Preparing a Pro Forma Operating Statement - Part 1

The term “Pro Forma” is short for Pro Forma Operating Statement. A pro forma is an annual operating budget for an income property and is probably the most important single document in an income property loan package. An experienced processor will always assemble the package with the pro form as one of the very first items prepared.

Because you have been provided a form entitled ‘Pro Forma Operating Statement” the actual preparation of a pro forma is merely a matter of filling in the blanks. The numbers you choose to insert, however, must be supportable and well documented. While preparing your statement make sure that the operating expenses ratio you are using is not less than 30-35%. Remember the loan size, rather than the interest rate or points, is usually the sticking point in income property negotiations.

Multi-Family Properties
First let us discuss Gross Scheduled Rents. You should usually use the current actual rent roll. Make sure to include on your rent roll the potential rent of any vacant units. Scheduled increases in rent may be allowed, but usually they would have to be in place before the loan funds for the new higher numbers to be factored in.

The required Vacancy Allowance will vary based on property type and location. A good rule of thumb is to use the lesser of actual vacancy or market vacancy (with a minimum of 5%.) The estimated market vacancy can be found at sites like www.irr.com or from a local Real Estate agent.

Borrowers will often protest with claims of actual vacancy rates of 2% to 3%. In these cases remind your borrower that a Vacancy Allowance is really a shortened version of Vacancy and Collection Loss Allowance. Anyone in business eventually gets a few bounced checks and/or deadbeats.

Inserting the actual operating expenses is greatly simplified if the borrower already has a well done appraisal he can provide. In this case, simply insert the expenses as listed in the appraisal, and footnote them as follows: Based on the MAI appraiser’s estimate.

However, you usually should not order an appraisal. In many circumstances the Lender will not accept an appraisal that they did not order. It is also wise to hold off on such a large expense until the lender has reviewed the package and the borrower has accepted in writing the lender’s proposal. Therefore you must be prepared to estimate the expenses yourself and to document them well.

Ideally you will want to review the past 2 years and the year to date operating expenses for the property you are looking to finance. It is always best when a property has an increasing pattern of cash flow, and reviewing more than a few months of data can help do this for you. Do not forget to ask questions about large expenses you may notice on the statements. The most common deviation is the result of non-recurring expenses (such as from a major remodeling), and they can often be extracted from your Pro-forma to lower the estimated expenses on the property.

Common Lease types

I am not a real estate agent, nor a property management expert. Therefore this brief, simplistic summary of commercial real estate leases is taken from my experience reading the leases as we underwrite deals.

With that said, commercial and industrial properties can be leased in a variety of lease agreements. The tenant might be responsible for the real estate taxes, the insurance premiums, and the repairs; or the lessor (owner) may be responsible for all of them. Another possibility is for the owner to be responsible for taxes and insurance, and for the tenant to be responsible for the rest of the operating expenses.

In fact, there could be an endless variety of ways the lease can be structured. However, the most common lease types are as follows:

• A full service lease is a lease in which the lessor (owner) is responsible for all of the operating expenses, including but not limited to taxes, insurance, repairs, and utilities.
• A net lease (N) is a lease in which some of the operating expenses are paid by the tenant. A net-net (NN) lease is a lease in which the lessee (tenant) pays the two major expense items: taxes and insurance.
• A triple net lease (NNN) is a lease in which the tenant is responsible for “all” of the operating expenses. This includes, but is not limited to, the three most significant expense items: taxes, insurance, and utilities. A true triple net lease is one in which the lessee (tenant) pays all of the operating expenses and the lessor (owner) simply receives his one check every month. Unfortunately the term is often misapplied to leases in which the lessee pays for most, but not all of the operating expenses. You are cautioned to read the lease carefully to determine which expenses each party is responsible for.

Expenses often paid by the lessor (owner) in so called “triple net” leases are management, common area maintenance (CAM) and common area utilities.

Many Multi-tenant buildings are leased on a “triple net” basis where the real estate taxes, the insurance, the common area util­ities, and the common area maintenance expenses are prorated among the tenants on a pro rata basis. The basis most commonly used is the net rentable square footage of each tenant’s space as a percentage of the total net rentable square footage. By net rentable square footage we mean the space actually available for rent as opposed to the gross square footage which includes hall­ways, stairwells, elevator shafts, and lobbies.

With this simple overview you should be better able to analyze deals and put together useful operating statements.

The Operating Expense Ratio

In my experience it is the size of a loan that the borrower can obtain that is usually more of a sticking point than the rate or the loan fee. Now that you all know that loan sizes are gen­erally limited by the debt service coverage ratio (i.e., cash flow) rather than the LTV, the operating expense figure that the lender uses in his calculations is critical.

Whereas operating expense ratios are helpful in evaluating Multi-family properties, they are not as useful for commercial or industrial properties. This is because those spaces can be rented on a triple net basis, a net basis, or a full service basis.

Let’s suppose you have a commercial property with gross leases and the following Operating Statement: [Click here to view a PDF of the statement]

The operating expense ratio is defined as follows:
Operating Expense Ratio = Total Operating Expenses
______________________________EGI
or in our example,
Operating Expense Ratio = $159,311 = 44.7%
_______________________$356,670

Appraisers and professional property managers often keep track of the operating expenses of the buildings they appraise or manage, and publish their results. For example, the National Association of Realtors publishes the results of their surveys annually in several hardbound books including Income and Expenses Analysis – Apartments and Income and Expense Analysis – Office Buildings.

Lenders have access to these types of publications and therefore are reluctant to accept at face value operating expenses supplied by the borrower when their operating expense ratios are less than those experienced by similar buildings in the area.

It might be possible to operate an apartment building or commercial building with gross leases IN THE SHORT RUN at an operating expense ratio of less than 30%. However, in the LONG RUN the end result will be a seriously deteriorated building. It might be possible to get an operating expense ratio as low as 28% accepted on a very new building if it had fewer than 10 or so units, and if it had no pool and very little landscaping, and if you had 2 to 3 years of authentic source documents to back up your claim. But in general, it is difficult to get operating expense ratios on apartments of less than 30% accepted.

The following are factors that will influence the lender to use a higher operating expense ratio:

1. Lack of individual metering or utilities
2. Swimming pool
3. Elevator
4. Extensive landscaping
5. Low income area and/or tenants
6. Presence of families with children

In general, larger projects will require a larger required operating ratio. Large projects usually entail extensive recreational facilities and pools, and often require a full time on-site management team.

So after you are done putting together the operating statement with the information from the borrower double check the operating expense ratio to see if it will meet what most lenders are looking for.