How to Read a Real Estate Pro Forma: Part 1
High Level P&L Statement
This is Part 1 of our series on how to read a real estate proforma. You can find the entire series here. Knowing how to read a proforma will help you spot aggressively underwritten deals.
There isn’t anything wrong with underwriting aggressively, for the record. But as an LP, you need to understand what measure of risk you are taking.
Let’s get going, we have a lot to cover.
Summary
The highest impact on overall returns (outside cap rate on exit, which is not in GP’s control) will come from revenue and NOI growth. Thus, rent and expense growth assumptions should be scrutinized.
If you remember nothing else from this article, remember this chart: it shows quarterly rent growth in Austin. Note the average stands at 1.9% - I’ve seen dozens of pitch decks with multifamily deals in Austin, and I’m yet to see one that projected anything below 3%. The difference between 3% and 1.9% may seem small, but when compounded over 5-10 years, it makes a huge difference in outcomes.
The charts below show median rent across the nation. Rents don’t always go up, and if you are evaluating a deal, it’s a good idea to stress-test it to see how much of a rent drop it can absorb.
What’s a Pro Forma?
Some of the most important information about a deal will be in the proforma. In fact, that’s where we usually start when evaluating new opportunities: a quick scan of the pro-forma can tell us whether the deal is worth investigating further. In this post we’ll cover the most impactful line items on the P&L statement, and give examples of how each of them affects returns.
Below is a downloadable cheat-sheet:
A pro-forma (aka Financial Analysis, Projected Cash Flows, Financial Summary, Operation Projections, and about two thousand other names) is nothing other than a model of estimated future cash flows. The sponsor uses a number of inputs to make this model, some being more accurate than others: both from third parties and internally.
✅ Sponsors who own multiple properties in the submarket will generally have more accurate numbers both on the revenue and expense side. However, actual cash flows will vary (sometimes vastly) from these estimates.
✅ Ideally, each pro-forma will have trailing 12 month numbers (T-12) and/or trailing 3 month (T-3) numbers – the latter will need to be annualized (multiplied by 4). Those are provided by sellers, and are used as a baseline for the sponsor’s estimates of future cash flows.
Seeing T-3/T-12 data helps us gauge what levers the sponsor can pull immediately upon purchase and how aggressive sponsor’s assumptions are. On value-add properties, comparing Year 1 per unit rent revenue to T-12 allows us to see what rent premium the sponsor will charge.
Always check comparable rents from nearby properties (most offering memos show rent comps), but keep in mind that in some markets, 2 miles can make a world of difference in terms of desirability/safety and rents.
Generally, the more detail is included in the pro-forma, the better. Each of the line items has an impact on overall returns, and understanding what the sponsor is doing with the business plan helps us identify where the risks of a particular investment exists.
Income
Here’s what a detailed pro-forma will show:
Most investor presentations, however, will have at least some of those lines consolidated.
The important part here is calculating year-over-year rent growth assumptions post renovations. If the sponsor doesn’t include a note on what those assumptions are, it’s fairly easy to calculate using a CAGR calculator or AI.
What To Look For:
Assumptions that approximate historical averages (typically, 1.5-3.0%). Higher numbers on this range warrant questions to the sponsor. Factors such as high population growth, topographical constraints (think San Diego with mountains, ocean and the border constraining land supply) and regulatory resistance to new construction affect rent growth favorably. Markets with inexpensive land and easy regulatory environment typically experience lower rent growth. This said, we’ve seen very small tertiary markets with very inexpensive land experience massive spikes in rent growth due to limited supply. It’s always a good idea to ask the sponsor on what factors will drive rent in a particular location.
Secondary Stuff: assumptions on vacancy, bad debt, and loss to lease. If any of those vary vastly from the T-12 numbers, there needs to be a very good reason why. On value add projects, most of those numbers should be higher than T-12/T-3 in Year 1, since sponsors will incur higher vacancy during renovations. Historical vacancy rates across the US average 9% (according to NMHC), and anything above 95% should be questioned.
Expenses
A detailed pro-forma will have expenses broken up by category (see table above). At a minimum, you should see taxes, insurance and payroll.
What To Look For:
Expense ratio for T-12, Year 1, and the last year of hold. Expense ratio is total expenses divided by total income. Smaller and older properties will generally have higher expense ratios. Anything below 33% is questionable (even on Class A), anything below 37% on Class C is also questionable. Properties in states with higher tax millage rates and insurance premium rates (South, South East) generally have higher expense ratios than properties located in Western states.
Expense growth assumptions: anything below 2.5% is questionable. The last few years have highlighted how expenses can get out of hand in a very short period of time. Most sponsors have dealt with double-digit tax, insurance and payroll increases, and we have seen deals that had to reduce or stop distributions due to unforeseen increase in non-controllable expenses.
Secondary Stuff: Taxes, insurance and payroll will typically be the highest categories. Most sponsors have little to no control over those expenses, so it’s important to make sure they are underwritten conservatively to begin with. Taxes should ALWAYS be higher in Year 1 vs T-12/annualized T-3.
Insurance rates have been skyrocketing throughout the US, especially in disaster-prone states (TX, FL, LA, etc). We have seen deals from FL with insurance rates of $2,200 per unit per year (as of early 2024) – always check what the premium rate per unit is and keep track on what other sponsors who buy properties in these states pay.
Net Operating Income (NOI)
Net Operating Income = Gross Operating Income - Operating ExpensesNOI determines a number of factors, including the price paid for the asset. Every sponsor wants to grow NOI as quickly as possible, as much as possible. Most of that growth will come via revenue increases, but we’ve seen deals where sponsors can realize substantial savings on the expense side.
What To Look For:
Most value-add deals will experience a hefty (~7-10%) boost in Years 1 and 2, but the rest of the holding period should approximate the rate of inflation (or lower). Typically, we will see a bump in NOI realized by Year 2, with the NOI growth = revenue growth the rest of the holding period.
Debt Coverage
Typically the loan payment will be a separate line item below NOI. Very important to understand if the loan has an interest-only period (I/O) and when it starts amortizing (repaying principal). Stay tuned for a deeper dive on loans.
What To Look For:
Is the loan floating or fixed? If the loan is floating, is the sponsor purchasing a rate cap? If so, when does it expire and what is the max interest rate? What assumptions is the sponsor using for forward-looking rates?
Debt Service Coverage Ratio (DSCR): annualized NOI divided by annualized debt service. Most sponsors will provide this information, and most lenders require a minimum of 1.25x. The higher this number is, the better: higher number means there is ample left-over cash flow and less risk of defaulting on the loan. Make sure the DSCR reflects amortizing amount in the appropriate year (i.e. if the loan starts amortizing in Year 3, DSCR will change in that year to reflect a higher annualized debt service payment).
Ask the sponsor for break-even occupancy: this is the minimum occupancy % at which the cash flow will cover debt service. The lower that number, the better: this reduces the risk of loan default even if the property experiences high vacancy rates for a period of time.
Reserves
This is how much a sponsor saves up for any future unforeseen expenses. Typically, on older vintage properties, this number will be higher (which makes intuitive sense: older properties will cost more to maintain over time). Anything under $250/unit per year is questionable. The smaller the property (under 100 units), the higher this number should be.
Most Important Thing
If you are a limited partner evaluating a deal, you NEED to understand whether assumptions are aggressive.
Keep track of assumptions on deals you see in a spreadsheet (NotebookLM is an excellent AI resource that can automate this):
Cap rate on purchase/exit
NOI growth
Rent growth assumptions
Expense ratio
Expense growth assumptions
Next:
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What does CAGR stand for?