A.CRE

Pro Forma

A financial projection that provides an estimate of the potential income, expenses, and profitability of a real estate investment or development project. Typically used for planning, analysis, and decision-making purposes, a real estate pro forma presents anticipated revenues, operating expenses, financing costs, and cash flows, allowing investors, developers, and stakeholders to evaluate the financial viability and expected returns of the project.

While a pro forma is based on assumptions and estimates, it is an essential tool in real estate investment, enabling informed decision-making and risk assessment. In some contexts, the term pro forma is used to describe the projected state of a given financial metric as such is the case with pro forma NOI.

Putting ‘Pro Forma’ in Context

Horizon Equity Partners, a real estate private equity firm, is considering the acquisition of Cedar Creek Apartments, a 200-unit garden-style apartment community in a suburb of Nashville, Tennessee. Built in 1995, the property presents a value-add opportunity through targeted renovations and operational improvements. To make an informed decision, the firm creates a detailed pro forma to project the financial performance of the investment over a 10-year hold period.

Building the Pro Forma

The pro forma incorporates anticipated revenues, operating expenses, financing costs, and cash flows. Key assumptions include:

  • Effective Gross Income: Starting at $3.6 million annually, with projected rent growth of 3% per year
  • Operating Expenses: Estimated at $1.1 million annually, increasing by 2% per year
  • Renovation Budget: $2 million, funded upfront
  • Financing Costs: 65% loan-to-value (LTV) at a 5.5% interest rate
  • Stabilized Occupancy: 95% post-renovation

Pro Forma Net Operating Income (NOI)

The pro forma calculates the anticipated Net Operating Income (NOI) at stabilization by subtracting pro forma operating expenses from pro forma effective gross income. Here’s the projection for Year 1, post-renovation:

  • Effective Gross Income (EGI): $3,600,000
  • Operating Expenses: $1,100,000
  • Pro Forma NOI: $2,500,000

Financial Decision-Making

Using the pro forma, Horizon Equity Partners evaluates key financial metrics:

  • Debt Service Coverage Ratio (DSCR): Calculated as Pro Forma NOI divided by annual debt service, providing a measure of the property’s ability to cover its financing costs
  • Cash-on-Cash Return: Based on the projected cash flow after financing costs
  • Exit Proceeds: Estimated using a 5.75% exit cap rate applied to the projected NOI at stabilization

Conclusion

This example demonstrates the importance of a pro forma in evaluating a real estate investment. By projecting income, expenses, and NOI, Horizon Equity Partners can determine whether Cedar Creek Apartments aligns with their financial goals and risk tolerance. The pro forma serves as a vital tool for assessing the project’s feasibility and expected returns.

Related Content:
Click here to get this CRE Glossary in an eBook (PDF) format.
by