I believe quite strongly that a seller-provided pro forma is all but completely useless. I’ve even gone so far as to call them “pro-fake’as”. After all, the seller can put in whatever estimate they want. And you can pretty easily guess whether that estimate is going to be high or low. However, the operating statement is very useful. It provides the real numbers of how the property has performed over the last year and that is the basis for valuing it in the present and predicting its future returns.
That being said, one should not just take an operating statement at face value either. They most certainly aren’t useless, in fact, they are the most important thing to evaluate when it comes to valuing a prospective acquisition. Unfortunately, seller’s can still hide and obfuscate the real numbers in several ways. So here are the key things to look for in an operating statement.
If the seller is using accrual accounting, it is extremely important to make sure that the seller has charged off all the bad debts or that you account for the bad debts somehow. With cash accounting, you will see how much money comes in, so there’s no hiding it (although cash accounting can make things messy in other areas and make the statement look more erratic, say if they pay their employees every two weeks and three payrolls fall in one month instead of two). But with accrual, all the potential rent is counted as collected and then what does not come in because of non-payment is charged off as a “bad debt.” That’s all fine and good, but it’s important to make sure those debts have actually been charged off on the P&L.
If you have a full year (or T-12) statement, you can see all the seasonal adjustments. But if you only have a six month statement, be wary. First, you should ask why the trailing history is so short? Maybe it was a reposition, or maybe the property simply struggled for a long time and the owner doesn’t want to highlight that.
Regardless, expenses aren’t uniform throughout the year. Landscaping is highest in the Summer, snow removal in the Winter. Heating and cooling (if the owner pays the utilities) is highest in the Summer and Winter. So for example, if you have only six months and that includes the Summer but not the Winter and the tenants pay the electric but the owner pays for the gas (and there are gas furnaces), this could make the operating statement look better than it actually is. That’s because A/C uses electricity, but the furnaces use gas so the owner’s utility bills will be highest in the Winter. You need to be aware of such things.
In Jackson County, where I’m from, taxes are paid in December. If its cash accounting, often they won’t account for the taxes each month, so if you don’t look carefully, you may miss one of the biggest expenses. Also, it is important to know if they pay their insurance monthly or every six months or every year? A short statement could miss some of the insurance payments and leave you blind to another major expense.
This is the big one. A lot of owners will try to shove things into the capital expenses (i.e. below the line so it doesn’t effect the net operating income) that don’t belong there. Things like major upgrades belong under CAPEX, of course. Roof replacements do to, although I would argue that unless it was done when the property was bought to upgrade it, it is a recurring capital expense that should go above the line under a “Replacement Reserve”. You should account for some recurring CAPEX in your estimate regardless. HVAC replacement is definitely a recurring CAPEX expense, in my opinion. And often, things like turnover or carpet is even put in CAPEX when that is undoubtedly an operating expense. Make sure to look carefully at what the CAPEX expenditures are and add the one’s that should be in the operating expenses back to get an accurate picture of what has been going on.
Remember, never take anything a seller gives you on faith.