Every offering memorandum arrives with a pro forma: a tidy projection of income, expenses, and returns. Some are honest attempts to describe a property's potential. Some are marketing documents with decimals. The difference is not in the formatting — it is in the assumptions, and assumptions can be examined.
Start with what is, not what could be
The most important distinction in any pro forma is between in-place income and projected income. In-place income is what the property actually produces today, from signed leases and paying tenants. Projected income is what the property would produce if rents rose, vacancy fell, and everything went according to plan.
Both numbers are useful. The mistake is paying for the second as if it were the first.
Net operating income — revenue minus operating expenses, before debt service — is the figure that anchors everything else. Buyers should be able to rebuild it from the rent roll and the actual expense history, not accept it from a summary page.
The assumptions that move the answer
Vacancy. A pro forma that assumes 5% vacancy in a property currently running 12% is making a claim about the future. Sometimes that claim is justified — a new leasing strategy, an improving submarket. Sometimes it is optimism with a formula.
Rent growth and effective rent. Asking rents are not achieved rents. Concessions, free months, and tenant improvement allowances all reduce what landlords actually collect. Effective rent is the number that matters.
Tenant quality and lease expirations. Income is only as durable as the tenants and leases behind it. A property where half the income expires within two years is a different risk than one with staggered, longer-dated expirations.
Expenses and recoveries. Operating expenses have a way of being understated in projections: insurance repriced at yesterday's premium, property taxes at the seller's assessment rather than the post-sale reassessment, management fees omitted because the buyer plans to self-manage. Expense recoveries from tenants can offset costs, but only to the extent leases actually allow them.
Capital expenditures and deferred maintenance. Roofs, pavement, HVAC systems, and elevators do not appear in operating expenses, but they consume real cash. A pro forma with no capital reserve is describing a property that does not exist.
Financing and exit assumptions. Projected returns often depend on a loan at an assumed rate and a sale at an assumed exit capitalization rate. Both are forecasts about markets, not facts about the property. Small changes in either can swing projected returns dramatically.
A hypothetical illustration
The following numbers are purely illustrative — they are not market data, and they are not a quote for any property or loan. Imagine a 20,000 square foot flex property:
- In place today: rents average $12.50 per square foot, occupancy is 88%, and operating expenses run 30% of effective income. Potential gross income is $250,000; after 12% vacancy, effective income is $220,000; after expenses, in-place NOI is about $154,000.
- The pro forma: rents marked to $14.00, occupancy projected at 95%, expenses held at 30%. Effective income becomes $266,000 and projected NOI about $186,200 — a 21% improvement.
- A stress case: rents achieve only $13.00 and occupancy 85%. Effective income is $221,000 and NOI falls back to roughly $154,700 — essentially no improvement over today.
The property did not change across these three columns. The assumptions did. An investor who prices the deal off the pro forma column is paying for the rent growth and lease-up to be delivered; an investor who prices off the stress column is paying for what the property already does. The right answer is usually a negotiation between the two — but it should be a conscious one.
Stress testing as a habit
Sophisticated investors do not ask whether a projection is right. They ask how wrong it can be before the deal stops working. That means running the property at higher vacancy, lower rents, higher expenses, and a slower exit — not because those outcomes are expected, but because the distance between the projection and the breaking point is the real measure of the risk. A deal that only works in its base case is not a deal with a base case; it is a deal with a best case.
Five questions to ask before trusting a pro forma
- Which income figures are in place today, under signed leases, and which are projected?
- What vacancy and rent assumptions drive the projection, and what evidence supports them?
- Are property taxes and insurance shown at post-sale, current-market levels?
- What capital expenditures and reserves are included — and what has been deferred?
- What exit assumptions does the return depend on, and what happens to the return if they move against you?
The RANGEFINDER Perspective
The opportunity in a property is not just the projected return. It is understanding what has to go right to achieve it — and deciding whether you are being paid to take that risk.
Evaluating a property and want a second set of eyes on the assumptions? Discuss a Commercial Real Estate Opportunity with our team.