The Northwood Group

Building Partner Investors

Buying on Pro Forma Rent

March 27


Back in the peak of the commercial real estate market many investors bought properties with values underwritten by “pro forma” rents.  By “pro forma” rents I mean that properties were underwrittten based on projected lease rates, occupancy rates, and future increases as opposed to actual operating history of a property.  The obvious risk with this approach is that inaccurate assumptions can lead to dramatic swings in actual property performance.  To complicate matters, many lenders also underwrote deals based on these assumptions.  Many of these puffed assumptions added to the crash that we’ve experienced in recent years.

With the downturn in the commercial real estate investment market, investors and lenders alike were forced to “get real” with the way that they valued properties.  Properties values were derived based on actual operating history which was a tough pill to swallow for those properties experiencing high vacancies.  Essentially no value was being given to that square footage that was not leased.

It is amazing how short our memories are in this industry.  I have seen a resurgence in the last 12 months of properties being offered based on a “pro forma” basis.  The most typical scenario I see is that of a property with higher than market vacancy (say 20%) include rent for the vacant space as part of the net operating income and then taking out a less than market vacancy factor (say 5%) of that net operating income.

There are several factors that need to be addressed when analyzing properties presented by this approach.  Please keep in mind that I am addressing this from the standpoint of an investor looking for stabilized returns and not speculative upside deals.

  • Market vacancy – What is real market vacancy for the property?  How has this property performed relative to the market historically? It is important to understand what stabilized occupancy really is.
  • Costs to Obtain Pro Forma Occupancy – If pro forma occupancy is realistic, there will usually be a cost in the form of downtime, leasing commissions, and tenant improvements to reach pro forma occupancy that must be considered in the analysis.
  • Lease rate risk – Make sure that projected lease rates are reflective of current market conditions for comparable properties. It is too easy to say that lease rates “should” be higher when historically they have not been.  It is also important to underwrite in-place leases to determine where those leases will renew at.

Despite the uptick in the market in recent months I remain hesitant to recommend properties to clients that rely too heavily on future assumptions.  For the most part, I want to make sure that a property can perform to expectations based on actual operating history.  In those cases where pro forma analysis is relevant, it is necessary to fully understand the assumptions being made to avoid those equity losses that so many investors experienced in recent years.