Building a Pro Forma That Survives Contact With Reality

A commercial real estate pro forma projects future property cash flows over a hold period. Investors, lenders, and partners rely on pro formas to underwrite deals. But most pro formas break down when actual results start rolling in because assumptions were too optimistic, expense categories were understated, or one time events were treated as recurring. Building a Rochester commercial pro forma that survives contact with reality requires realistic assumptions and conservative treatment of the categories that consistently disappoint.

Revenue assumptions. Start with signed leases and verified rent rolls. Use in place rents through lease expiration, then market rent for expected renewals or new leases. Do not assume market rents will rise faster than they have historically. Rochester area industrial rent growth averaged 3 to 4.5 percent annually through the recent cycle, so modeling 6 or 7 percent growth annually requires strong justification. Vacancy assumptions should include realistic downtime between leases, typically 3 to 7 months in Michigan markets depending on property type.

Expense assumptions. Start with actual historical operating expenses over the past 2 to 3 years. Adjust for known changes like insurance premium increases, property tax reassessments, or contract rate changes. Do not assume expense growth below inflation. Rochester area property insurance has been rising faster than general inflation recently, and modeling 3 percent annual growth against actual 8 to 12 percent recent increases produces immediate underperformance.

The property tax uncapping. Michigan uncaps taxable value to state equalized value when a commercial property sells. The buyer’s post sale property tax bill typically exceeds the seller’s, sometimes significantly on long held properties. Pro formas that use the seller’s current tax bill for year one produce inflated NOI and inflated projected returns. Realistic pro formas apply post sale tax estimates from the first year forward, and this adjustment is often larger for Michigan properties than for markets without similar capping mechanisms.

Capital reserves. Set aside $0.25 to $1.25 per square foot annually depending on building age and condition. Michigan freeze thaw cycles wear parking lots harder than milder climates, pushing capital reserves higher. Reserves cover major capital events like roof replacement, HVAC replacement, parking lot resurfacing, and tenant improvement allowances at lease turnover. Pro formas that skip reserves show artificially high cash flow that will reverse when capital events hit.

Tenant improvements and leasing commissions. Model TI and commissions on projected rollover. Typical commercial TI allowances run $15 to $50 per square foot for new leases and less for renewals. Leasing commissions run 3 to 6 percent of aggregate lease value. These costs hit at lease turnover, not evenly across years, and pro formas need to reflect the timing.

Management fees. Include property management even if the buyer plans to self manage. If the buyer’s time has value, self management still has a cost. If the property will be sold to an investor who will hire management, the fee should show in the pro forma from year one. Standard management fees run 3 to 5 percent of collected income.

Interest rate assumptions. Model current market interest rates for both acquisition financing and eventual refinance. Do not assume rates will decline significantly during the hold. Sensitivity analysis showing performance at higher rates helps stress test the deal. Michigan commercial loans currently price in the 7 to 8.5 percent range depending on structure.

Exit assumptions. Terminal cap rate at exit should typically be higher than acquisition cap rate to reflect the property being older at exit. Adding 25 to 100 basis points to acquisition cap rate for exit is standard. Modeling exit cap rates tighter than acquisition cap rates requires strong justification like significant value add work completed during the hold.

Sensitivity testing. Run the pro forma with vacancy 200 basis points higher, expenses 10 percent higher, and exit cap 50 basis points higher than base case. If the deal still works under stress, the underwriting has cushion. If the deal breaks under mild stress, the base case is too optimistic.

TDG Commercial, known as best commercial real estate agents in Rochester, builds conservative pro formas on Michigan investment analyses to help clients avoid deals that will disappoint after closing.