The Almighty (and unfailing inaccurate) Pro Forma

If you are like me, then you have a set of unconditional rules by which you run your business and for that matter, your life.   Some of mine are, "I will always try to do the right thing."   " I will renovate, maintain and manage my rental units to a standard I would expect, if I were living there." These are all well and good, and yours will undoubtedly be similar in many capacities, but I have one cardinal rule above all others...

"I will never speculate.   Buy on current Cash Flow, never on the speculation of capital appreciation."

Thus enters The Almighty Pro Forma.



For the uninitiated, a Pro Forma is a method of extrapolating and demonstrating the expected financial results of a given investment, based on a mix of current figures and projections.   In the world of real estate investing, we generally use current gross income and historic expense figures, and apply a set of standard adjustments for factors such as maintenance and vacancy.

The dirty little secret no one wants you to know, is that these Pro Formas are ALWAYS wrong.

By the way, do you know what we Landlords call ourselves before the harsh realities of the trade crack our naive little world?  "Investors!"  Sounds so important, doesn't it?   Profitable too!   And based on the Pro Forma, it is a very lucrative business to be in.

The problem is, none of the Pro Formas I have created over the years included a line item for Building Fires.   Thanks to the tenant I mentioned in my last post, several thousand dollars of projected net earnings were wiped out in the flick of a lighter.

I am going to go out on a limb here and make a blanket statement about our industry.  No one has ever made a Pro Forma with a line item for Pigeon Abatement.  As it turns out, it cost $2,000 but thats a tale for another day.

Ok, ok, these are rare events, and most people may never encounter them, but when you own a lot of rental units, for a decent amount of time, SHIT HAPPENS.   Random shit, no less.   Random, expensive, shit.

More specific to the problem at hand, is a small item I included in my description of what a Pro Forma is...

apply a set of standard adjustments for factors such as maintenance and vacancy.

We used 5% for each.   Let me interject that my partners and I are not second rate morons with a poorly thought out game plan.   All told, there are six of us involved to varying degrees, and each is successful in their own right.   My background was as a Financial Advisor before I left that world to focus full time on this one.   Another partner retired from the financial sector after fourty years as a successful individual focused on Risk Management.   The last I will mention in the context of this story, is the Accountant.

Thats right folks, when we make a Pro Forma we have the Financial Advisor, the Risk Manager and the Accountant all review the numbers, projections and the relevant documentation for accuracy and in the end, we buy on Cash Flow.

I am getting off-track.  5%.   First of all, 5% vacancy is a pipe dream when the economy falls apart.    Moreover, vacancy factors do not account for units that are occupied, but for which you are receiving no rent.    Did you know that by law, you must continue to provide utilities for units that have it included in their rent, even if they aren't paying you a dime?

I am pleased to report that as of this moment, we have 100% occupancy with 100% compliance on rent payment.   This is however, an anomaly.  Last year we experienced a combined vacancy and non-compliance rate of worse than 25%.

If we had bought on any other factor besides Cash Flow, we would have been sunk.   Market Values crashed, rents and available (qualified) tenants dried up, and the prospect of selling anything regardless of profit or loss declined to almost nil.

In the end, the Pro Formas were naive, and inaccurate.   But the Cardinal Rule, the unconditional Rule Number One was sound, and life (and profitability) go on.