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:
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:
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:
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:
Once we know the gross annual rent per unit, we can divide that number by 12 to get the gross monthly rent per unit:
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”.
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).
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.
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.
Operating expenses are all the bills associated with your investment property. These will include items such as, but not limited to:
- Property Taxes
- Property Management/On-Site Manager Accommodations
- Repairs and Maintenance
- Capital Equipment/Materials
- Pest Control
- Pool/Gym Services
In this example, the sum of all the expenses is:
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.
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:
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:
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.
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:
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:
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.
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:
In the Pro Forma statement, the Cash Flow is found under “Pre-Tax Cash Flow”.
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:
If no financing is used, the Cash-On-Cash return will exactly match the Effective Cap Rate.
The Return On Investment (ROI) is equal to the Effective CAP Rate, which is equal to the Cash-On-Cash.
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:
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:
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 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:
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 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.