Pro formas for condo developers, sellers and buyers

Date Published : Nov-26-2020

Written By : Phillip Livingston


Whether you are developing, selling or purchasing a condo, a pro forma statement can be a vital tool for decision-making, and minimizing risks associated with investing. But in order to be truly useful, pro forma statements must be based on objective and reliable information. This is the only way to create an accurate projection of costs and profits.

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What is a pro forma?

A pro forma, which means “for the sake of form,” is a document that shows financial results in order to emphasize current and/or projected figures. In real estate, a property’s pro forma is essentially its cash flow projections. These projections help determine anticipated cash flow, expenses, and expected return on investment for a building or a unit.

 

The basics

Pro formas have a wide variety of applications for individuals, small businesses and large companies. It’s not uncommon to create multiple pro formas to compare different building scenarios, sale prices or properties. Pro formas are commonly used to help with:

  • Developing revenue and expense projections
  • Comparing balance sheets
  • Reviewing proposed decisions and assessing their impact on profitability and liquidity
  • Identifying alternatives
  • Assessing and planning for the impact of changes

Pro forma statements may look like budgets, but it’s important to note that they’re based on what-ifs, not concrete financial results. Even good pro formas may not accurately predict a buyer’s ROI if there is a drastic and unexpected change in the real estate market. That being said, a budget may be designed based on a pro forma statement.
 

Pro formas for developers  

A pro forma is a basic “go or no-go” analysis that condo developers will use to decide on whether to move forward with a project. When creating a pro forma, developers will include the number of units in the development, total square footage, and the average size of each unit. They should also include:

  • Gross residential revenue
  • Net residential revenue
  • Total project revenue
  • Project costs (hard and soft)
  • Net profit

Ultimately, developers want to know how profitable their project will be. A pro forma will give them a rough estimate.

 

A seller’s pro forma vs. a buyer’s pro forma

Developers, sellers and buyers all have different objectives, and as a result, each of their pro formas will be different. A seller clearly wants to get rid of their unit, so their goal is to make the pro forma look as lucrative as possible. Buyers should be aware that not all pro formas are created equal. Sometimes, key expenses that will impact the buyer’s bottom line are left out. This is why buyers are strongly encouraged to make their own pro forma.

 

Pro formas for buyers

The best way to get a realistic idea of expenses for the property you are interested in purchasing is to look at a month-to-month breakdown from the last two years.
If you can’t secure a month-to-month expense breakdown, you can request estimates from a property management company. Alternatively, you can use the 50% rule, which assumes 50% of your rental income will go toward operating expenses.
There are four key items that should be included in a buyer’s pro forma: repairs, vacancy loss, property management, and miscellaneous costs.

1. Repairs. Prepare to set aside money for regular (perhaps even monthly) repairs and maintenance. Typically, you will want to take 5% of the rent you receive each month for these sorts of expenses. If the building is older, it’s a good idea to put away even more. The purchasing price of an older unit might be less, but expenses related to repairs tend to be higher.

2. Vacancy loss. There may be times where your property is empty, and buyers need to plan for potential vacancies. Vacancies can be very costly, but this is a reality that a smart buyer will have considered before purchasing the property. If a 2-month vacancy would be detrimental to your finances, then you may need to consider a more affordable property. Also, don’t forget to include cleaning, painting, and repair expenses after a tenant moves out.

3. Property management. Even if you plan to manage your own property, make sure this line is included. After all, time is money, and looking after a property will require some of your time. If you don’t plan on charging anything for managing the property, it is still important to include this expense because the property’s financial merit is based on all related costs. Some people prefer to hire a property manager to care for the unit on their behalf. If you plan to take this route, set aside 8% to 10% of the rental income you receive.

4. Miscellaneous costs. This part of the pro forma should be used for any other expenses, including insurance costs, legal fees, advertising costs, and taxes.
When putting your pro forma together, make sure the projected rent is based on actual rent. Buyers need to look at the unit’s actual average rent, not what it could rent for. Take a look at what other units of the same size are renting for in the area, and if you can get a hold of the data, see how much rent has increased, on average, over the past few years.
You are always taking a risk when you invest, so even if the seller gives you a pro forma that is accurate and realistic, you should create different versions that take into account what would happen if your investment is very successful, reasonably profitable, and unprofitable.
 

How to recognize misleading pro formas

Unfortunately, there is no standard pro forma document since these statements can be used for different roles and purposes. As a result, some are overly simple, while others are unnecessarily complex.
The first thing to be aware of is statements that look too good to be true. A pro forma that only includes the purchase price, gross annual rent, cash flow per month, and appreciation, is quite misleading because most of the numbers you see relate to profit. It assumes that there will be no recurring expenses, which is impossible.
Buyers should also be careful of pro formas that are too complex. While they can be detailed, pro formas shouldn’t leave you confused. If you see unnecessary items that don’t actually help you make an informed decision, then you may need to fill in the blanks by creating your own statement.

 

Conclusion

Pro formas help developers, buyers and sellers with financial projections. They anticipate cash flow, expenses, and expected return on investment. They can also help investors gain a clearer picture of best-case scenarios, as well as worst-case scenarios.
After preparing your initial pro forma statement, be prepared to update the projections monthly, quarterly, and/or annually. Pro formas are like educated guesses, and while they can help fine-tune your goals and expectations, they will rarely be completely accurate.

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