A real estate pro forma is a forecast of the income and expenses that are associated with a project. The pro forma is usually accompanied by one or more "feasibility ratios," or indices of financial soundness of the project.
There are two basic approaches to the pro forma. The "front door" approach begins with the cost of acquiring and improving a property, and arrives at the minimum rent (income) needed to make the project work. It is an "acquisition-driven" model. The "back door" approach begins with market rents and arrives at the maximum amount of money available for acquiring and improving a property. It is an "income-driven" model. Both approaches provide similar information, the difference lies in which information the analyst needs to find.
A project can be analyzed in terms of its pre-tax or in terms of its after-tax return. The 1986 Tax Reform Act has eliminated many of the tax advantages of real estate investment. Depreciation does still provide some tax advantage, however, and in some cases the after-tax return from a project may be greater than the cash flow generated by the project itself. Of course, the tax advantage is a benefit only for partners who pay income tax (local governments do not).
A simple (pre-tax) pro forma will be divided into several sections. Although the elements included in each section may differ from statement to statement, the categories are basic. Expenses are divided into capital costs (the expenses associated with acquiring and improving a property) and operating costs (interest on the mortgage, costs of operating the project, and taxes). Income is divided into potential income and effective income (potential income less vacancies and associated losses). The relation between income and expenses is used to develop the "feasibility ratios," which are used to judge the soundness of the project.
An after-tax pro forma is more complicated, because it must specify the costs and income flows more precisely. If a project is a clear money-maker or a clear money-loser on a simple pre-tax analysis, there is no need to go through the expense and bother of an after-tax analysis. An after-tax analysis is needed to decide the feasibility of a project that is close to the minimum necessary return. As a result, the analysis is more detailed so finer distinctions can be made in the end. The tax analysis also requires more detail to assure that tax definitions of various items are satisfied.
© 1996 A.J.Filipovitch
Revised 11 March 2005