The Oxford Language Dictionary definition of pro forma is "done or produced as a matter of form" or "a standard document or financial statement.” Similarly, the original Latin meaning is “for the sake of the form.” In contemporary usage, a Pro Forma is a cash flow projection for real estate investments. Pro Formas are typically forward-looking estimates of financial results. Real estate investors rely on the pro forma to analyze potential income and expenses.
By necessity, a pro forma contains assumptions, but a reliable one is carefully crafted. The essential elements of a pro forma include expense and revenue projections. Line items should consist of:
For an accurate statement, each item should be calculated using historical data, modified by current market conditions and growth assumptions. The buyer and seller in a real estate transaction often have somewhat different numbers input into their version of the property’s pro forma. The pro forma is typically a spreadsheet and is included in the property's offering documentation.
The reliability of the pro forma document is crucial for an investor considering a purchase. Yet, the statements are based partly on estimates and assumptions about the future. For example, a pro forma includes projections about future rental income. The numbers used may reflect current rates and vacancies, with future potential being estimated optimistically. An investor should examine the current rent roll to evaluate the likelihood that future projections are achievable based on the rental market, property conditions, and other factors.
Expenses are the second major component of a pro forma and are based on current costs, including property taxes, insurance, utilities, maintenance costs, and property management charges. The data on the pro forma is based on actual current expenses but should also be validated by analyzing comparative data from other similar properties and may also be modified based on apparent trends (like pending tax increases and the age of the property), plus any deferred maintenance which could impact future expenses.
Property taxes impact the calculation of net operating income, and the owner can't control the increase in taxes. Therefore, depending on the time horizon of the pro forma period, increasing property taxes can affect the bottom line. Similarly, in some cases, debt expenses may change the outlook. For example, if the mortgage has an adjustable interest rate, current costs could fluctuate significantly in the future.
Investors should examine the seller’s or sponsor’s pro forma and evaluate its value. A reliable pro forma can help calculate potential net operating income, the IRR (internal rate of return), and the cash on cash return for a property.