The term “Pro Forma” is short for Pro Forma Operating Statement. A Pro Forma is an annual operating budget for an income property, and it is probably the most important single document in an income property loan package. An experienced processor will always assemble the package with the Pro Forma as one of the very first items that the lender sees.
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. The stakes are high. If a lender does not accept your Pro Forma, he will not take the time to prepare one of his own. He will merely select a very conservative operating expense ratio such as 40 to 45%. Operating expenses of 40 to 45% will kill most deals.
Remember, the loan size rather than the interest rate or points is usually the sticking point in income property negotiations.
At this time, please take a moment to review the attached Pro Forma Operating Statement form. Since this is a universal form, only a few of the blanks will be filled in for any individual property.
First let us discuss Gross Scheduled Rents. You should usually use the current actual rent roll. Insert in your rent roll the market of any vacant units.
The only time a lender will accept projected rents is if the rent increase letters have already been sent. It is helpful, but not mandatory, to include a few samples of the rent increase letters that have been mailed. However, be careful not to scare your client away by asking for copies.
The new rent level should be no further off than 90 days. Then if the lender objects, the Placement Officer can suggest that the file be put aside for a few weeks until the rent increase is in effect. Invariably the lender ends up accepting the projected rents now. Another time you can get away with projected rents is if the apartment building is located in a city with rent control, and the annual increases are scheduled to take effect within 90 days.
There were times in the late 1980’s when lenders would consider in certain areas, such as the Bay Area, the greater Los Angeles area and the greater San Diego area, a Vacancy Allowance of less than 5%. Those days are gone. You must use at least 5% today.
The lender may insist on 7% to 10% for Sacramento, the Central Valley and most outlying California areas; however, you should still insert 5% for these areas and pray.
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 deadbeats.
Inserting the actual operating expenses is greatly simplified if a well-done appraisal arrives with the package. 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 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 you should document them well.
Few borrowers, however, keep records that current, and you must be careful not to scare the borrower away by demanding that he spend hours poring over his records.
Be careful not to double count the insurance premium or real estate taxes by annualizing them. Remember that these expenses are just paid once or twice a year. The best source for the annual real estate taxes is the preliminary report. You might find the annual insurance premium in the previous year’s tax return, or you might simply have to ask the borrower or the borrower’s fire insurance agent.
Here are a couple of useful rules of thumb. Because of Proposition 13, real estate taxes in California are computed by taking 1.25% of the original purchase price. To compute an estimate of a fire insurance premium, use $5.50 per thousand dollars of coverage. Therefore, if the sum of the existing 1st mortgage and your new 2nd mortgage is $787,000; you can take 787 times $5.50 to arrive at a very rough estimate of the new fire insurance premium.
There will be times where the borrower simply has only a few months operating history. Examples include properties taken back in foreclosure, and recent purchases. In cases like this, ask the borrower to prepare for you a Utility Statement. A Utility Statement is a breakdown of the building’s various monthly utility expenses for the last 12 months or less. You can annualize these numbers for your Pro Forma.
The real estate taxes can be obtained from a prelim and the insurance premium from the borrower.
To estimate Repairs and Maintenance, use between 6-10% of Effective Gross Income, depending on the age of the property and the quality of the tenants.
In the absence of specific offsite management numbers, you should use 5% of Effective Gross Income. This is what most professional property management firms charge. Onsite management should be handled as follows.
Show the full market rent of the resident manager’s unit on your rent roll and on your Gross Scheduled Rents.
Then list as an expense under Management Onsite the difference between the market rent of the unit and what the resident manager actually pays. This difference is known as a rent credit, and is fully taxable under the IRS codes. If the resident manager receives a small salary in addition to a rent credit on his unit, be sure to include this as well.
Many small units do not have resident managers, and lenders will accept this. However, even if a building is owner managed, you should include an off-site Management expense of 5% of Effective Gross Income.
The reason why is because in the event of a foreclosure, the lender will have to hire a professional property management firm to manage the property.