How to Prepare a Commercial or Industrial Pro Forma
A commercial or industrial Pro Forma is prepared in a manner very similar to that of an apartment Pro Forma. The main difference is that in net leases, the tenant is responsible for some of the expenses.
First let us look at a full service lease. You will recall that in a full service lease the lessor (owner) is responsible for all of the operating expenses. Therefore, prepare your Pro Forma just like you would if the building were an apartment building. Use the current actual rent roll, inserting the market rent of any vacant space, and use the actual operating expenses.
We almost always use a Vacancy Allowance of 5% for commercial and industrial properties nationwide. In reality, office buildings are overbuilt and 10 to 15% would be more realistic.
You are reminded to use an Offsite Management expense of 3 to 5% of Effective Gross Income. Use 5% if the building is a multi-tenant building. You can sometimes get away with 3% if the building is large but there is only one tenant. The logic here is that 3% of a large rental income is enough where a property manager only has to deal with one tenant and no prorations are necessary.
In addition to Vacancy and Management, there is one other expense item you should almost always use, the Replacement Reserve.
The Replacement Reserve is used to repaint the exterior of the building, resurface the parking lot, and to replace the roof from time to time. Even under “triple net” leases the lessor (owner) is still responsible for these items, as well as for the structural soundness of the building. Therefore you should insert 23% of Effective Gross Income into the Replacement Reserve line of all of your commercial and industrial Pro Formas. Generally you should use 3%, unless the building is less than 3 years old. For these new buildings, you can often get away with 20.
Please refer at this time to the attached “Sample Triple Net Pro Forma Operating Statement”. Note that a triple net Pro Forma is relatively simple to prepare.
When a unit is owner occupied, ignore any existing lease. Since the owner is both the lessor and the lessee, he is in a position to draw up any lease he wants. Simply ignore any existing lease and base all of your calculations and Pro Formas based the MARKET RENT of the owner’s space or unit. Insert the market rent on both the Schedule of Leases and the Pro Forma, and footnote the entry with the words:
Since this space is owner occupied, we have used a market rent of $________ dollars per square foot for that unit.
The only time commercial/industrial Pro Formas are difficult is when some of the units are leased on a net basis, and the others are leased on a full service basis. You cannot merely insert 100% of the operating expenses because some of those expenses are later pro rated to the tenants. When a tenant pays a pro rated portion of the operating expenses, it is known as a “tenant expense contribution”. Unfortunately, when most owners prepare their income and expense statements for tax purposes, they generally combine the rents and the tenant expense contributions together, making your job particularly difficult.
In cases like this, you have no choice but to analyze each lease to first determine which tenants are responsible for pro rations and the expenses for which they are responsible. Then you must compute, generally based on net rentable square footage, what percentage of each expense is paid by each tenant. Show on your Pro Forma 100% of the operating expenses, but then recapture some of those expenditures in the Tenants’ Expense Contribution line of the income section. See the “Sample Partial Net Pro Forma Operating Statement” for an example.
When a tenant is responsible for increases in an expense item over a certain base year, this is known as an “expense stop”. The most common usage is for taxes and insurance. If a tenant were to make an addition to an existing improvement, the owner might be subject to a reassessment by the County. In this case the tenant would be responsible for 100% of the increase in real estate taxes and insurance as a result of the reassessment.