One of the mistakes that many new real estate investors make is not properly estimating costs for buying a property. That’s what happened with Joseph Hogue, who was once the owner of 6 properties.
The fact that he didn’t initially calculate the real property management fees and didn’t account for a high vacancy loss were among the main factors that resulted in further sale of the properties.
The pro forma development for real estate could have prevented such an outcome since property management fees and vacancy loss are one of the main elements of real estate development and construction pro forma.
Pro forma projections help to buy real estate for appropriate prices and avoid unprofitable investments.
Below, we share what to include and exclude from real estate pro forma solutions, why to use real estate pro forma software, and what benefits they offer.
What Is a Pro Forma in Real Estate?
Similarly to corporations and enterprises, properties should also have financial reports. However, the reality is that investors only need some specific data for calculating the true property value. That’s where real estate pro forma plays a major role.
A pro forma in real estate is a documented report that compiles current or estimated income and expense data to forecast the net operating income and cash flow of a property.
Real estate pro forma also gives investors a projection of expenses, as well as the expected return on investment.
Investors need to be very precise and accurate when preparing their pro forma for real estate development since NOI (net operating income) and cash flow predictions from a pro forma are then used in other investment property calculations such as cash return, ROI (return on investment), and cap rate.
Probably, the most valuable thing about the real estate pro forma is that it helps to understand a property’s value, not only here and now, but also to make income and cash flow predictions for many years into the future.
The 4 Basic Elements of Real Estate Pro Forma
Among the basic elements of real estate pro forma we can list income, net operating income and cash flow, operating expenses, and capital costs. Let’s look closer at these 4 elements.
Below are the main elements of real estate pro forma.
Potential Gross Income (PGI)
PGI is an estimated total rental income of a property if the property was fully rented out with no vacancies.
Projecting potential growth income depends both on contractual lease terms and market rents. For all contractual leases included in the rent roll, the cash flow for each lease is estimated for each year in the holding period. This includes the particular lease terms for each tenant.
Often, to forecast a possible future rental income, investors need to take into consideration accounting for renewal assumptions after a lease expires. This involves predicting market leasing commissions, abatement, tenant improvements, reimbursements, and so on.
Vacancy Loss or Allowance
It is never the case that a property is 100% leased at all times. So, it should be expected that there are going to be gaps between rents.
Vacancy loss is an inevitable loss of potential rental income, rather than an expense that happens when a new tenant hasn’t moved in yet and the previous tenant has already moved out and it takes time to find a new one.
There are a couple of simple ways to calculate vacancy:
- by taking a simple percentage of the potential rental income
- by using a total amount for each year in the ownership period.
The more complex calculations include estimating downtime between leases and take into account current market conditions.
This real estate element generally varies from 5 to 10% of gross rental receipts in multi-family and office properties.
Concessions & Free Rent
This is a type of incentive that landlords offer when a new tenant moves in or an existing tenant renews. In this situation, the incentive is usually free rent for a month or two.
Even though these are expenses that residents handle, expense reimbursements usually refer to revenue. Tenants cover expenses such as property taxes, utilities, and insurance. This element of real estate pro forma may vary since there can be different types of leases that tenants and landlords agree on.
The general vacancy is the percentage of available units that are unoccupied during a particular period of time.
Effective Gross Income (EGI)
The EGI consists of a projected gross income plus other income, including late fees or laundry.
This element of pro forma in real estate includes any other additional source of potential income from the property, such as vending or laundry machines, or revenue from payments from cell phone providers who put cell towers on the properties.
Property Management Fees
Property management fees should be always included in the pro forma for residential real estate development, whether the owner manages the property directly or the property owner decides to hire a third-party management company to handle tenants, collect rent, resolve any occurring issues, and set up property repairs and maintenance.
The cost of hiring property management varies from 3% to 8% of the property’s rental income. So, it is important to add this expense to pro forma since an investor should always be compensated for managing the property on their own.
Other Operating Expenses
No matter whether the property was just built or was built a while ago, it is essential to allocate a part of the monthly gross income in a reserve account to cover future repairs, maintenance expenses, and utilities.
All properties are liable to local or government taxes. Usually, these taxes include a small percentage of the total value of the property. Moreover, these taxes tend to escalate every year as the value of the property grows.
There are always cases when unexpected capital costs will come up. Reserves help to balance the property’s cash flow. Starting by allocating a small amount of money each year, investors can then tap into reserves when they need them without hurting the property’s cash flow. In case, the reserves are not enough to cover the costs, then investors will have to use the property’s annual cash flow.
In case the property is leveraged, this will include principal, interest, insurance, and taxes.
Net Operating Income and Cash Flow
Almost at the bottom of the real estate pro forma are some of the most important metrics for valuing the property and determining its performance in a deal.
Net Operating Income (NOI)
Net operating income is a calculation used to estimate the profitability of real estate investments that generate income. The NOI is calculated by deducting all operating costs from the effective gross income of a property.
Net operating income is one of the most commonly used indicators of cash flow for commercial real estate pro forma software.
The NOI does not include expenses such as tenant improvement allowances, rental fees, and some capital improvement costs. Accounting for these items in the NOI provides greater accuracy in establishing the profitability of the project.
It is the property’s NOI minus the net capital costs not covered by the reserves. Adjusted NOI leaves out income taxes and the change in working capital.
Cash Flow to Equity
It is an adjusted net operating income minus debt service. Cash flow to equity tends to be close to the distributions made to the equity investors of the property. That is because properties almost never compile large cash balances.
Such costs are also called below-the-line expenses which are calculated after the net operating income is figured out. Capital costs can be related to expenses that will be beneficial for a long time.
Capital Expenditures (CapEx)
These are expenses that are not attached to tenants, but rather the property itself. Such expenses may include a new elevator, heating system, roof, air conditioning, and so on. Expenses can fluctuate from time to time and depend on the state and age of the building.
Tenant Improvements (TIs)
Tenants improvements are paid incentives that are offered to tenants as a way of encouraging them to start renting or to renew a lease. These improvements can be additional doors or walls, or any other kind of property improvement. This is not a day-to-day expense, but more of yearly expenditure.
Leasing Commissions (LCs)
These are commissions that are paid to real estate agencies, individual realtors or brokers to find new tenants or to persuade existing tenants to renew their lease. Commissions are based on a percentage of the total lease value over the period of the lease.
What Is Not Included in Real Estate Pro Forma?
There are 2 elements that are not included in real estate pro forma:
Real estate is often owned by flow-through entities, a legal entity where the income of the property is treated as the income of investors or owners. This means that if investors decide to form a partnership and acquire a property, they would be paying taxes individually rather than as a corporation.
Depreciation is an income tax reduction that lets taxpayers restore the cost or other basis of specific property placed into service by the investor. Basically, it is a non-cash deduction that decreases the investor’s taxable income.
Thus, there is no point in including depreciation in real estate pro forma, since pro forma excludes taxes.
5 Essential Features of Real Estate Pro Forma Software
Real estate pro forma software allows investors to predict and estimate a property’s financial condition before buying a property.
We have gathered the main features of real estate pro forma software:
This is the main feature of this software since it enables investors to enter all the necessary elements that a real estate pro forma requires and get a forecast. Projections can be created in detail month to month for each coming year.
Real estate pro forma software allows easy handling of lease terms with changing rent growth, reimbursements, tenant improvements, lease expirations, market leasing assumptions, renewal probabilities, and leasing commissions.
The software’s interface allows previewing output immediately as investors make changes to their assumptions. In this way, they can instantly try out different scenarios.
Modeling of Different Scenarios
Pro forma helps to model different scenarios in case a deal goes great, average, or poorly, since investing in general is very theoretical.
Using a real estate pro forma software solution, investors are able to create any amount of scenarios that would differ in time periods, financial factors, input from various sectors, and so on.
Investors are also able to print or download a great variety of scenarios and run reports based on those scenarios.
The modeling feature reduces the effort required to create different projections while ensuring consistency in the creation of various scenarios.
Not only does real estate pro forma software allow comparing different scenarios, but it also enables comparing different properties.
Therefore, when investors consider a few properties, they can easily analyze them both separately and together in order to determine the best deal.
With the help of real estate pro forma software, investors are able to generate reports such as pro forma itself, market leasing projections, rent roll, construction loan budget, and other projection reports. Based on these reports, investors can make presentations for external and internal professionals.
Reports can be also customized by including contact info, investor’s photo, page numbers, and so on. The selected reports can be exported in PDF or Excel formats.
Automatic report generation saves some of the valuable time that investors are short of. There is no need to transfer data from software manually. Real estate analysis software makes it possible to produce reports with the click of a button.
Pro Forma Sharing
Besides investors, parties such as consultants and team members can also get access to real estate pro forma analysis. By sharing a custom link with team members via an email, investors are able to register in the software and obtain view-only access to the pro forma.
Advantages of Using Real Estate Pro Forma Software
The pro forma functionality itself shows its importance. Nevertheless, below we will define in more detail the benefits of using real estate pro forma software, and why it is better to use this software instead of Excel sheets:
One of the main advantages of using real estate pro forma software is to exclude errors that happen when performing analysis manually. Even the slightest mistake can result in a major loss of money. Software automates the calculating process and property analysis.
Instead of wasting time on creating and calculating a pro forma manually, investors are now able to fill in the data they have in pre-designed fields and get the projections automatically.
Also, it is possible to compare property reports simultaneously and decide what is the best option.
Calculates True Property Value
The whole reason for creating a real estate pro forma is to find out the property’s true value and reduce overpayment.
That’s why real estate pro forma software development allows estimating property value over the lifetime of its existence, including the option of selling it at some point in the future.
What software gives investors is the ability to compare and chop away properties that aren’t going to make investment sense and to choose the one that is most likely to be the most profitable one.
Estimates Discounted Cash Flow
When creating a real estate pro forma solution, investors usually only consider the basic elements, such as rental return, purchase price, and likely capital gains. This often leads to negative cash flow with a property that requires additional monthly investment to keep the property flowing.
The real estate pro forma eliminates this scenario by giving investors the whole picture of the property by introducing all essential elements of the pro forma into the software.
Gives a Property Lifetime Overview
By creating a pro forma, investors have the chance to make projections about the property for the years to come. Usually, property forecasts can be done for up to 25-30 years. This software gives an overview of the property’s lifetime for each year.
Real estate CRM
Our client is a residential real estate agency that helps customers to buy and sell residential properties. The agency had issues with navigating various data management channels to find the necessary information. The data was stored in Excel sheets and in a commercial CRM.
Sloboda Studio created a real estate CRM that helped to automate the work processes. After the software was launched, our client experienced sales conversion and productivity growth.
To conclude, today, real estate pro forma software is an irreplaceable tool for evaluating a property’s potential income and expenses. Pro forma gives the whole picture of a property and its value.
There are 4 basic elements to consider when creating a real estate pro forma: income, operating expenses, net operating income and cash flow, and capital costs.
Income taxes and depreciation are not usually included in the real estate pro forma, since these are tax-related elements that vary depending on the investor’s income.
Investors can greatly benefit from using software instead of Excel sheets. As real estate software allows making more precise estimates of property. Also, it automates almost every aspect of generating pro forma.
In the article, we have listed the most important features of this software. This already gives an understanding of the importance and irreplaceability of real estate pro forma software.
Sloboda Studio has been on the market for 10 years and during the recent 5 years we’ve been building different software for the real estate industry.
If you have any questions related to any real estate software, feel free to drop us a line.