Building a Real Estate Pro Forma 

A real estate pro forma is a financial document that estimates a property’s future cash flows, income, and expenses over a specific period. It serves as a crucial tool for evaluating the potential return on investment (ROI) and determining the property’s value. By projecting future financial performance, a pro-forma helps investors, lenders, and property owners make informed decisions about purchasing, financing, and managing real estate assets. Essentially, understanding the process of creating a pro forma in real estate allows you to figure out how a property is expected to perform financially, allowing investors to assess risks and opportunities effectively. 

Below are some general benchmarks that can be used for each of these values, but always do your homework. An accurate pro forma is essential to ensure positive monthly cash flow on your investments. 

Revenue Section  

Rental Income

The most conservative and reliable estimate you can use for rental income is the rent that tenants are already paying. Sometimes, however, you may acquire a property that does not have current or recent tenants, or you might be planning to do significant upgrades to the property that make current rental amounts no longer relevant. In these instances, you will want to estimate potential rental income. Potential rental income represents the income a property could generate if fully occupied and all tenants paid market rent (we will account for potential vacancies later).  

A competitive analysis is a great way to determine what your potential rental income could be. You will want to find similar properties/units to find out how much they are charging in rent. Ideally, you can find properties in the area that have the same bed/bath combination and similar square footage. If you have certain stand-out amenities/features, you will want to include those as well (these can be things like garage parking, similar appliances including in-unit washer/dryer and dishwasher, allow/don’t allow pets, etc.). You should also look to see how updated the units are compared to yours. If yours is newly renovated, make sure to look at apartments that are similar in quality to yours. 

Vacancy Allowance

Vacancy allowance estimates lost income due to tenant turnover. The standard rule of thumb is that you should budget for 5-7% vacancy. This means if you have a three-unit multifamily property, with each unit renting for $1,000 (total annual rental income of $36K), then you’ll want to assume anywhere from $1,800-2,520 in annual vacancy loss.    

Bad Debt Expense

Unfortunately, even with safeguards like applicant screening and legally binding lease agreements, there will still be instances when tenants do not pay on time, in full, or even at all. It’s important to account for this when building out a strong pro forma. A good rule of thumb is to assume 2% of your gross rental income as bad debt expense, or tenant debt that will not be paid back. Going back to the three-unit multi-family example, we would want to budget $720 per year in bad debt expense (2% * $36K).  

Other Income

Other income is any revenue you receive from your property outside of rent. This can include income from coin laundry, storage rentals/fees, or additional services that you offer and charge to your tenants. 

Why are vacancy allowance and bad debt expense included in the income section of the pro forma? These two line-items represent a loss of potential income rather than an outgoing expense since you are not actually paying anything here. Think of these as things that prevent you from reaching your maximum rent potential. 

Expenses Section  

Utilities

The utilities line in the pro forma should capture all utility expenses that you, as the landlord cover. In multi-family housing, this will often include water and any common areas (i.e. hallways, shared basements, garages, front/back porches, etc.). You may be able to get some of these numbers directly from the seller, but in other cases you will want to make a best guess based on information available in your area.  

Repairs & Maintenance

The Fannie Mae rule of thumb is to allocate 1-4% of your home’s value each year for maintenance costs. This means that if you bought your property for $500,000, then you should assume anywhere from $5K to $20K per year in regular maintenance costs.  

This may seem like a wide range, but the exact value you use depends on your risk tolerance as well as the general condition of the property. If you are looking at new construction, you may feel more comfortable using the lower end of that range; however, if you’re looking at a property that was built in the 1800’s, then you may want to budget closer to the 4% range for maintenance. 

Insurance

You will either be looking at homeowner’s or landlord insurance for your property. Use one of the free online insurance coverage calculators to get a general estimate for what you can expect to pay both monthly and annually.  

Property Management

If you are planning on working with a property management company, then you will want to include an expense line for those fees. The performance and competence of the property manager play a critical role in determining the success or failure of the investment, as real-life factors can greatly impact outcomes.  

Property management fees typically range from 8-12% of the monthly rent. In our multi-family example, this means you will be looking at an additional expense between $2,880 to $4,320 in annual fees. If you self-manage your properties, management costs could include the annual premium or monthly fee you pay for property management software. 

HOA / Fees

Depending on the type of property you are purchasing, you may have additional fees such as those from a homeowner’s association. The seller or real estate agent will be able to provide these numbers for you.  

Replacement Reserve

Replacement reserve, or CapEx, are funds set aside for larger capital expenses. This goes beyond regular maintenance and repairs and will cover things like replacing your furnace, washing machine, flooring, or roof. To get an accurate assumption for your replacement reserve, you will want to take a list of all the major components within your property, then divide the replacement cost by the expected lifespan to determine the cost per year and month to use.   

As an example, let’s say you have a furnace that is 12 years old, and you think there’s probably another five years left in it. Replacing the furnace is going to cost you $5,000, which means you should set aside $5K / 5, or $1,000 per year to cover replacing the furnace. You’ll repeat this for each capital expenditure on your property. Like repairs and maintenance, this is going to look very different for newer vs. older homes.  

Property Taxes

Property taxes, specifically annual property taxes, are calculated as a percentage of a property’s assessed value and are a crucial factor in budgeting for property expenses. Property taxes will vary by area and property, but you should be able to get an accurate picture of what this expense will look like based on historical data from the seller or by consulting public records. 

Mortgage Loan

Finally, you will want to account for your mortgage debt. This expense is shown after the net operating income since it is not considered a property level expense, but rather one that is specific to that owner. If you choose to pay for your property in cash, then you will not need to worry about this line item. 

Cash Flow  

A real estate investor uses pro forma analyses to evaluate market value and potential rental income, helping to determine net operating income and make informed decisions about pursuing property deals. The last row in your pro forma represents your expected cash flow. It’s important that this value is positive once you have entered in all your income and expenses, but how the amount is going to depend on your risk tolerance and specific goals. 

Note: You may want to exclude replacement reserve if you want to understand your ‘actual’ cash flow. Replacement reserve represents a holdout expense, which is money you’ve theoretically set aside to cover any large property issues as they arise. By setting it aside, you’re ensuring the capital is available for major repairs or replacements when needed. However, if you’re focusing strictly on cash flow, you can choose to omit this reserve from your expense calculations. 

Conclusion 

Creating a reliable pro forma is essential for making informed decisions about rental properties. By estimating income, expenses, and potential cash flow, investors can better gauge a property’s financial performance and minimize risks. With Innago’s free five-year pro forma template (downloadable above), you’ll have a clear picture of how a rental property fits your financial goals.