An important part of real estate investing is understanding how to determine a property's potential income, or pro forma. You will surely come across pro forma projections as you analyze investment opportunities, and knowing how to verify and calculate a pro forma can help you avoid buying a property for more than it's worth. Learn what pro forma is in real estate, how to calculate it, and when it's used in real estate investing.
What is pro forma in real estate?
Pro forma is a term used in real estate investing that relates to an investment property's projected income potential. It's a forecast of the property's cash flow using its future potential income and expenses to show how a property could perform if certain adjustments were made like raising rents, decreasing vacancies, making capital improvements, and developing or expanding.
How is pro forma calculated?
Pro forma is a future projection of a property's cash flow or net operating income (NOI). Here's how to calculate it:
- Estimate the property's potential gross rental income.
- Estimate the vacancy rate.
- Estimate all future expenses.
- Subtract the projected future expenses from the property's gross rental income minus vacancy rate.
Income and expenses should be based on realistic projections. Learn how to analyze and determine a true, fair rental rate for the property based on its location, condition, or future condition, and take into consideration the average vacancy rate for your property type in that market.
Keep in mind that some of the property's current expenses will stay relatively the same, but it's fairly common for expenses to increase or decrease. You may manage the property more efficiently or have a higher cost because you hire a third-party management company. Property insurance may be higher than the policy the current owner has in place, and property taxes may increase after the time of sale or shortly thereafter. Know how to estimate expenses and base them off realistic numbers for your property type and market.