Rental Proforma: Everything You Need to Know
When investing in rental real estate, a critical component in determining the property’s potential income is the proforma.
These are projections that help you analyze the cash generation potential of a specific real estate property. Knowing how to verify and calculate the rental proforma will also alert you whether you are purchasing the property for more than it is worth.
Getting an accurate proforma is the key to differentiating between a positive and negative monthly cash flow and helps you make an excellent investment.
Find out more about proforma in real estate, how it is calculated, and how to use it to compare rental investment properties below.
What Is Rental Proforma?
In Latin, proforma means “for the sake of form.”
In the finance world, the proforma concept offers a simple way of estimating the current or future financial results of an asset. Similarly, in real estate, the proforma provides the cash flow projection of a rental property.
Further, the document provides buyers with an estimate of expenses and the expected return on their investment. Think of the proforma as a combined cash flow statement and income statement for the property.
How to Create a Proforma for Your Rental Property
Always start with the projected revenue, which assumes that 100 percent of the property is occupied and all tenants are paying market rates.
Next, have a list of the operating expenses for daily operations in the property.
Further, create a list of the capital costs on items you expect to last more than a year.
Finally, consider the debt service and cash flow.
The process is further broken down as follows:
Effective Gross Income
Base Rental Income assumes that the property is fully occupied and that the tenants are paying market rent
Tenant Vacancy Turnover characterizes the in-between months after one tenant leaves and before the next one moves in
Other income constitutes additional revenue generated by coin-operated laundry, late fees, or pet fees
Some landlords offer a free month of rent as an incentive.
Effective Gross Income = Base Rental Income add Other Income minus Tenant Vacancy Turnover
Property management fees are the expense paid when you hire a property pro real estate management company to enroll tenants, collect rent, resolve tenant problems, and oversee property maintenance and repairs
Operating expenses include those such as utilities, maintenance, sales and marketing, landscaping, security, and staff payroll for extensive properties
Total Operating Expenses = Property Management Fees plus All Other Expenses
Property taxes are taxes paid to the local and federal governments to fund infrastructure, police, and school systems
Reserves are a percentage of the property cash flow that you keep aside for emergency repairs
From the total operating expenses figure, you can now deduce the Net Operating Income (NOI) using the following formula:
NOI = Effective Gross Income minus (Total Operating Expenses plus Property Taxes plus Reserves)
These are the items you can purchase that will benefit the property for years to come:
- Capital Expenditures (CapEx) are items for the entire property, including the heating system, elevator, roof, and air conditioning
- Tenant Improvements (TIs) are those items you install into individual tenant units, usually as an incentive. TIs include doors and additional walls.
- Leasing Commissions (LCs) are the charges from agents that help you find and negotiate with new and existing tenants
After calculating the relevant entries of a property’s current state, use your knowledge of the property, tenants, and neighborhood to deduce how the figures will probably sway. This provides you with an important baseline when negotiating the deal.
This Sevierville rental proforma provides a snapshot of what to analyze when looking at potential investments.
For example, when investigating a deal, start by looking at the proforma you receive from the seller. Study the figures for aggressively high income and unrealistic low expense predictions—a sign that something is not right with the deal.
If the numbers look good on paper, it is time to move ahead and investigate further.
That deeper investigation involves creating your own proforma using a list of essential elements.
Elements of a Good Real Estate Proforma
Make sure you include several critical elements in your real estate proforma. These are:
- Repairs even for newly constructed or renovated buildings. As an investor, expect to set aside some cash monthly to take care of maintenance and repair costs. Most landlords put aside about 5 percent of the base rental income. If buying an old property, consider increasing the amount you save.
- Vacancy loss is a high expense on the proforma sheet. Consider the length of your lease and the time your property might be vacant. Repairs, painting, and cleaning before a new tenant moves in are to be considered as vacant days.
- Property management is sometimes opted out by a buyer who expects to manage his or her own property. If this is your intention, make sure you include this line, because you need to compensate yourself for the effort and time you put into managing your property. If you do not want to pay yourself, still include this line, since a property’s financial standing depends on all expenses related to running it. The cost of hiring a property manager is usually about 8 or 10 percent.
- The miscellaneous line is for including other expenses. Such expenses include insurance, inspection, and repair costs and more.
Importance of Making an Accurate Proforma
It is common to see different proforma rent versions for the same property from sellers, brokers, real estate agents, and turnkey companies.
Learning how to make an accurate proforma is an effective skill that allows you to analyze the seller proforma critically. Your best bet is to find that proforma that fits your requirements and not those of the seller.
So, what types of proforma documents are misleading?
- Overly simple—Such a proforma has the purchase price, gross annual rent, monthly cash flow, and appreciation. However, this document does not account for any expenses and further assumes an appreciation in cash flow.
- Complex—This document has maintenance and vacancy allowance included, but actual expenses in figures are not available. The figures only appear as a percentage. Complicated proforma have unnecessary items to confuse buyers or make the property look more attractive than it is.
Learning how proforma documents are created also helps you identify different versions of the document, including:
- Seller proforma vs. buyer proforma—The seller projected expenses differ from those of the buyer. Sellers want to sell the property, so they will make the proforma look good by making it seem like it generates a lot of cash flow by not including some critical expenses. Therefore, a buyer should have his or her own proforma to make accurate projections and estimations on expenses and cash flow.
- Proforma vs. actual rent and expenses—Calculating the residential property value requires carrying out a comparative sales survey of similar properties in the same area. This is useful information that gives you a good idea of what a certain property is worth.
So, buyers should not base their purchase decision solely on the proforma from the seller. Further, use actual expenses to get financing, since the proforma provides the best estimation of these.
After reading this information, you have learned what rental proforma is, how to create your own, and the importance of this document. As you analyze and compare potential rental investments, take advantage of this knowledge to make better estimates on returns and avoid making terrible investments.
Do you need more help to finalize your business plan, create a financial forecast, or even get funding from potential lenders? An accurate proforma can go a long way!
For more real estate advice and how you can navigate the home buyer and landlord journeys, read more from us here.