New build development projects, large, small, infill or otherwise, all start with a pro forma.
What is a pro forma? A pro forma, Latin for “for the sake of form,” is a financial model that is an essential tool in a real estate developer’s toolbox and can complement GAAP reporting.
Pro forma statements are financial documents that are based on assumptions and hypothetical data, not reality. Companies use them to make and present financial decisions. They may or may not include a balance sheet or other financial statements that summarize the future status of the company.
If you are considering building a new construction project or acquisition/rehabilitation, whether from a single-tenant industrial property to a 100-acre master-planned mixed-use community, building your pro forma is one of the first steps to take. ‘will take. Developers use proformas to help negotiate with equity partners, structure financing with potential lenders, and draft project specifications with architects and engineers. Better yet, developers use pro-formas to decide how big (or small) and how fancy (or simple) a specific project will be.
Just as an architect communicates his design through blueprints, the developer communicates internally and externally through his pro forma.
Here are a few important things to consider when creating a pro forma.
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Why is flexibility so important when building an investment-worthy pro forma for a new construction project?
- Starting with a clean slate leaves you with countless options and decisions to make. Your pro forma, by analyzing different scenarios, will give you the best way to maximize your investment. For example, which is a better use of your assets, rent or apartment? Should it be 100 units or 150 units? These decisions, which can have huge implications for your financial results, are analyzed with your pro forma before a shovel hits the ground.
- Your project is constantly changing. As you move through the early development process – through due diligence, financing, design and rights – information about your project becomes more available and solidified. As your project changes, so does your pro forma, which affects your investment and risk in the project.
How do you create a robust, yet flexible pro forma when these kinds of questions arise?
- The land seller has another plot that we can buy. What if we change our 80 unit multifamily project to 120 units? How does that affect our financial return?
- There is a new update with the permissions. We have to push our construction start date by another four months. How does that affect our investment?
- We have to adjust our unit absorption assumptions because our competition across the street had a harder time filling their units than we initially thought. What does a slower withdrawal period look like financially?
These questions and concerns are raised every day when developing a new property. As a result, a flexible, well-constructed pro forma saves you time, money and a lot of headaches when developing your project.
There are two parts of your development pro forma where putting time and effort on your structure upfront will save you time later in the development process.
Know the right timing
Create a timetable in your pro forma that can be quickly adjusted as timelines change.
When starting a new construction project, developers usually have a general understanding of project planning. For example, they expect design to take four months and completion of construction in 14 months. Despite early projections, the timing of projects is always changing. In reality, construction can take 18 months, while design only takes 2.5 months. You want your pro forma to adapt quickly to these changes because timing affects your bottom line.
When starting your pro forma, create a timing section in your Assumptions tab that will feed into your entire financial model. When the timing changes, you can quickly adjust this piece. If your cash flow timing is fueled by these entries, they will automatically adjust and save you hours of reworking your pro forma.
Three essential elements for your pro forma development
Each pro forma has three elements that determine its design, structure and use. If you have a new project on the books and are faced with a mountain of messy information, start with these three pro forma elements and jump right in.
Pro formas are essentially models that show us what we think will happen in the future. They are based on many assumptions that are unknown at the beginning. As a project progresses, these assumptions become more and more sophisticated. Here are typical kinds of assumptions that drive a pro forma.
- Timeline. When will the main phases of the project begin, continue and end (usually: analysis, design, construction, rental, stabilization and disposition)?
- Cost. What are the hard and soft costs associated with construction, design, financing, etc.? You may eventually need a pro forma invoice, which is a preliminary sales invoice.
- Sources and Uses. What financing structure is there and what will that money be used for?
- General entrances. What are the physical features of the project that drive development potential (number of units, plot size, zoning plans)?
2. Cash flow
Once assumptions are established, estimating cash flow is the next step. Below are the typical stages of a project that one considers when building this part of the pro forma.
- Pre-construction and construction. What costs will be incurred to produce a completed building or space ready to be rented or sold?
- Stabilization. If the property produces cash flow, what are the estimated revenues and expenses one must incur to operate the stabilized property?
- disposition. If you want to sell after stabilization, what are the expected final value and terms of sale?
Each development is analyzed with regard to the estimated return on investment over time. Returns allow the developer to understand the relative risk of a project and compare that risk with other investment alternatives. Typical returns for the pro forma include:
- Internal rate of return (IRR)
- Net present value (NPV)
Pro formas are always developed iteratively. They are usually edited, updated and refined as a project gains traction and becomes more real. They go through a constant process of refinement and reconstruction. But if you stick to the framework outlined above, that process can become easier to navigate and much less messy over time.
Build your own pro forma
Building a pro forma investment grade development is a major undertaking. It is something that has been built up in stages, torn apart, built up again, torn apart again and built up again. Still, it doesn’t have to seem so daunting because of one key point:
Every pro forma starts somewhere – usually with a blank page.
There are a few strategies for starting and building a pro forma development:
- Building from scratch nul
- Reuse an existing pro forma
- Use a hybrid model
Building a pro forma from scratch is time consuming, but it is an excellent method for understanding the ins and outs of a potential project in great detail. Don’t get overwhelmed by the need to get everything in place right away. Start with what you know and expand from there.
See what you already know in the Assumptions tab, such as site size and zoning. Then estimate a rough development and construction schedule and make a preliminary construction size.
To reuse an existing pro forma, follow a template created by another person or company and adapt it for your project. This strategy can backfire when you have to spend more time repairing and patching the template than it takes to build one from scratch.
Pro forma templates usually have the most value when they teach you how to build your own model. To do this, use the pro forma template as a reference, but build your own from scratch: a hybrid model.
The best way to implement this strategy is to find a well-built, high-quality pro forma and keep it running in the background to a minimum. When you encounter a roadblock and need guidance, open the template to understand how and why certain inputs or formulas were used. Over time, you will begin to recognize patterns, methods, tricks and styles that you can then graft into your own modeling toolkit.
The most important thing to understand with financial models is that they are not built overnight. It can be intimidating to want to develop a project but not know how to properly endorse it. Since development is a risky business, pro formas are essential to get the process going and mitigate risk. So if you’re stuck trying to get your pro forma off the ground, try one of the strategies above and jump in.