The Document That Controls Everything
Every CRE transaction revolves around a single document: the pro forma. It is a year-by-year projection of a property's cash flows, typically covering a 10-year hold period plus a terminal sale. The pro forma determines the purchase price, the loan amount, the projected returns, and ultimately whether a deal is worth pursuing.
The problem: the seller's broker wrote it. And their job is to sell the property at the highest possible price.
This does not mean every broker pro forma is dishonest. It means every broker pro forma is optimistic. The assumptions lean toward higher rents, lower vacancy, smaller expenses, and no surprises. Your job as a buyer is to re-run the pro forma with realistic assumptions. The gap between the seller's version and yours is where the negotiation lives.
The Standard Pro Forma Cascade
Every institutional pro forma follows the same structure, line by line. Understanding this cascade is the foundation of CRE analysis.
Potential Gross Income (PGI)
- Vacancy Allowance
+ Other Income
- Operating Expenses
────────────────────────
= Net Operating Income (NOI)
- Capital Expenditures (CapEx)
────────────────────────
= Property-Before-Tax Cash Flow (PBTCF)
At the end of the hold period, there is a separate reversion calculation:
Projected NOI (Year 11) / Exit Cap Rate
= Gross Sale Price
- Selling Expenses (1-3%)
= Reversion Cash Flow
Every number on a pro forma feeds into one of these lines. If you understand each line, you can audit any deal in commercial real estate.
Line 1: Potential Gross Income (PGI)
PGI is the rent the property would generate at 100% occupancy at market rates. It is the theoretical maximum.
Two components matter here:
In-lease PGI is the rent you will actually collect from existing tenants under signed leases. This is verifiable from the rent roll and the T-12 operating statement. There is nothing to debate.
Post-lease PGI is the rent you project after current leases expire. This is where the assumptions live, and where most of the value in a typical building sits. As Geltner puts it: "Most of the value of most buildings is derived from the building's earning potential after the current leases expire."
The seller's broker will project post-lease rents at market rates growing at inflation (3% or more). Here is what institutional data actually shows:
NCREIF data covering 1978 to 2004 found that NOI growth for institutional properties ran approximately 200 basis points below inflation annually. For a building that is 10 to 15 years old, the empirically correct default is rent growth 1% to 2% below inflation, not at or above it.
Why? Functional depreciation. Newer buildings in the same submarket compete for the same tenants and command higher rents. An aging building's rent premium erodes over time, even in strong markets. The only exceptions: recently renovated properties or markets with severe supply constraints.
The red flag: any pro forma projecting rent growth at or above inflation for a building over 10 years old without documented renovation or supply-shortage justification.
Line 2: Vacancy Allowance
Vacancy is deducted from PGI to reflect the reality that no property stays 100% occupied forever.
For apartment buildings and other short-lease properties, vacancy is typically modeled as a percentage of PGI. The calculation: average tenancy length plus typical vacancy period between tenants. If average tenancy is 5 years and re-tenanting takes 3 months, the structural vacancy rate is 3/63 = 4.8%.
For office, retail, and industrial with multi-year leases, institutional underwriting models vacancy lease by lease. When does each lease expire? What is the re-tenanting timeline for that space? What is the market's natural vacancy rate?
The natural vacancy rate is the equilibrium benchmark. If the market's natural vacancy is 7% and the pro forma models 4%, you need a specific reason why this property outperforms its market. "Good location" is not a reason. A documented waitlist of prospective tenants is.
Aging buildings also carry structurally higher vacancy than newer buildings in the same submarket. A 20-year-old Class B office building competing against a 3-year-old Class A building will not sustain the same occupancy rate. If the pro forma treats them identically, the vacancy assumption is wrong.
Line 3: Operating Expenses
Operating expenses split into fixed costs (property taxes, insurance, security, management fees) and variable costs (utilities, maintenance, repairs). Two line items deserve special scrutiny.
Property taxes. In most jurisdictions, a sale triggers reassessment to the purchase price. The seller's tax bill is based on their original purchase price, which could be half of yours. The pro forma uses the seller's number. Your actual tax bill could be 50% to 200% higher. This is the most common expense understatement in CRE.
Insurance. In climate-exposed markets (Florida, Gulf Coast, California wildfire zones), premiums have increased 200% to 500% since 2022. If the pro forma uses pre-2022 insurance costs, NOI is materially overstated. Get a current insurance quote before you underwrite.
A useful benchmark: expense ratios by property type.
| Property Type | Typical Expense Ratio (% of EGI) |
|---|---|
| Multifamily | 38% - 50% |
| Office (full service) | 45% - 55% |
| Retail (NNN) | 10% - 20% |
| Industrial (NNN) | 10% - 20% |
If a multifamily pro forma shows an expense ratio below 35%, it is almost certainly understated. Either specific line items are missing or the operator is projecting expense reductions that may not materialize.
Line 4: Net Operating Income (NOI)
NOI is the line most people stop at. It is also the most misleading number in CRE if taken at face value.
NOI is an accounting construct. It tells you what the property earns before debt service and before capital spending. It does not tell you what cash the property actually puts in your pocket. Cap rate is calculated from NOI. So is DSCR. So is debt yield. All three metrics inherit whatever errors exist in the lines above.
When a broker says "this deal trades at a 7% cap," they are dividing their pro forma NOI (with all its optimistic assumptions) by the asking price. If you recalculate NOI with reassessed property taxes, current insurance, and empirically supported rent growth, the actual cap rate may be 5.5%. That is the difference between a deal and a pass.
Line 5: Capital Expenditures (CapEx)
CapEx is deducted below NOI to arrive at Property-Before-Tax Cash Flow (PBTCF). This is where the pro forma's honesty is truly tested.
CapEx includes two categories:
- Leasing costs: Tenant improvement allowances ($15 to $80+ per square foot) and leasing commissions (2% to 8% of total lease value). These are the costs of retaining or replacing tenants.
- Property improvements: HVAC replacements, roof repairs, elevator modernization, parking lot resurfacing. The capital spending that keeps the building competitive.
NCREIF institutional data shows that CapEx averaged over 30% of NOI annually for institutional-quality properties. That means a property with $1 million in NOI might only produce $700,000 in actual distributable cash flow after capital spending. The cap rate says 10%. The actual cash yield is 7%.
This gap between cap rate and actual cash yield is approximately 100 to 200 basis points across the NCREIF dataset. It exists because cap rate ignores CapEx. PBTCF does not.
For multifamily, a reasonable capital reserve is $250 to $350 per unit per year. For office with upcoming lease expirations, TI and LC costs can easily consume 20% to 30% of a single year's NOI. If a pro forma shows no CapEx line or budgets $100 per unit, it is not a pro forma. It is a brochure.
Line 6: PBTCF (The Number That Actually Matters)
PBTCF is what the property actually puts in your pocket before taxes and debt service. It is the correct input for a DCF analysis. It is the number institutional investors use to calculate unlevered returns and make investment decisions.
Most retail investors never see this number. They stop at NOI. But NOI overstates distributable cash flow by the full amount of CapEx, which NCREIF data shows is 30%+ of NOI annually.
The distance between NOI and PBTCF is the distance between what the property earns on paper and what it earns in reality.
The Reversion: Where 60% to 75% of Value Lives
The terminal sale (reversion) at the end of the hold period typically represents 60% to 75% of total value in a 10-year DCF model. This makes the exit cap rate assumption the single most sensitive number in any pro forma.
The calculation: projected Year 11 NOI divided by the exit cap rate, minus selling expenses (1% to 3%).
If the exit cap rate is 25 basis points lower than reality, terminal value is overstated by 5% to 8%. If it is 50 basis points lower, the overstatement is 10% to 15%. A deal projecting a 15% IRR at a 5.5% exit cap might deliver 9% to 10% at a 6.0% exit cap.
The institutional standard: exit cap rate 25 to 50 basis points above going-in cap rate. Buildings age during the hold period. Markets cycle. The probability of cap expansion over a 10-year hold is higher than compression.
Broker Version vs. Buyer Version: A Worked Example
Here is a 120-unit multifamily property listed at $12M. The broker's pro forma and your corrected version, side by side.
| Line Item | Broker Pro Forma | Your Corrected Version | Delta |
|---|---|---|---|
| PGI (120 units x avg $1,250/mo) | $1,800,000 | $1,800,000 | — |
| Vacancy (broker: 4%, you: 6.5%) | ($72,000) | ($117,000) | ($45,000) |
| Other Income | $36,000 | $36,000 | — |
| Effective Gross Income | $1,764,000 | $1,719,000 | ($45,000) |
| Property Tax (broker: seller's basis) | ($120,000) | ($204,000) | ($84,000) |
| Insurance (broker: 2021 quote) | ($48,000) | ($108,000) | ($60,000) |
| Other OpEx | ($528,000) | ($528,000) | — |
| NOI | $1,068,000 | $879,000 | ($189,000) |
| CapEx ($300/unit) | — | ($36,000) | ($36,000) |
| PBTCF | $1,068,000 | $843,000 | ($225,000) |
| Stated Cap Rate | 8.9% | 7.3% | -160 bps |
| True Cash Yield (PBTCF/Price) | 8.9% | 7.0% | -190 bps |
The broker's 8.9% cap rate becomes a 7.3% cap rate and a 7.0% true cash yield. The three corrections: reassessed property taxes at your purchase price ($12M x 1.7% effective rate), current insurance (Gulf Coast, 2024 quotes), and a vacancy rate matching the submarket's 3-year average instead of the seller's cherry-picked trailing quarter.
Notice the broker's pro forma shows no CapEx line. It presents NOI as if it were distributable cash. The $36K in reserves ($300/unit) drops the true yield another 30 basis points.
This $225,000 annual gap is not theoretical. It is the difference between the deal the broker is selling and the deal you are actually buying. At this corrected NOI, your DSCR on a $9M loan at 7% drops from 1.52x (broker version) to 1.25x (your version). The comfortable deal becomes a tight deal.
The Five-Minute Audit
You do not need a complex model to evaluate a pro forma. Run through these checks:
- Rent growth assumption: Is it at or above inflation for a building over 10 years old? If yes, it contradicts NCREIF data. Adjust to 1-2% below inflation.
- Vacancy rate: Is it below the market's natural vacancy rate? If yes, you need a specific reason why this property outperforms.
- Property taxes: Are they based on the seller's assessment or your purchase price? Recalculate at your acquisition basis.
- Insurance: Is the premium current (2024+) or historical? Get a real quote.
- CapEx: Is there a line item? Is it at least $250/unit (multifamily) or 1-2% of property value? If not, the PBTCF is overstated.
- Exit cap rate: Is it equal to or below going-in cap rate? Add 25-50 bps and see what happens to the IRR.
Every one of these checks can be done in the first 60 seconds of reviewing a deal package. The answers tell you whether the pro forma is a legitimate projection or a sales pitch with a spreadsheet attached.
Where to Go Next
The pro forma audit tells you whether the income is real. The next questions:
- What does the cap rate actually mean? Read What Is a Good Cap Rate to understand the growth bet embedded in the price.
- Does the financing work? Read DSCR Explained to stress test the debt against your corrected NOI.
- Where are you in the cycle? Read Real Estate Cycles to check whether your rent growth assumptions align with where the market is heading.
- What are the common traps? Read 8 Underwriting Mistakes for the full checklist of errors that inflate returns.
Sources
- Geltner et al., "Commercial Real Estate Analysis and Investments," 2nd Ed. (2007), Chapter 11: Cash Flow Proformas
- NCREIF Property Index, 1978-2004 (NOI growth, CapEx, and rent depreciation data)
- CBRE U.S. Cap Rate Survey, H2 2025
- Krewson-Kelly and Thomas, "The Intelligent REIT Investor" (2016), Chapter 4: Leases