In the world of commercial real estate, understanding the financial potential of a property is crucial before making any investment. This is where a pro forma comes in. A pro forma is a financial model that projects the future income, expenses, and profitability of a property. It’s an essential tool for investors, developers, and lenders to assess the viability of a real estate project.

In this blog, I would like to walk you through the process of creating a pro forma for commercial real estate, breaking it down into simple, actionable steps.

What is a Pro Forma?

A pro forma is a detailed financial forecast that helps you understand how much money a property is expected to make (or lose) over a period, typically 5 to 10 years. It takes into account various factors like rental income, operating expenses, financing costs, and potential resale value, allowing you to make informed decisions about your investment.

Steps to Create a Pro Forma for Commercial Real Estate

1. Collect Property Information

Before you start crunching numbers, gather all the relevant details about the property:

• Property Type and Size: Is it an office building, retail space, industrial warehouse, or multifamily complex? How large is it?
• Location and Market Data: Understand the local market conditions, including comparable properties, vacancy rates, and rental trends.
• Purchase Details: What’s the purchase price? What are the closing costs? What are the financing terms?

2. Estimate Potential Income

Income is the driving force behind any real estate investment. Start by projecting how much income the property will generate:

• Rental Income: Calculate the potential rental income based on current lease agreements or market rent rates. Factor in potential rent escalations over time.
• Other Income Sources: Include any additional revenue streams, such as parking fees, vending machines, or storage rentals.

3. Project Operating Expenses

Next, estimate the operating expenses that will be necessary to keep the property running:

• Property Taxes: Based on the assessed value and local tax rates.
• Insurance: Costs to insure the building and its operations.
• Maintenance and Repairs: Regular maintenance and potential repairs to the property.
• Utilities: Water, electricity, gas, and other utilities.
• Property Management: If you plan to hire a property management company, include their fees.
• Other Expenses: Include legal fees, accounting, marketing, and any other anticipated costs.

4. Calculate Net Operating Income (NOI)

Once you’ve estimated your income and expenses, calculate the Net Operating Income (NOI):

NOI =Total Income−Operating Expenses

The NOI is a key indicator of the property’s profitability before accounting for financing costs.

5. Include Financing Costs

If you’re financing the property, you’ll need to factor in the cost of borrowing:

• Mortgage Payments: These include both the principal repayment and interest. Use the loan amount, interest rate, and amortization period to calculate your monthly or annual payments.
• Other Financing Costs: Include any loan origination fees, refinancing costs, and prepayment penalties if applicable.

6. Determine Cash Flow Before Taxes

Subtract your mortgage payments from the NOI to determine your Cash Flow Before Taxes:

Cash Flow Before Taxes= NOI−Debt Service Service

This figure represents the amount of money left after all operating expenses and debt service, which can be used for taxes, distributions, or reinvestment.

7. Account for Capital Expenditures (CapEx)

Capital expenditures refer to significant expenses required for major repairs or improvements. These costs are not included in regular operating expenses but are necessary for maintaining or increasing the property’s value:

• Renovations or Upgrades: Include the expected costs for any planned renovations, upgrades, or major repairs.
• Reserve for Future CapEx: It’s wise to set aside a reserve for future capital expenditures to avoid cash flow disruptions.

8. Estimate the Property's Resale Value

At some point, you may want to sell the property. To forecast its resale value:

• Exit Cap Rate: Estimate the cap rate at the time of sale based on future market conditions.
• Appreciation: Consider the potential appreciation in the property’s value over time.

Resale Value = NOI at Exit / Exit Cap Rate

This gives you an idea of what the property could be worth when you sell it.

9. Perform Sensitivity Analysis

It’s important to understand how changes in key assumptions impact your pro forma. Perform a sensitivity analysis by adjusting variables such as rent growth, vacancy rates, and cap rates to see how they affect your projected returns. This helps in identifying potential risks and developing contingency plans.

10. Calculate Key Financial Metrics

To evaluate the investment, calculate key financial metrics that help measure the property’s profitability:

• Internal Rate of Return (IRR): The rate of return that makes the net present value of all cash flows equal to zero. It’s a critical measure of the investment’s overall profitability.
• Cash-on-Cash Return: The annual cash flow divided by the initial investment. It measures the cash income earned on the cash invested.
• Cap Rate: The NOI divided by the property’s current market value, indicating the rate of return expected.
• Debt Service Coverage Ratio (DSCR): The NOI divided by debt service, which lenders use to assess the risk of the loan. A DSCR above 1.25 is typically favorable.

11. Prepare the Pro Forma Statement

Now that you’ve gathered all your data, it’s time to compile it into a clear, organized pro forma statement:

• Income Statement: Summarize your projected income and expenses for each year.
• Cash Flow Statement: Outline your projected cash inflows and outflows, including financing costs.
• Assumptions: Clearly list the assumptions used in your projections, such as rent growth rates, vacancy rates, and expense inflation.

12. Review and Revise

Finally, review your pro forma with stakeholders, such as investors or lenders. Be prepared to adjust your assumptions and projections based on feedback or changes in the market.

Conclusion

Creating a pro forma for commercial real estate is an essential step in evaluating the financial feasibility of a property investment. By carefully estimating income, expenses, and potential resale value, you can make informed decisions and maximize your returns. Whether you’re a seasoned investor or a newcomer to commercial real estate, mastering the pro forma process will help you navigate the complexities of the market with confidence.

Good luck on your journey to becoming a commercial real estate Investor. If you'd like to further discuss, you may also contact me directly at (818) 433.0548