Pro Forma

A forecast wearing the clothes of a financial statement

Every commercial listing arrives with a pro forma. It describes what the building would produce if the rents were raised, the vacant suites were filled, and the expenses cooperated. None of that has happened. A pro forma is a hypothesis formatted to look like history.

That does not make it useless. A carefully built pro forma is how value-add deals get underwritten, how construction gets financed, and how you decide what a property is worth to you. The problem is never the document. The problem is treating the seller's version of it as evidence.

The test is straightforward. Put the pro forma next to the trailing 12-month operating statement and read the two side by side, line for line. Every place they differ is a claim, and someone has to defend it.

Worked example

A 24-unit apartment building. The seller's pro forma:

• Gross potential rent — 24 units at $1,650, or $475,200 a year
• Vacancy at 3% — minus $14,256
• Effective gross income — $460,944
• Operating expenses at 32% of income — minus $147,502
• Pro forma net operating income — $313,442

The T-12 for the same building, same twelve months:

• Gross potential rent at in-place rents of $1,520 — $437,760
• Actual vacancy and credit loss at 7.5% — minus $32,832
• Effective gross income — $404,928
• Actual operating expenses — minus $178,900, which is 44% of income
• Actual net operating income — $226,028

The pro forma NOI is $87,414 higher, about 39% above what the building really produced. Three assumptions did all the work: a $130 rent increase on every unit, vacancy cut from 7.5% to 3%, and an expense ratio twelve points below anything the property has ever run. At a 6.5% cap rate, that $87,414 of imaginary income is worth roughly $1.34 million of value — which is usually the entire gap between the asking price and what the asset is worth on its own performance.

What it means for you

The gap does not stop at the negotiating table. It comes back at the loan.

Lenders size on actual net operating income. At a 1.25x debt service coverage requirement and a loan constant near 7.8%, the real $226,028 supports roughly $2.32 million of debt. The pro forma figure would have supported about $3.21 million. That is a $900,000 hole, and it does not close through argument. It closes with your cash, or the deal dies in underwriting.

This is the most common way first-time commercial buyers get hurt: they negotiate against a pro forma, sign at a pro forma price, and learn during underwriting that the lender never believed a line of it. Build your own numbers from the T-12 and the rent roll before you make an offer. If you want a sizing check on real numbers before you go under contract, send us the deal and we will tell you what it finances today, not what it might finance in year three. Our CRE loan guide walks the same sequence an underwriter uses.

What to watch for

• The missing management fee. Owner-operators routinely show no management expense because they do the work themselves. Add back 3% to 5% of effective gross income. A lender will, whether you do or not.
• No replacement reserve. Pro formas almost never carry one. Lenders require it, commonly a few hundred dollars per unit per year, and it comes straight off net operating income.
• Taxes at the seller's assessment. If the property reassesses at your purchase price, the tax line is understated from the day you close. Check the local reassessment rule before you underwrite anything.
• Insurance at last year's premium. Get a live quote from a broker. In several markets premiums have moved enough to swallow an entire projected rent increase by themselves.
• "Market rent" with no comparables attached. If the pro forma claims $1,650, ask which buildings are collecting $1,650 today and what condition those units are in. A rent that requires $12,000 of renovation per unit is a capital plan, not an assumption.
• Interest expense hidden inside the expenses. Debt service does not belong in operating expenses. If it appears there, the whole statement was built by someone who does not know how NOI works, and every other line deserves a second look.

Should you trust a seller's pro forma?

Use it as a list of the seller's assumptions, not as a statement of income. Read each projected line against the trailing 12-month actuals and ask what specifically has to happen for the projection to come true, how much that costs, and how long it takes. Assumptions with a documented plan and a budget behind them are worth something. Assumptions with neither are marketing.

What is the difference between pro forma and T-12?

A T-12 is a record of the last twelve months of actual income and expenses. A pro forma is a forecast of future performance under a set of assumptions. The T-12 is auditable against bank statements and tax returns; the pro forma is not auditable against anything, because the events it describes have not occurred.

Do lenders use pro forma NOI?

For a stabilized property, almost never — the loan is sized on trailing actuals. For construction, heavy value-add and bridge loans, lenders do underwrite to a stabilized pro forma, but they discount it, require the business plan and capital budget in writing, and typically size the loan against actual performance until the property hits stabilization. Even then, the pro forma is a target with conditions attached, not an input they simply accept.