Understand the Numbers

What's in a Pro Forma?

A pro forma is a financial projection that outlines the expected performance of a real estate investment. It's essentially a forecast of the property's income, expenses, and returns over the investment period.

Key components of a pro forma include:

• Income: Rental income, parking fees, laundry, and other revenue sources
• Expenses: Property taxes, insurance, maintenance, property management, etc.
• Assumptions: Rent growth, expense growth, vacancy rates, exit cap rate
• Debt Service: Mortgage payments and loan terms
• Cash Flow: Income minus expenses and debt service
• Returns: Projected IRR, equity multiple, cash-on-cash return

Example: Annotated Pro Forma

A typical pro forma showing projected income, expenses, and cash flows over a 5-year hold period.

Key Metrics to Understand

Cap Rate

The capitalization rate (cap rate) is the ratio of a property's net operating income (NOI) to its purchase price. It's expressed as a percentage and represents the unlevered return on the investment.

Formula: Cap Rate = Net Operating Income ÷ Property Value

A higher cap rate generally indicates a higher potential return, but also higher risk. Market cap rates typically range from 4-10% depending on property type, location, and quality.

Internal Rate of Return (IRR)

IRR is a metric used to estimate the profitability of an investment. It accounts for the time value of money and considers all cash flows over the investment period.

IRR is expressed as an annualized percentage and is one of the most important metrics for evaluating real estate investments. Most crowdfunding deals target IRRs between 12-20%.

Equity Multiple

The equity multiple shows how many times your initial investment will be returned over the life of the investment, including the return of your principal.

Formula: Equity Multiple = Total Cash Distributions ÷ Total Equity Invested

For example, an equity multiple of 2.0x means you'll receive $2 for every $1 invested over the life of the investment. Typical equity multiples range from 1.5x to 2.5x for a 5-year hold.

Debt Service Coverage Ratio (DSCR)

DSCR measures the property's ability to cover its debt payments. It's the ratio of net operating income to debt service.

Formula: DSCR = Net Operating Income ÷ Annual Debt Service

A DSCR of 1.0 means the property generates just enough income to cover its debt payments. Lenders typically require a minimum DSCR of 1.25, and a higher DSCR indicates a safer investment.

Common Assumptions to Watch

The assumptions in a pro forma can dramatically impact projected returns. Here are key assumptions to scrutinize:

Rent Growth

Be wary of projections that assume rent growth significantly above historical averages (typically 2-3% annually). Aggressive rent growth assumptions of 5-7% or higher should be questioned unless there's strong market evidence to support them.

Exit Cap Rate

The exit cap rate is the projected cap rate at the time of sale. It's common for sponsors to assume a lower exit cap rate than the entry cap rate, which boosts projected returns. This assumption should be realistic based on market trends.

Be cautious if the exit cap rate is significantly lower than the entry cap rate without strong justification.

Vacancy and Bad Debt

Projections should include realistic vacancy rates based on the local market. Assuming near-zero vacancy in a market with 5-10% typical vacancy is unrealistic and inflates returns.

Capital Expenditures (CapEx)

Older properties require more maintenance and capital expenditures. Be skeptical of projections with minimal CapEx reserves, especially for value-add investments that may encounter unexpected issues during renovations.