the net Cash Flow (before taxes) is the annual income obtained from subtracting the Debt Service from the Net Operating Income:

Cash_Flow

In the Pro Forma statement, the Cash Flow is found under “Pre-Tax Cash Flow”.

Cash-On-Cash Return

Cash-On-Cash implies the use of financing. In a low interest rate environment, it can be advantageous for an investor to make use of leverage (“cheap” debt) since the Return On Investment (ROI) will be greater. Further, many investors like to use leverage to reduce the amount of Downpayment needed to purchase a property. In addition, the benefits of principal paydown and tax deductible interest can be gained through the use of leverage.

In this example, the Cash-On-Cash Returns through financing are higher than the Cap Rate, which are the returns for an all cash purchase:

Cash_On_Cash

If no financing is used, the Cash-On-Cash return will exactly match the Effective Cap Rate.

Cash_On_Cash2

The Return On Investment (ROI) is equal to the Effective CAP Rate, which is equal to the Cash-On-Cash.

Cash_on_Cash_Cap_Rate

Return On Investment

The Return On Investment (ROI) is the annual return of the investment property. Depending on whether the buyer elects to purchase all cash, or through financing, the ROI will vary.

In this example, the ROI would be:

ROI

Principal Reduction

An added benefit of using financing, as mentioned previously, is the Principal Reduction gained each month. If an investment property cash flows positive after all Operating Expenses, this implies that the principal is also being paid down by the tenants.

In this example, an investor only needs to come up with a 25% downpayment. Over a 30 year term loan, the remaining 75% balance will be paid off in full. So, although an investor only put in $293,750, by the end of 30 years, due to principal reduction, the investor will own the property outright. By claiming 100% ownership, the investor will have increased their equity position from $293,750 to the full $1,175,000 (assuming no price appreciation).

For Year 1, the Principal Reduction would be:

Principal_Reduction

Total Return

Cash-On-Cash returns do not take into account any principal paydown. A common calculation used to boost yields is to add in the Principal Reduction portion on top of the net Cash Flow.

This is the Total Return (before taxes), as shown below:

Total_Return

Total Cash Return Rate

The Total Cash Return Rate (TCRR) is the Total Return (before taxes) expressed in terms of percentage. TCRR takes the Total Return and divides it by the downpayment. In this example, the Downpayment is 25%, or $293,750.

The TCRR is calculated as follows:

TCRR

In the Pro Forma statement, TCRR can be found under “Total Return Before Taxes”.

Gross Rent Multiplier

The Gross Rent Multiplier (GRM) is a crude calculation used to estimate the value of a property.

GRM takes the Purchase Price of the property and divides it by the Scheduled Gross Income:

GRM

GRM comes in handy when you are evaluating the prospects of an investment property and are trying to come up with a suitable offer. Having knowledge of what the appropriate market GRMs should be will help prevent an investor from overpaying.

For instance, if an investor knows that the GRMs around this commercial apartment typically hover around the 5-6 range, then they will immediately know that the seller’s offering price of $1,175,000 runs on the high side. By plugging in the appropriate GRM, the investor will know what the ceiling should be for any offers they make.

Granted, the GRM will never tell the complete picture. It does not take into account: desirability of neighborhoods, condition of property, vacancy rates, etc., which are absolutely vital pieces of information needed to make an informed buying decision.

GRM should only be used as a crude calculation, providing a cursory glance of the investment’s potential prior to any deep dive analysis.

Current vs. Market Returns

The Pro Forma statement above runs CAP Rate, Cash-On-Cash returns, GRM, etc. using current rent and market rent figures. The market rent return numbers show a higher return, and are provided to basically inform the prospective buyer that units are currently renting for below fair market value.

All numbers calculated in this article ONLY used current rent figures found on the LHS of the Pro Forma table. Further, all returns generated do not take into account any additional closing costs that may be required.

{ 30 comments… read them below or add one }

1 JC @ Passive-Income-PursuitNo Gravatar February 17, 2014 at 11:51 am

Great introduction to REI terms. I’ve learned so much from your other posts and hanging out on BP but this is a great starter post for anyone interested in REI.

Reply

2 FI FighterNo Gravatar February 17, 2014 at 8:20 pm

JC,

Yeah, BP is a wonderful community and great place to learn. I wrote this article particularly for those who want to get started in REI and wanted a one stop shop to learn the most commonly used terms for doing analysis work.

Cheers!

Reply

3 writing2realityNo Gravatar February 17, 2014 at 12:30 pm

Great post FI! Important to realize for all investors is that any information provided by the buyer must be taken with a large grain of salt. The more information you can get that can be corroborated, the better. I was evaluating a couple of 7-12 unit buildings near where I live and it was insane to me how unrealistic the numbers were as presented. Having a solid understanding of the true condition and vacancy cost of the properties is huge.

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4 FI FighterNo Gravatar February 17, 2014 at 8:22 pm

writing2reality,

Thanks! That’s right, never trust a seller completely and always perform you own analysis to double check their work. In this example, the seller did not include closing costs in the calculations, which are real out of pocket costs to the buyer. If you add in those figures, the returns get lowered… Although, from my own experience, I have very seldom come across Pro Forma’s with closing costs added into the ROI calculations…

To calculate true ROI, a buyer needs to add in all costs.

Cheers!

Reply

5 Liam @ HBS Real EstateNo Gravatar February 17, 2014 at 1:47 pm

Given the size of the property, I believe this property will not qualify for a standard 30-year mortgage. The commercial loans that I have access to are 5-5-5 ARMs, meaning the rate changes every five years.

Generally, 30-year mortgages are available for 1-4 residential units. A property that contains even 1 commercial space or is 5+ units falls to commercial lending.

The 15 year pay down can significantly affect the numbers. I just refinanced one of my properties to free up some of the equity. My new loan has a 15 year pay down and my payment is $336/month. With a 30 year mortgage, the payment would be closer to $236, which is significant. Obviously, if I can pay that loan off in the next year or so, I’ll have an additional $336/month cash flow to my bottom line, which is VERY significant.

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6 FI FighterNo Gravatar February 17, 2014 at 2:03 pm

Liam,

Good catch! You are right that this example uses a commercial building which would not qualify for conventional, residential 30 year fixed rate.

The numbers don’t change (luckily), but it should say 3.7% fixed for 5 years, amortized over 30 years due in 30 years.

I will make the correction above… I think I’m just too much in the habit of getting residential loans that I tried to back calculate using my standard 30 year mortgage calculator 🙂

Just so no one is confused, all this means is that the debt service will adjust after 5 years and it won’t be locked at a fixed rate for 30 years. Although the life of the loan is still 30 years, the rate readjusts after 5 years, changing the debt service numbers. This variable has no impact on Pro Forma numbers for Year 1, which is what the statement and calculations show.

Thanks!

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7 AJNo Gravatar February 17, 2014 at 1:57 pm

I haven’t actually owned multifamily but researched for many months, but minor nitpicks:
In this property, you likely need a commercial loan (over 4 units).
Probably impossible to find a commercial loan that goes 30 years, anticipate 3-10 year of fixed interest rate then balloon or adjustments..
Closing costs will be significant and should be taken into account in cash on cash return.
Any repairs after the purchase should also be taken into account with cash on cash.

Nice summary.

Reply

8 FI FighterNo Gravatar February 17, 2014 at 2:22 pm

AJ,

Thanks for the feedback. Yes, I made a mistake in assuming a 30 year fixed rate would have been possible for a commercial building. The correction has been made, and the loan is now fixed for the first 5 years, adjusting after.

Yes, closing costs and any post-acquisition repairs would eat into the returns… To keep the example simple and straight-forward, we are living in a make believe world where the property is 100% turnkey ready and the seller is nice enough to pay for all closings costs 🙂

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9 DavidNo Gravatar February 17, 2014 at 5:56 pm

Great blog!
That is an expensive rent. These finances seem all but great, because this means that you need to rack in a huge amount of money to pay them off. I do agree that money in IS definitely greater than money out! But, it doesn’t seem that this will be the case.
Good luck!

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10 FI FighterNo Gravatar February 17, 2014 at 8:24 pm

David,

Thanks! The example I provided is merely an example and not an actual property I am considering purchasing. Also, by no means did I mean to imply it was a good deal, or bad deal.

The purpose of the article is to provide an example on how to calculate numbers you would often find in a Pro Forma sheet. The calculations I worked out match what is on the statement.

Whether this investment is worthwhile or not is beside the point. I’ll save that for a future article 🙂

Cheers!

Reply

11 The First Million is the HardestNo Gravatar February 17, 2014 at 6:51 pm

Great info, there’s a lot more to take into consideration than I would have thought at first. Is there a minimum ROI that makes a “good” real estate investment, or does it just depend on whatever return the individual investor is comfortable receiving.

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12 FI FighterNo Gravatar February 17, 2014 at 8:27 pm

Jay,

Yeah, this example might be a tad more complicated b/c it is for a commercial building that has 16 units. For a single family home, or 4-plex, the analysis wouldn’t be as complicated.

The good news is, if you understand how all this works, those residential properties should be a piece of cake to work through.

ROI is very, very subjective, and most folks will argue this until the cows come home… There’s really no right or wrong answer, it just depends on what you are looking for. In a prime real estate location, you’ll never find outrageous returns… In depressed areas, you better have a high ROI to even considering investing in…

My own strategy is to go for diversification and find the right balance. I try and match my REI strategy to what I use when buying dividend stocks.

Hope that helps, although I didn’t answer it concretely 😉

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13 EricNo Gravatar February 18, 2014 at 5:36 am

I am not sure if this is a hypothetical example, or if you are actually buying. But here is my take.

I will assume that you always look at leases, not rent ‘potential’ to figure current cape rate. You can always figure potential cap rate later. Your offer should be based on current numbers, not future numbers. Let the appreciation be yours, not the sellers.

I would say that the expenses may be a bit on the light side. That affects the cap rate and ROI. I always assume a 45% expense ratio, or actual, whichever is higher. $164,245 * .45 = $73,910. I prefer a 15% ROI, which most of my properties get handily. (All but the first one…)

In that 45% expense ratio there would be 10% for maintenance, 5% for vacancy and 8% for management. Most of the rest of the expenses should have actual receipts or invoices. I larger cities, taxes are bad, and it’s hard to maintain a 45% ratio, so you have to adjust your offer to still get your desired cap rate.

In a commercial building, look at the apartment classification, A, B, C or D. Each one requires a higher cap rate to make it worthwhile. An ‘A’ class building, 6% cap rate might be OK. With a ‘D’ category, you should get a minimum of a 12% cap rate. A ‘B’ should be at least 8%, ‘C’ should be at least 10%. If you are unsure of what apartment classifications are, and how to categorize a building, you have no business thinking about buying commercial properties.

Keep this in mind always. You are buying to make you money, not make the seller money. Do not jump on a deal just because you need one, do it because you can make money. Even if things do not go exactly as planned.

Remember, everything is selling at market value. If you are the only offer, always ask yourself what you see in the building that others do not. Maybe you have an inside edge? Maybe you have better turn-around skills, etc.

If all you are doing is buying turnkey and bringing in a property manager, you are no better than anyone else and might suffer in the long run.

Reply

14 FI FighterNo Gravatar February 18, 2014 at 8:18 pm

Eric,

Yes, this is just an example, although I do wish I had $300k at the ready for another downpayment 🙂

You have a lot of experience and knowledge… Have you thought about writing a book, or blog, if you haven’t already? Perhaps you would be interested in doing a guest post to share some tidbits of wisdom? I’m sure readers (and myself) could learn a thing… or ten.

Cheers!

Reply

15 Done by FortyNo Gravatar February 18, 2014 at 6:39 am

I’m bookmarking this for future use. Very concise, one-stop-shop for a multi-family breakdown. Would the same apply to something as small as a duplex, or is this sort of analysis really only appropriate when looking at apartments?

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16 EricNo Gravatar February 18, 2014 at 6:57 am

The calculations are the same. The classification of the neighborhood can be similar (A-D), which would indicate what you would expect in terms of cap rate and ROI.

Most investors buying duplexes do not know much about investing, only what their Realtor tells them. Most Realtors do not know much about investing, only what their commission tells them.

Ask your realtor, how many investment properties they have, before taking their advice about investment properties….

Reply

17 FI FighterNo Gravatar February 18, 2014 at 8:23 pm

Done by Forty,

Yeah, this analysis would work for any property, even a single family home. With commercial, it’s really the loan terms (debt service) and Operating Expenses (see above section) that are more complicated to figure out.

I don’t even use GRM for residential stuff. Mostly, just cash on cash return, and monthly cash flow is what I focus on.

The expenses for residentials are usually straight-forward (mortgage, property taxes, insurance, HOA, utilities (mostly for multi-family… gas/electric/water/landscaping), property management) and budget room for vacancy/maintenance.

Reply

18 MattNo Gravatar February 18, 2014 at 8:45 am

Helpful stuff – thanks for walking through the pro-forma statement! I know it can be intimidating for someone that’s never seen one or isn’t too confident with reading statements or spreadsheets. I’m sure this was helpful for a lot of readers.

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19 FI FighterNo Gravatar February 18, 2014 at 8:24 pm

Matt,

Thanks! Glad you found the post helpful. I hope others do as well. 🙂

Cheers!

Reply

20 Mark RossNo Gravatar February 19, 2014 at 3:56 am

That’s a lot of numbers and formulas right there. Anyway, thank you for sharing those, at least I learned something here. 🙂

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21 MarvinNo Gravatar February 19, 2014 at 3:48 pm

Thanks for the simple lesson FI, I really like how you broke everything down step by step and made it simple enough for someone like me to understand.

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22 FI FighterNo Gravatar February 19, 2014 at 9:44 pm

Marvin,

Thanks! It’s helpful to have for me as well, especially when I’m talking to local investors and they want to clearly see how the numbers get calculated. Once you learn the terms you tend to take them for granted, but I always have to remember what it was like when I was first starting out.

Best way I know of to convey clarity is to map out each and every step… Kind of reminds me of college when I was taking Calculus and had to do proofs… If you skipped a step, the professor would dock you 5 points or so…

Reply

23 TomNo Gravatar March 6, 2014 at 7:55 am

Thanks for this info FI, part of the problem with investing in real estate that I am already having is following the numbers and keeping emotions in check. At the moment I am looking into buying a property but I am not sure what targets I should be looking for. The cash on cash return (including debt) that I calculate for the property is 7.9%. Given a mortgage at 5.25% and 15 years, the total cash return rate of 25.4%.

Do these numbers sound like a decent investment? I live in the Cayman Islands and while I’m not sure if the property market is the best investment, part of the reason I would like to do it is because owning property gives me a much better chance at obtaining permanent residency here, otherwise I would have to leave after 8 more years.

Thanks,
Tom

Reply

24 FI FighterNo Gravatar March 8, 2014 at 8:22 am

Tom,

Returns will vary from location to location, so it’s difficult to say what a “good” return is. I know in the Bay Area, anyone would jump on a 7.9% ROI.

If you go out in the Midwest, 7.9% is probably considered on the lower end of returns possible… I’m not sure about the Cayman Islands as I have never researched into that area.

You would have to study the local market in order to determine what is a typical return found there… Also, it is important to take into account things like location, and potential for appreciation.

Appreciation is a very speculative game, but if the cash flow is good and you know there is potential for appreciation there as well, it’s just another positive in the analysis.

Best of luck!

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25 TomNo Gravatar March 8, 2014 at 9:20 am

Thanks FI! I’m certainly doing more diligence on the market here as a whole, and more positive info seems to be coming in, I may have over estimated some expenses and mortgage rates are lower than anticipated. Would I be able to pm you my excel calculations which include NPV over a 30 year period and appreciation? (Yes I’m a bit of an excel dork)

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26 Deborah LongNo Gravatar October 12, 2014 at 4:19 pm

May I have your permission to use your sample operating data in an online course for real estate agents I will use in Florida only?

Thank you.

Dr. Deborah Long

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27 milissa girardNo Gravatar September 15, 2016 at 3:53 pm

Great post! Thanks for this info. part of the problem with investing in real estate that I am already having is following the numbers and keeping emotions in check. At the moment I am looking into buying a property but I am not sure what targets I should be looking for. The cash on cash return (including debt) that I calculate for the property is 7.9%. Given a mortgage at 5.25% and 15 years, the total cash return rate of 25.4%. By the way, I’ve found PDFfiller – online service for forms filling. It’s pretty easy to use and pretty cheap. You can find fillable a form here “https://goo.gl/AO9P43“.

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28 PortiqoNo Gravatar December 18, 2016 at 10:01 pm

This article is a really great guide at reading pro forma statements. This will be really helpful for investors or property managers who are new to this industry , This article will help learn reading pro forma statements quite easily.

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29 SteveNo Gravatar August 14, 2017 at 2:17 pm

Your second Cash on Cash example shows the formula should be divided by the downpayment yet you use the purchase price to equal the 7.11% to match the effective CAP rate – Why?

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30 FI FighterNo Gravatar August 14, 2017 at 5:56 pm

“If no financing is used, the Cash-On-Cash return will exactly match the Effective Cap Rate.”

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