# Reading a Pro Forma Without the Hype > A section-by-section walkthrough — with illustrative numbers — and where the optimism quietly hides. **Analysis · 11 min read · Updated Jan 2025** **Compliance note:** This article provides general educational information and does not constitute an offer to sell or solicitation of an offer to buy any securities. Hermance Capital is not a registered investment advisor, broker-dealer, attorney, or accountant. Nothing here constitutes legal, tax, or investment advice. Real estate investments involve risk, including potential loss of principal, and past performance is not indicative of future results. Numbers below are illustrative — no real deal and no specific property. --- A pro forma is a forecast. It is a sponsor's best-faith estimate of how a property will perform under a given business plan. It is also where most of the optimism in private real estate lives. The pro forma is where rent growth assumptions get a little aggressive, where exit cap rates compress quietly, where the renovation contingency shrinks, and where the projected IRR ends up just above wherever the comparable deals are landing this week. None of that is necessarily fraud. Some of it is just the natural drift of an unchecked spreadsheet. This article is a section-by-section guide to reading a pro forma critically. We will work through illustrative numbers — no real deal and no specific property — so the structure is clear without anyone mistaking it for an offering. The goal is to give you the muscle memory to spot where assumptions can hide. ## What you'll learn - The difference between a T-12 and a pro forma, and why both matter - How rent growth, vacancy, and other-income assumptions get inflated - How operating expenses get understated - How the NOI walk works - Why the exit cap rate is the single biggest swing factor - What a real sensitivity analysis looks like - The line items that are most often missing or undersized ## T-12 versus pro forma The T-12 is the trailing twelve months of actual operating performance. It is what the property has done. The pro forma is what the property is projected to do under new ownership and a new business plan. Both should be in any serious deal package. If you only see one, ask for the other. The T-12 is the fact base. Look there for current rents, current occupancy, actual expenses, and historical patterns. The pro forma is the story. Look there for assumptions about how the new owner will change the trajectory. The most useful single comparison is the T-12 and the year one pro forma side by side. If year one already shows fifteen percent revenue growth and a thirty percent expense reduction, you are looking at an aggressive plan. Year one is the year the new ownership has the least leverage to change anything because most rents are still under existing leases and most expenses are still under inherited contracts. If year one looks dramatically different from the T-12, the assumptions deserve scrutiny. ## The income side Rents are usually the largest line item. The pro forma will show current rents (as inherited), market rents (what comparable units rent for), and post-renovation rents (what units will rent for after the value-add work). ### Common patterns to watch for **Rent growth that exceeds the trailing five-year average** for the submarket. Three percent annual rent growth is roughly the long-term US average for multifamily, but it varies by metro and time period. A pro forma using five percent or more annual rent growth in normal market conditions deserves a hard question. **Post-renovation premiums that exceed nearby comparables.** If similar renovated units in the submarket rent for two hundred dollars above unrenovated units, but the pro forma assumes three hundred fifty, ask why. **Loss to lease that disappears in year one.** Loss to lease is the difference between what tenants are paying and what the rent roll says they could pay. Capturing it requires waiting for leases to roll. If a pro forma assumes one hundred percent of loss to lease is captured in year one, that requires every tenant to either renew at market or vacate and be replaced. **Other income matters more than people think.** Other income includes utility reimbursements (RUBS), pet fees, parking, late fees, and amenities. A modest property might run two to four percent of effective gross income on other income. An aggressive pro forma might project ten percent. Ask what specifically generates the additional other income. **Vacancy assumptions** usually run five to seven percent for stabilized multifamily. Lower than five percent is unusual. A pro forma that drops vacancy from current ten percent to five percent in year one is making an operational claim worth scrutinizing. ## The expense side Expenses are often where pro formas understate the real cost of operating. Look at each major line item. - **Payroll.** Onsite property management staff costs. Often runs five hundred to seven hundred dollars per unit per year for value-add multifamily. Verify against the T-12. - **Repairs and maintenance.** Typically four hundred to eight hundred dollars per unit per year for stabilized property, higher during heavy renovation periods. Older properties cost more. - **Property taxes.** One of the most commonly understated items. When a property sells, the tax assessment usually resets based on the new sale price. A pro forma that uses the seller's current tax bill will understate year two and beyond significantly. Ask how the sponsor modeled the reassessment. - **Insurance.** Multifamily insurance costs have risen sharply since 2022, especially in coastal and tornado-belt markets. A pro forma using a 2021 quote on a 2024 acquisition is using stale data. Ask for current quotes. - **Utilities.** Look at whether the property is master-metered or sub-metered. Master-metered properties have higher utility expense and usually offset some of it through RUBS reimbursement. - **Property management fees.** Typically three to four percent of effective gross income for third-party management, sometimes lower at scale. - **Capital expenditure reserves.** A real reserve for ongoing capital needs (HVAC replacements, roof repairs, parking lot resurfacing) typically runs three hundred to five hundred dollars per unit per year. A pro forma that uses one hundred fifty dollars is underfunding ongoing capex. ## The NOI walk Net Operating Income is the property income after operating expenses but before debt service. The NOI walk is the year-by-year projection of NOI growth. A clean NOI walk shows the assumptions that drive growth: rent increases, expense control, occupancy improvement, other income capture. Each year NOI should be reconcilable to the assumptions on the income and expense pages. Take year five NOI from the pro forma. Divide by year one NOI. The growth rate over the hold period is what is driving the upside. If year one to year five NOI growth is fifty percent, that is roughly an eleven percent compound annual rate, which requires strong operational improvement plus market tailwinds. Operators rarely produce much faster NOI growth than they have historically unless something specific has changed. ## Capex and value-add budget The renovation budget is its own line item. A typical value-add multifamily plan might include unit interior renovations (eight to fifteen thousand dollars per unit), exterior improvements, amenity upgrades, and deferred maintenance. Industry standard contingency is ten percent on hard costs. Less than that is aggressive. The contingency exists because renovation costs are notoriously hard to predict. Materials availability, labor markets, and unforeseen conditions on older properties all push costs upward. Phasing matters because most value-add plans renovate units as they turn over rather than all at once. The pace of unit turns drives the speed of revenue capture. A pro forma that assumes a rapid renovation pace is also assuming high tenant turnover, which often correlates with lower than projected occupancy during the renovation period. ## Debt service and capital structure The loan terms drive a significant portion of returns and a significant portion of the risk. Fixed rate debt locks in interest expense. Variable rate debt floats with an index (often SOFR), which means rising rates increase the interest payment and decrease cash flow. Many of the value-add multifamily deals that have struggled in 2023 and 2024 had variable rate bridge debt that became unaffordable when rates rose. Loan to value (LTV) and debt service coverage ratio (DSCR) are the two main loan metrics. Standard agency multifamily debt runs sixty-five to seventy-five percent LTV and 1.25 to 1.30 DSCR. Bridge debt can go higher on LTV but usually requires variable rate and shorter terms. Refinance assumptions are where capital structure risk often hides. If the pro forma assumes a refinance in year three at a specific rate, what happens if rates are higher? What happens if the property has not stabilized in time to qualify for the refinance? ## Returns and the language they use The standard return metrics are: - **IRR (Internal Rate of Return).** Annualized return that accounts for timing of cash flows. Sensitive to the assumed exit and the timing of distributions. - **Equity Multiple.** Total dollars returned divided by total dollars invested. A 2.0x equity multiple means you got back two dollars for every one invested over the hold. - **Cash on Cash Return.** Annual cash distributions divided by invested equity. Useful for current yield analysis. - **Average Annual Return (AAR).** Total profit divided by hold period. Easy to inflate by extending the hold. The number to focus on is the IRR. The number sponsors sometimes lead with is the AAR or total return because it is higher. AAR is a less rigorous metric. IRR accounts for the time value of money. AAR does not. ## The exit cap rate The exit cap rate is the single biggest assumption in most pro formas. Cap rate is the property NOI divided by its value. A lower cap rate means a higher property value at the same NOI. A small change in cap rate can change projected sale proceeds by hundreds of thousands of dollars. A common practice is to add twenty-five to fifty basis points to the going-in cap to model the exit. Adding zero or compressing the exit cap is aggressive. The pro forma that compresses the exit cap is assuming you sell into a stronger market than you bought into, which is not a defensible base case in most environments. Run this exercise yourself. Take the projected year five NOI. Divide it by 5.5 percent (or whatever cap rate you think is conservative for the market and asset class at exit). Compare your number to the projected sale price in the pro forma. If your number is significantly lower, the deal is more sensitive to cap rate movement than the pro forma admits. ## Sensitivity analysis A real sensitivity analysis shows how returns change when assumptions change. A typical table might show IRR at three rent growth assumptions (low, base, high) crossed with three exit cap assumptions. A property whose IRR ranges from six percent to twenty-four percent across the table has high variability. A property whose IRR ranges from eleven percent to seventeen percent has narrower variability. What to watch for: a sensitivity table that only shows the upside. A table where the worst case is still a strong positive return. An absence of a sensitivity table altogether (this happens more than it should). ## Questions we'd ask before approving any pro forma 1. What are the key drivers of return: rent growth, exit cap, renovation premium? 2. Show me a sensitivity table with IRR at low, base, and high cases for each driver. 3. How does year one pro forma compare to the T-12? 4. What is the renovation contingency and how was it sized? 5. How did you model property tax reassessment? 6. What is the loan structure and what happens at refinance under stressed conditions? 7. What does the exit cap rate look like under a flat market scenario? ## Plain-English summary A pro forma is a forecast built on assumptions. The biggest assumptions are rent growth, exit cap rate, and renovation execution. Each can be quietly inflated. The T-12 is the fact base. The year one pro forma is where aggressive assumptions show up. Property taxes, insurance, and capex reserves are often understated. The exit cap is often compressed. A real sensitivity analysis shows the range of outcomes. The questions that matter are specific, not general. If the answers do not add up, walk away. --- ## Related reading - [Real Estate Syndications 101](syndications-101.md) — 9 min · Foundations - [How to Vet a Sponsor](how-to-vet-a-sponsor.md) — 12 min · Due diligence Full Learning Hub: [/learn/index.md](index.md)