How To Prepare a Pro Forma Operating Statement For an Apartment Building

Arguably the single most important document in any commercial loan package is the Pro Forma Operating Statement. A pro forma operating statement is a projected budget on an income property for the next twelve months. This pro forma must take into consideration that the owner will suffer some vacancies and some collection losses, that apartment lenders will insist on a line item expense for professional property management, and that the owner must set aside some reserves every year to cover the eventual cost of replacing the roof, replacing the HVAC unit(s), maintaining the exterior walls, and repaving the parking lot.

As you prepare your apartment pro forma operating agreement, keep in mind that the most important feature of any new apartment loan is that it be as large as possible. The vast majority of apartment borrowers want to leverage their building as high as possible. You will therefore want your gross potential income to look as large as possible and your operating expenses to appear as low as possible. You can’t cheat, however, because the lender will surely catch you and punish you by offering you or your borrower a much smaller loan than you deserve. In the detailed section at the bottom of this training article I will teach you what adjustments you can or cannot get away with.

The order in which the documents appear in a commercial loan package is called the stacking order. The higher that your Pro Forma Operating Statement appears in your stacking order, the more respect for, and the more confidence in, the commercial loan officer for the bank will have in the borrower and/or the loan broker. I recommend the following stacking order for a multifamily loan request:

Executive Loan Summary
Picture Page and Description of the Collateral
Pro Forma Operating Statement
Rent Roll
Last 12 Month’s Actual Operating Statement
The rest of the package

Here is what your pro forma operating statement should look like:

CHERRY BLOSSOM APARTMENTS 123 BEALE STREET MEMPHIS, TENNESSEE PRO FORMA OPERATING STATEMENT
INCOME:
Gross Scheduled Rents (a)	$1,876,000
Laundry & Vending Income (b)	4,132
Parking Income (b)	7,902
Gross Potential Income:	$1,888,034
EXPENSES:
Real Estate Taxes (c)	$56,387
Fire and Liability Insurance	23,876
Repairs and Maintenance	36,877
Gas	4,890
Electric	13,301
Management (d)	89,683
Pool Maintenance	16,588
Cleaning and Painting	4,000
Reserves for Replacement (e)	53,809
Total Expenses (f):	309,411
Net Operating Income:	$1,488,181
Notes: a. Current actual rents, including the market rent of the manager’s unit and any vacant units. b. Last year’s actual income. c. Because this is a purchase money deal and real estate taxes will be reassessed, we have used 1.25% of the purchase price. d. 5% of Effective Gross Income. e. 3% of Effective Gross Income f. Unless otherwise indicated, all expenses are last year’s actual figures.

Here is that same sample pro forma operating statement as a Word document. Be sure to download this document right now to your Desktop or your Documents. You will want to use this sample pro forma operating statement as an exemplar. The next time that you need to prepare an apartment pro forma, simply open this exemplar, copy it, and edit the copy for your particular apartment loan. Please note that I have used a Courier font in this exemplar. Courier is a proportional font, which means that every character takes up the same amount of space on the page. The reason this is important is because you will want your columns of numbers to line up properly.

The Nuts and Bolts of Preparing Your Pro Forma

Below you will find some helpful comments and tips about each line item. A line item is an entry that appears as a separate line in a budget. For example, "Fire and Liability Insurance … $23,876."

Gross Scheduled Rents

This is the most important line in any apartment pro forma because so many deal-killing mistakes are made here. You need to make sure that this top-line number as large as possible because a great many apartment lenders will determine the maximum size of your loan by seizing this number, taking off 5% for vacancy and 35% or 40% for expenses, and then plugging this resultant net operating income into their formula. So pay attention: You must make the Gross Scheduled Rents appear as large as possible.

So how do you do this? First of all, don’t forget about your vacant units. You must show on your Rent Roll the market rent of any vacant units. Don’t forget that the lender is going to take off 5% to 10% of your effective gross income for vacancy and collection loss. Therefore, if you were to fail to include the market rent of any vacant units in your Rent Roll, you would essentially be double-counting any vacancies. And if those 2-bedroom, 2-bath units are renting from $900 to $950, be sure to use the market rent of $950 rather than just $900.

Many apartment owners pay their apartment managers by giving them a free apartment. It is extremely important that you list the manager’s unit on the Rent Roll at its fair market rent. Remember, all apartment lenders are going to require that you have a separate line item for professional property management, typically 5% or 5% of Effective Gross Income, so if you fail to show the manager’s unit at its fair market rent, you would be penalizing your borrower by double-counting the property management expense. In addition, the manager’s unit is usually the nicest apartment in the building. It may have an extra bedroom, an extra garage or parking space, and/or be much larger than the typical unit. Therefore be sure to be extra-generous to the borrower in your estimate of the market rent of this premium unit.

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Laundry and Vending Income

Many apartment buildings feature washing machines and vending machines. Most lenders will allow you to include such income in your Gross Potential Income. You should use last year’s actual figure. Conservative lenders may require that you use the average of the last two years’ actual income.

Parking Income

Many apartment building owners charge for garages, covered parking spaces, or even uncovered parking spaces. In big cities this extra income can be substantial. Most lenders will allow you to include such income in your Gross Potential Income. You should use either last year’s actual receipts or the bottom line of a Parking Space Rent Roll.

Reserve For Vacancy and Collection Loss

Property owners will often say something like, “My apartment building is so desirable that I haven’t had a vacancy in four years.” That may be true, but you might ask them in reply, “But have you had any collection losses?” Invariably that stops them in their tracks. All apartment building owners suffer from collection losses.

The point is moot. There is not an apartment lender in the country who will accept a Reserve For Vacancy and Collection Loss of less than 5%. Some apartment lenders will use an even higher number, say 7% to 10%. If you try to use some number of less than 5% - let’s say 2% - the lender will automatically disregard your pro forma and make a whole new one of his own. When he does so, he might use 8% or 10% for Vacancy instead. His estimate of operating expenses will also be much higher than what you have submitted. If a lender has to throw out your pro forma, prepare for your requested loan amount to be cut. Ouch!

On the other hand, never voluntarily use a Vacancy Reserve of higher than 5%. You might use 7%, trying to avoid the lender’s use of 10%, the lender might say, “Hmmm, I was going to use 5% for Vacancy, but the borrower used 7%. I guess I better use 7%.”

Bottom line: Using a Vacancy Reserve of other than 5% can never help you, but it can often hurt you. Always - always - always use 5%, even if the vacancy rate in the area is 20%.

Real Estate Taxes

If the loan is a refinance, you should use the current tax bill from the preliminary report/title commitment, or, if the new tax bill is unavailable, you could use last year’s actual taxes. In theory using the current tax bill is theoretically in correct. Pro forma operating statements are prepared for both lenders and prospective buyers. Prospective buyers want to see at what cap rate they are buying the building, and the current tax bill is deceiving. Most states will initially value and tax a building based on its purchase price. Because tax assessors often undervalue properties, the purchase price will usually be markedly (30%) higher than the assessed value, resulting in a 30% higher tax bill. Nevertheless, as a prospective borrower or commercial loan broker, you will usually want to qualify for as much leverage as possible. You should therefore always try to get away with using the current tax bill.

If the apartment loan requested is a purchase money loan; i.e., you are using the loan to buy the apartment building, then you simply must use your best estimate of reassessed real estate taxes.

Fire and Liability Insurance

You should use the actual figure from last year.

Repairs and Maintenance

Ideally you should use last year’s actual expense. If there were no extraordinary items - like repairing fire or water damage - you’re in good shape. A problem arises, however, if the property owner had renovated a number of apartment units and he had expensed the cost of renovation. When you renovate an apartment unit; i.e., replacing the floors in the bathrooms and/or the kitchen, installing new kitchen countertops and/or new cabinets; the property is supposed to capitalize those costs for tax purposes over seven years. Few apartment owners do this. Instead they expense the entire cost of the renovation in year one, in order to reduce this year’s tax bill. This creates a huge problem when you try to use last year’s figures for Repairs and Maintenance. That number will be huge, which will greatly reduce the apartment’s Net Operating Income (NOI) and therefore the size of the apartment loan for which you will qualify.

When faced with this problem, you should footnote this line item and say something like, “Since the property owner renovated the apartment building last year and expensed the entire cost, we have used $200 per unit per year as a reasonable estimate of next year’s Repairs and Maintenance expense.”

Gas and Electric

You should use the actual figure from last year.

Pool Maintenance

You should use the actual figure from last year.

Cleaning and Painting

You should use the actual figure from last year.

Property Management

Property owners will often tell you that you don’t have to use anything for Property Management because he does the management himself. Unfortunately there is not an apartment lender in America who will not insist on a fairly substantial line item expense for Property Management.

The number you should use for Property Management is 5% of Effective Gross Income; i.e., that number in your pro forma left over after you take off 5% Reserve for Vacancy and Collection Loss. If you try to use 4% of Effective Gross Income, the lender will likely punish you and use 6% to 8%. You can often get away with using just 5%, but absolutely no lower.

Replacement Reserve

A replacement reserve is a little money set aside every year to cover the eventual cost of replacing the roof, replacing the HVAC unit(s), and repaving the parking lot. When you prepare a pro forma operating statement on a commercial property, you must always - always - always use a Reserve for Replacements, even if the property is brand new. I recommend using 3% of Effective Gross Income as the Replacement Reserve for office buildings, retail buildings, and industrial buildings. If the building is brand, spanking new, you can try to get away with just 2% of Effective Gross Income.

Prepare to be shocked. Most apartment lenders do NOT require a Reserve for Replacements on multifamily loans. Why? Apartment buildings have so parts and components that are constantly being repaired or replaced that it is almost impossible to distinguish between a repair and a replacement. Rather than go nuts, most apartment lenders simply use last year’s actual Repairs and Maintenance figure, which should be between 6% to 8% of Effective Gross Income.

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