The Problem with Pro Forma

There are few things more deceptive and dangerous to a new commercial real estate investor than “pro forma.”

Selling a property on “pro forma” figures means pricing the property on the maximum possible theoretical value — pricing into it the “potential” (read: non-existent) proceeds of fillnig vacancies, rasing rents to “market rent”, adding units — whatever the seller deems to be possible, whether or not it is.

The problem is this: you cannot predict what may or may not happen with the property. If there was so much potential, why didn’t the owner do it himself? There is an inherent “risk factor” to any purchase, and the risk is exponentially higher if it is something that hasn’t happened yet, and indeed, may not even be possible.

When you buy a bag of rice, you do not pay the “potential future value” of the rice — you pay the CURRENT MARKET VALUE. Any upside that may (or may not exist) in the property is undeterminable and impossible to price, and should be the buyer’s incentive to buy the property — that if they put in more money, they may increase the cap rate of the property.

So DO NOT EVER BUY ON PROFORMA FIGURES. It is especially important now in the falling Los Angeles commercial real estate industry, because “assured” rent increases and appreciation is a thing of the past, and the only thing you can count on is slight depreciation.

For more investing advice, please visit our Los Angeles Commercial real estate site at Monocle Real Estate Services.