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What is Pro Forma CAP Rate

What is Pro Forma CAP Rate in Private Real Estate Investing?

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The pro forma cap rate is a crucial tool used to properly underwrite what your capital improvements will yield in future cash flows. In a value-add deal, your return on cost is a quick way to quickly disqualify a deal if the number doesn’t hit what you deem to be your minimum accepted yield.

In this article, we’ll go through everything you need to know about the pro forma cap rate in private real estate investing and how to use it to underwrite your next multifamily investment opportunity better.

Key Takeaways

  • The pro forma CAP rate is identical to the capitalization rate formula, except that in the pro forma cap rate formula, the cost associated with the project includes both the property’s purchase price and the cost of repairs.
  • You can use the pro forma cap rate to evaluate the ROI or the return on cost of a property.
  • The Pro forma cap rate is an effective tool for analysis because it considers the repair costs, which depending on how much repairs are needed to stabilize the property, can drastically change the return profile. Also, it gives you a solid forward look into future yield and the property’s cash flow.

What is a Multi family Real Estate Pro Forma?

numbers on spreadsheet

A multifamily real estate pro forma is a report, document, or spreadsheet that models and details a real estate venture’s current and projected revenue, expenses, and future value. It’s one of the key elements in analyzing the viability of an investment property and the sufficiency of the cash flow estimates. Similar to how a corporation utilizes a pro forma to forecast for its business.

These are the main things to have in a real estate pro forma:

  • Trailing 12 months’ income and expenses
  • Make projections for the number of years you expect to hold the property (five years, seven years, ten years)
  • Make Loss to Lease assumptions.
  • Make Vacancy assumptions
  • Make Concession assumptions
  • Make Bad Debt assumptions.
  • Adjust expenses for increases in expenses items such as property taxes and insurance, and other expenses.
  • Have your operating expenses increased by a predefined expense escalator rate year over year.
  • Rent growth rate year over year.
  • Gross income growth rate year over year.
  • NOI growth rate year over year.
  • Operating expense growth rate year over year.
  • Operating expense ratio to gross income represented as a percentage.
  • Several market cap rate scenarios and values based on those market cap rates. Showcasing annual values based on the projected NOI for that year.

The multifamily pro forma is an exercise at its core to determine what the net operating income (NOI) will be for the duration of the project hold. 

The NOI is simply your gross income minus your operating expenses; this is where value is derived. So, understanding where we can drive NOI to at different points in the future tells us what it will be worth and what we can pay for it today.

Now that you understand pro forma in real estate, let’s see what the pro forma cap rate entails.

What is Pro Forma CAP Rate? (Pro Forma CAP Rate Definition)

The pro forma CAP rate is identical to the capitalization rate formula, except that in the pro forma cap rate formula, the cost associated with the project includes both the property’s purchase price and the cost of repairs.

You can use the pro forma cap rate to evaluate the ROI or the return on cost of a property. 

The Pro forma cap rate is an effective tool for analysis because it is:

  • Considers the repair costs, which depending on how much repairs are needed to stabilize the property, can drastically change the return profile.
  • It gives you a solid forward look into future yield and the property’s cash flow.

Investors can benefit from a higher cap rate because they receive more yield on their initial investment day one. A lower cap rate is also advantageous for investors because every dollar of NOI is worth more in property value. Lower caps also mean some stronger underlying fundamentals to the property specifically or the market where the property is situated.

Let’s now look at how an investment property’s pro forma cap rate is calculated using a cap rate formula.

Pro Forma CAP Rate Formula

The formula for calculating the pro forma cap rate is as follows:

Net Operating Income After Repair Costs (NOI) / Purchase Price (PP) + Rehab

You’ll need the following three pieces of information to complete the formula:

  • The NOI (Gross Income – Operating Expenses)
  • The Purchase Price (PP)
  • The Rehab Costs (Add this to your PP)
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Pro Forma CAP Rate Example

Let’s say I was interested in purchasing a $5,000,000 multifamily property at a 6% cap rate. That would mean the property has an in-place NOI of $300,000 ($5,000,000 X 0.06=$300,000).

The property needs $1,000,000 of capital improvements to fix some deferred issues and effectively value-add the property. After extensive underwriting, financial modeling, rent growth analysis, and diving deep into rental comps in the area, by year three, we believe we can achieve a post-renovation stabilized NOI of $550,000.

I now have all three inputs to calculate this property’s pro forma cap rate.

($550,000 (Post-Stabilized NOI) / ($5,000,000 (PP) + $1,000,000 (Rehab))= 0.092 or 9.2%)

This would be a great deal, as $550,000 of NOI in a 6% cap market would reflect a stabilized value of $9,166,666 stabilized value ($550,000 / 0.06= $9,166,666). 

Also, if, in year three, I went back to the bank to refinance the property at 70% LTV, I could get a new loan of $6,416,666 ($9,166,666 X 0.70= $6,416,666). This would allow me to recapture my cost basis of roughly $6,000,000.

Let’s now take a closer look at a pro forma NOI.

What is Pro Forma NOI?

investor calculating numbers

The proforma NOI is simply the projected NOI post-stabilization of the property. Again, that means making forward-looking projections off of several assumptions as to how much income the property will produce and how much operating expenses it needs to produce that income. 

It would help if you made assumptions for the following items in your pro forma NOI:

  • The Vacancy rate
  • Late fines
  • Utility income
  • Other income
  • Market rent
  • The collection rate based on “bad debt” and “rent concessions.”
  • Payroll
  • Property management fees
  • Repairs and maintenance
  • Property tax increases
  • Insurance premium increases
  • And much more

Let’s now understand the pro forma rent roll.

The Pro Forma Rent Roll

The pro forma rent roll refers to the projected rent roll post-stabilization of the property. It helps an investor make assumptions about what the rent roll will look like based on various data points such as rental comps, inflation, market fundamentals, capital improvements, and much more.

An investor might focus on the following areas of a pro forma rent roll:

  • In-place rent and market rent
  • Duration of the leases
  • Occupancy 
  • Total gross rent potential

Now that we know what the pro forma rent roll is, let’s dive into the significance of the pro forma cap rate.

The Significance of the Pro Forma CAP Rate

A pro forma cap rate is a powerful tool for underwriting a new prospective deal because it gives investors a peek into whether this property that needs some capital improvements is worth its yield on cost. 

Not every real estate investment opportunity is equal, even if they are the same asset class in the same market. The added risk, time, and headache associated with a property that needs a significant amount of improvements to either fix deferred issues or to further update and improve upon the property need to be quantified.

Let’s say I’m evaluating two apartment complexes. The first property needs a relatively small amount of CAPEX dollars to fix a few HVAC units and fully remodel several interior units. The second property requires that you fully remodel every unit, new roofs on every building, and all new HVAC units. 

If both investment properties produced the same pro forma cap rate, which property had more added risk and headaches for the same target return profile? The second option, value-adding deals, is not easy, and there should be an added risk premium to all the added work that goes along with stabilization and for everything that could go wrong during that period.

Frequently Asked Questions about the Proforma CAP Rate

Pro forma financial statements use projection models to forecast a company’s future performance, whereas actual financial statements illustrate how a company has done in the past.

The purpose of a pro forma is to make sound assumptions based on various data points and use those assumptions to make projections of how an asset will perform over “x” years in the future.

You can build a proforma for a real estate project by predicting cash flow and NOI for a property based on the present and future operating costs and rental income.

What is Pro Forma CAP Rate – Conclusion

Investors use a pro forma to determine a property’s potential cash flow, NOI, and future value. An accurate pro forma is essential since it drives several financial indicators for rental properties, including ROI, COC, and the cap rate.

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