I estimate over 90% of all commercial sales offerings I review come complete with a Pro Forma (PF) operating statement. Opinions on the usefulness and voracity of PF analysis are as varied as the properties, their owners, and Listing Brokers. I used to think “Pro Forma” meant the seller has ‘maximized revenue and minimized expense estimates’. Over time I learned that I was lucky if that was all that was going on. Now, I only half-jokingly refer to Pro Forma as broker-speak for “I’m lying to you”. I shouldn’t call my peers liars and I’m not. I just look at the data as well, shall we say, suspect? Perhaps Pro Forma is best translated as “do your homework”.
I’ll explain the Headline in a bit, so let me lay out some data to support my brash assertions above, but first my qualifying statement: The break point between brief, casual PFs I speak of here and the very thorough and detailed accountant generated PF seems to be building values above $3,000,000. Certainly there are exceptions. While much more likely to be detailed and accurate in capturing actual expenses and revenue, the professionally generated PFs can be as equally optimistic as a quick one-page in their forecasting. I am talking here only about the informal less detailed PF practices I’ve encountered.
The online investment site Investopedia defines PF as …”A Latin term meaning "for the sake of form". In the investing world, it describes a method of calculating financial results in order to emphasize either current or projected figures…” I think you would agree this leaves a L O T of room for creativity and interpretation. If the definition doesn’t arouse your suspicions enough, Investopedia goes on to say “…Investors should be careful when reading a company's pro-forma financial statements, as the figures may not comply with generally accepted accounting principles (GAAP). In some cases, the pro-forma figures may differ greatly from those derived from GAAP.” Let the Buyer beware, applies nowhere, if not here.
I also did some unscientific research on common methods and practices in PF calculations and was not surprised to find that they’re all over the place. From the amount allowed for vacancy and bad debt, to the definitions of operating expense vs. Capex, to the method (or lack thereof) used to characterize, value, and apportion large irregular operating expenses, there are nearly no hard and fast rules. OK; no rules. And don’t be lulled into complacency by a PF that’s bursting with numbers. That usually just means you have more work to understand relevance and the big picture.
While not common and hopefully unintentional, it’s also quite possible that entire operating expense categories can be omitted from PF. For example, when pointing out that fire sprinkler service and monitoring expense had been omitted from the operating expenses of a full service building the response I got was “Oh, well its only $600.” That’s where I pointed out that a $600 reduction in income on a 6% return represented $10,000 in value reduction. Can you say ‘haircut’? Expenses are a big deal. I could give a long explanation of how every income and expense category in a PF needs to be dissected and evaluated but I’m sure you get my point. Suffice to say that you assume great risk by not giving the numbers a thorough stress test.
If you’ve hung in this long, here’s the Headline explanation for “We’re Sorry; There Is No Commission” A common revenue adjustment is an allowance for vacancy and bad debt which is most often estimated at 5 or 6%. Never mind that average vacancy is often closer to 8 or even 10% in some cases. 5-6% clearly isn’t enough to include vacancy, bad debt, AND commissions. Commission expenses are almost never accounted for in the operating expenses of basic PFs and they sure don’t belong in Capex. With few exceptions, leasing commissions are paid at some percentage on every dollar of gross rent revenue. This expense is far too often overlooked by Sellers, Buyers, and their Brokers. Remember that even a 5 percentage point reduction in income is a big hit to value.
The fiduciary duty we owe our clients demands a great deal of knowledge, expertise, and forever continuing education. Whether representing a Buyer or Seller, Tenant or Landlord, we must always give them the total picture; bad with the good, negatives with the positives. That’s what that commission is paying for.