In the world of real estate investing, understanding a multifamily pro forma is vital. This financial document provides a comprehensive projection of a property's potential revenue, expenses, and profitability over time. However, looking at a pro forma can be daunting, because if you’re going in blind, it just looks like a spreadsheet covered in random numbers.
In this article, we'll break down the key components of a multifamily pro forma and guide you through a general overview, enabling you to make informed investment decisions.
What is a pro forma?
A pro forma is a financial model that considers multiple factors, such as a property’s purchase price, projected rental income, operating expenses, and financing costs, to allow an investor to determine how profitable the deal will be. To put it simply, a real estate pro forma allows investors to determine what return they will make in future cash flow if they put a certain amount of money into the deal today, based on projections. The pro forma allows investors to determine their return on investment by giving them the information they need to calculate their return on investment.
Here’s a quick breakdown of NOI and ROI:
Return on Investment (ROI) = Net Operating Income /Total Investment Costs
Net Operating Income (NOI) =Total Revenue-Total Operating Expenses
But why does it matter?
Pro formas allow investors to build scenarios and essentially “stress-test” the property. For example, if vacancy goes from 7% to 14%, investors will want to understand how this change will affect the property’s net operating income and value. Pro formas will start off by demonstrating the projected revenue of a property assuming it is 100% occupied and all residents are paying market rent. An investor will then go in and adjust things such as vacancy to see what happens. In reality, it’s not uncommon to have at least one vacant unit.
Parts of a Pro forma?
There are some differences between property pro formas, depending on the property type. But most pro formas will include:
Summary Page -provides an overview of the deal
Rent Roll Page - projections of rent over a certain period of time
Budget Page - operating budget when the property is stabilized
Financing Page - a summary of the sources and uses of debt and equity
Cash Flow Page - cash flow projections and waterfall details
Exit Page - details the projected returns in the event of a sale or refinance
Example of a Pro Forma
How to read a pro forma?
Now that we’ve covered the parts of a pro forma, let’s expand on how to read one. For simplicity's sake, we’re going to discuss the pro forma modeling of a stabilized apartment building.
Step 1: Rent Roll Review
Start with the projected rental income. In a pro forma, the rent roll includes a line item per multifamily unit at the property. These line items detail:
The unit number
This rental information should be part of a market analysis to see how it compares to comparable properties in the area. Many investors opt to conduct a financial audit of the rental information provided by the previous owner when they are buying an existing property to make sure the reported rent roll is accurate.
Step 2: Budget Review
Rent roll review allows you to dive into the budget with more context on how much revenue the property generates. The stabilized operating budget outlines the projected rental income and the vacancy assumptions on the top half, with the projected operating costs on the bottom. These operating costs include:
This page will allow investors to calculate the Net Operating Income of the property.
If an investor is buying an existing property, they can compare the projected operating budget with historical data using a trailing 12 (T-12) or trailing 36 (T-36). This is just a financial breakdown of the property’s income and expenses over x number of months.
Step 3: Cap Rate and Property Value Projection Review
With the stabilized operating budget, you can calculate a NOI projection. With this, an investor can calculate the property’s value at that NOI. The formula to determine the property’s value is:
NOI/Capitalization Rate = Property Value
The capitalization rate is simply the cash-on-cash return of buying a property all cash. Cap rates vary by market and the property. A higher cap rate means a lower quality, and a higher risk market, property type, and resident base. So, higher cap rates typically offer higher potential returns. The opposite is true for lower cap rates.
It’s important for investors to contemplate how the projected cap rate in a pro forma was calculated, and ensure that it is realistic given the context of the market and the property type.
Step 4: Financing Review
With the property valuation, an investor can use the pro forma to review the sources of capital for the deal, and how it will be used. Typically, debt and equity are used to finance a deal. Most commercial lenders will cap their lending to a certain loan-to-value ratio. Sometimes, this can be 75% LTV, meaning that if the property has a $8,000,000 projected valuation, the investor can expect the lender to loan $6,000,000, and the investor has to raise $2,000,000 in equity (typically from passive investors) in order to close on the deal. (This example does not take into account closing costs).
Step 5: Cash Flow Projections
We’re almost there! Now that we’ve got the NOI and the debt figured out, investors can use the pro forma to calculate cash flow projections. To calculate cash flow, an investor will take the NOI of property and subtract the debt service.
Debt Service = (Loan Principal + Interest) - Capital Expenditures (Any Cash Expenses Not Included In Operating Expenses)
On the front page of a pro forma, investors can find this cash flow data. Assuming a deal is using a pro rata structure, the cash flow an investor receives is equal to the equity they have in the deal.
For example, if an investor has 20% equity in a deal, they will receive $20,000 of the total $100,000 of distributed cash flow.
Distributions can get complicated very quickly if a cash waterfall is involved. These waterfalls detail the rules of cash distributions, and can involve several steps, but we won’t get into that here.
Using a pro forma, an investor can determine where they fall in the order of the waterfall, and how much of the projected cash flow they are entitled to based on their investment.
Step 6: Exit Strategy and Return Review
A pro forma will also provide information on exit projections. An investor can analyze the assumptions being made about how profitable an investment will be when the property sells or undergoes a refinance. Using the final cash distribution projections, the deal’s total returns can be calculated. A pro forma also allows investors to calculate the deal’s internal rate of return over the hold period.
With all of this information, investors are able to make educated decisions on whether or not this deal would make a good investment.