Updated: Jun 21, 2020
If you are dipping your toes into real estate investing and start seeing this word online and hear it being thrown around by brokers and other investors, do you know what they are talking about?
What is a Proforma?
Today we will dive into what a proforma is, what it can be used for, and the pros and cons of proforma. The word “proforma” itself has roots in the 16th century Latin vocabulary, and it literally translates to, “according to form”.
Based on the translation alone, we can make numerous assumptions of what it could actually mean in practice. For the sake of brevity, we can quickly summarize it as being a picture of the future taken through the lens of history. For those curious to learn more, we will look into it in more detail below.
In the context of real estate, proformas are often used in order to estimate investment value, estimate market value, perform sensitivity analyses, and underwrite a property for debt financing. Using historical numbers and observable market trends in rental rate growth on similar income-producing properties, we are able to forecast anticipated future operating cash flows during the holding period (typically 5, 7, or 10 years) that we can then discount back to their present value and arrive at a justified purchase price for the investment.
This allows us to not only account for cash flow from annual rent but also from the equity reversion upon sale of the property at the end of the holding period. By including the value of this equity reversion at the end of the holding period, we are able to paint a more complete picture of the value of the investment and make a substantially more educated purchasing decision.
These often multi-year analyses are significantly more extensive than napkin numbers, but when making investments that require large capital outlay, they are just a starting point in the underwriting and deal analysis process. Although proformas have the potential to be an incredibly useful tool for those who build them out, be cautious of those presented to you by others trying to sell you a property. Look through it with a fine-toothed comb.
It is easy to make a proforma look fantastic with expenses decreasing, revenues increasing, and margins going through the roof every year. Don’t fall for this! If you are ever reviewing a proforma presented to you, don’t hesitate to reach out to me. I would be more than happy to give it a glance if it is not confidential information and let you know if it passes the smell test.
If it doesn’t pass the smell test, that does not necessarily mean it is a bad investment opportunity. It just means the seller might have unrealistic expectations regarding the property’s future performance capabilities. Take time to build out the most accurate representation of what you believe will occur over the holding period and pressure test it against other investments.
In summary, the proforma is an excellent tool to use when determining the value of an investment. But just like any other tool, it takes practice to develop it to the point where you can implement it effectively.
Matt Moreland, Realtor® is a real estate agent serving the Lubbock, Texas, and the South Plains. After graduating with a Bachelor of Business Administration in Finance with a concentration in real estate from Texas Tech University, he began practicing real estate full time at McDougal Realtors in Lubbock, Texas. Matt enjoys spending time with his wife and their dog. Some of his hobbies include investing in real estate, elk hunting, backpacking, barbecuing, and playing guitar. To schedule a commitment-free consultation please call 469-744-3610 or fill out this form to get started.