Pro Formas - Know the Numbers

Pro Formas – Know the Numbers

Every real estate deal begins with the pro forma. The pro forma is the table that provides the budget for the property and every relevant number that an investor needs to know. Rate of return, cap rates, cash-on-cash return, and every other fancy financial term found in the investment packet all stems from the pro forma.

But for the uninitiated, the pro forma can be a bit overwhelming. Many investors that try to understand the pro forma either stop and choose not to invest, or they pick an amount of capital they can afford to lose and take a chance.

Neither one of these is a good strategy, and I get way too many phone calls from investors who 1) do not know if their investment is or is not performing to expectations, 2) have invested in something that is not meeting their expectations, or 3) have invested in something that does not meet their needs.

Let us jump right in and learn about the pro forma

Discovering the pro forma

Here is an example of a pro forma that is loosely based on an investment I made a couple years ago:

With so many numbers flying around this chart gets overwhelming quickly.

Here is the trick with reading a pro forma: never start with the numbers.

How to read the pro forma

Reading the pro forma begins with understanding the investment thesis of the operator. You need to understand why they are buying the property. In general, there are three good reasons and one not so good reason to buy a property: 1) the buyer is getting a discount, 2) the buyer can lower the expenses on the property and make more money, and 3) the buyer can raise the rents on the property and make more money. Usually when one of these reasons is present, some element of all three of these are present. The fourth reason is less desirable and that is the buyer who is buying at market value and is counting on appreciation over time for their profit. I say less desirable because there are certainly markets where this could work like San Francisco, San Diego, Seattle, or maybe even Dallas. But, if the investment is sitting in your average Midwest market like Tulsa or Cincinnati, this might not be a great investment to jump into.

Knowing the investment thesis of the operator allows you to inspect the numbers to see if what the operator is telling you makes sense.

This pro forma represented a strategy that involved bringing rents up to market rate and billing tenants for their utilities instead of the property paying for everyone’s utilities. We will dive into the numbers to see if the forecast backs up the thesis.

Revenue and Operating Expenses

A pro forma’s numbers can get overwhelming fast. It does not help that every operator out there presents their numbers a little differently and define key financial metrics in slightly different ways.

That is okay, though. You only need to start with two key rows of information: revenue and operating expenses.

Revenue should always be somewhere at the very top of a chart, and it is the money that is being made before any expenses are removed. In this case, the operator claimed to be bringing rents up to market rate. Sure enough, you see a jump between years 1, 2, and 3 where revenue is increasing.

The second part to the thesis from the operator was that they were going to lower expenses by billing utilities to the renters instead of the complex paying all utilities. When I look at the Total Operating Expenses line, I see a drop in costs in Year 3. A quick scan across the numbers shows a drop in Utilities Expense in Year 3 that would be the cause of the decrease in costs.

Does everything make sense

Unless there is a specific reason which is generally highlighted by the operator, the costs and revenues should increase some over time. I like to make a quick review of the numbers to make sure that costs and revenues trend generally up over time unless the operator has already provided a reason why costs would go down or revenues would increase significantly.

In the example pro forma, the numbers tell the story. Revenue is increased between years 1, 2, and 3 but then it levels off in years 4 and 5. This follows the investment thesis.

Most of the costs increase slowly over time except for the utilities that the operator already called out. Even those costs include a planned increase after the drop in year 3.

Revenue takes time to grow. This is important in real estate. Most people sign leases for six months or a year (industrial and commercial leases are even longer). To drive revenue up requires leases to expire so that the operator can raise rent. When I look at the numbers from an operator that is going to increase rents, I want to see that revenue growth occur over a 2-4-year period. Anything less may be a red flag unless the operator is able to explain why.

Be careful picking apart the expenses too much

One area where I see some investors get lost is when they start trying to understand the minutiae. Take General and Administration expenses as an example. For a new investor it is not a bad idea to ask more questions around what goes into that category. However, it does not make sense to pick apart why office expenses are going to climb by $1,000 or $2,000 each year. When investing tens or hundreds of thousands of dollars into a multi-million dollar investment, quibbling about the cost of pens and copy machines is losing sight of the big picture.

Remember, you are trusting someone with thousands of dollars. If you do not think they can represent your best interests when hiring and paying office staff you probably should not be investing with them anyway. Also remember that a bank has reviewed their pro forma as well and has probably signed off on it before you ever had a chance to read through it.

Focus on the story

The next time you look at a potential investment, start with the investment thesis. Once you have found and understand the investment thesis, then jump to the big picture numbers (revenue and/or expenses) to see if the numbers tell the story.

This should keep you from getting overwhelmed and lost.