If you’re new to real estate investment, you may be wondering how to project the monthly cash flow for each property you own. After all, you’ve probably invested in real estate to generate income from your property, ensure that it will be a valuable long-term investment, or both. The key to understanding whether a property will be an asset or a drain on your finances is a document called a real estate pro-forma.
A beginner’s guide to a real estate pro-forma
On a basic level, a real estate pro-forma compares the revenue you’re likely to receive from a property with its expenses. That comparison provides an estimate that projects either a regular income or loss. Therefore, the fundamental data incorporated into the pro-forma are either revenue or expenses.
Start by assuming the property will always be occupied and earning full rent. Then, make adjustments that consider situations like a temporary vacancy or a discounted rent incentive.
Types of revenue (and adjustments):
- Rental income. This is the most straightforward figure. Your expected monthly rent multiplied by twelve.
- Vacancy. The months your property lies vacant are classified as a loss of revenue instead of an expense. This figure can be quite large and is often overlooked by novice investors.
- Bad debt. This is a projection of unpaid rent.
- Tenant expense reimbursements. Your lease should detail any expenses that you may pay up front but expect the tenant to reimburse, such as property taxes, insurance, or maintenance and utilities. (Related: 10 Must-Haves for Every Lease)
- Several other smaller reimbursement items include fees, cleaning, and repairs the tenant is responsible for.
When you add up all the potential revenue and subtract any adjustments, you’ll end up with the property’s potential gross income.
Next, calculate expenses.
Types of expenses:
- Taxes. No matter where you buy, you’ll owe real estate and property taxes on your property. Remember, if the property’s value increases, so will the taxes.
- Operating expenses. Owning and maintaining a property as an attractive rental unit comes with a wide array of expenses. These may include maintenance and repairs, lawn care, garbage removal, utilities that you offer to pay, etc. For larger properties, operating expenses may also things like include staff payroll, janitorial services, security and landscaping.
- Property management. If you hire a person or company to manage your property, you’ll pay them a percentage of each month’s rent.
- Interest. More often than not, your property is funded, at least partially, by debt.
- Debt principal. Again, if you have a loan on your property, you’ll need to include debt principal payments as an expense.
Subtract the total of these expenses from the potential gross income, and you’ll have the property’s anticipated net operating income.
A positive number indicates you could expect positive cash flow from the property. A negative figure means you might want to pass on the investment opportunity or reconsider underlying factors. You may be able to negotiate better loan terms, address a tenant turnover issue, raise the rent, or adjust other details that could make the investment a better opportunity for you.
Don’t rely on a seller’s pro-forma
Chances are, when you’re considering purchasing a property, the seller or their agent will present you with a pro-forma detailing the property’s expected cash flow. Do not rely solely on the seller’s pro-forma.
Unfortunately, it has become common practice for sellers’ pro-forma to actively attempt to mislead buyers. They can be overly simple, even excluding expenses and only detailing gross revenue. Or they can be overly complex, hiding unrealistic projections in a pile of figures and terms that beginners may be unfamiliar with. A pro-forma should be detailed enough to include reasonable estimates of revenue and expenses, while being simple enough to understand at a glance. Unfortunately, often the only way to get such a document is to do it yourself. Ask for up to two years of rental and expense info to get an accurate idea of the real numbers, as opposed to the seller’s projections.
Even if the seller is not actively manipulating the numbers to their own benefit, it’s important to remember that sellers and buyers have different goals. A seller wants to make their property as attractive as possible to maximize the selling price, and this instinct will often impact the details they include in their pro-forma.
Build your own pro-forma to estimate cash flow
Pro-forma templates are widely available online. A quick Google search will provide many options from which to choose one that fits your individual situation. Here’s one example you can use to get started: excel pro-forma template.
Greyhaven Realty Management is locally owned and has been managing properties in the Chattanooga area since 2006. We’d love to help walk you through the real estate investment process.