I wrote about the three essential elements of any real estate development pro forma last week (assumptions, cash flow, and financial returns). Development pro formas can often be messy, confusing, and increasingly complex with time. So this three-piece framework is one I use to keep the chaos from getting out of hand.
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Are pro forma financial models important in real estate development? Yes, yes, and yes! Many developers would argue that they are crucial to executing profitable projects and mitigating substantial financial risk. They are a necessary tool of the trade—one which is learned and sharpened over time.
If you’re looking to jump into development, yet have never built a pro forma, how the heck do you even start?! How do you treat a pro forma like a tool and not a chore?
Admittedly, building an investment-grade development pro forma is a major undertaking. It’s something that’s built in stages, torn apart, built again, torn apart again, and built again. Yet it doesn’t have to seem so daunting because of one MAJOR point:
Every pro forma starts somewhere—usually with a blank page.
With this in mind, here are a few strategies for starting and building a development pro forma.
1) Build from Scratch
This is the most time intensive way to start a pro forma. However, it’s also an excellent method for understanding the ins and outs of a potential project in intimate detail. Since you are building and controlling every input, projection, and return, you gain detailed knowledge much quicker than using someone else’s model, template, or formula.
This strategy takes the most time (and can be very frustrating), but it can also enhance one’s knowledge quickly relative to other strategies.
If you are trying to build a development model from scratch, don’t get overwhelmed by the need to get everything in place right away. Start with what you know, get that in place, and expand from there. The point is to just get something on your screen to start—the detail and complexity will build over time.
Here are a few ways to get started from scratch:
- Get what you already know down in the “assumptions” tab. This could include site size and constraints, land acquisition costs, zoning, previous tax payments, etc.
- Estimate a rough development and construction schedule. This will simply be a reasonable estimate for the time needed to start, build, and complete the project. As you get more information about timing, this will get updated and refined.
- Create a preliminary building scope. Will your ideal project be a duplex rental property, garden-style 50-unit apartment community, 200-unit apartment community, single-family home subdivision, etc? Or does it make more sense as a 20,000 square foot retail strip center or a four-story medical office building? The scope doesn’t have to be detailed and exact at the start. But, based on the site’s context and existing land uses, a rough scope of work for the scale and building type should get things in motion.
Once the known project details and rough assumptions are in place, the next step is to jump back in and refine what you know while creating new assumptions and projections for unknown project details. This process repeats itself over and over as the project gets more physically and financially feasible.
2) Re-Use an Existing Pro Forma
Pro forma templates are typically built by another person or company and customized by you as you analyze a project. They are useful when you want to analyze a project, but want guidance on what inputs and projections to focus on. They can save time and money because the structure and framework is laid out before you even begin. In an ideal situation, you’d simply have to input project-specific variables and the model takes care of the rest.
There are a few drawbacks to using an existing template instead of building from scratch. First, someone else has created the model, so you lose much of the skill-building work that goes into creating a model from scratch. Second, you don’t have a completely customizable tool to use for your analysis. Every project is different, which often requires a unique pro forma.
This strategy can backfire when you have to spend more time fixing and patching the template than it would take to build one from scratch.
3) Hybrid
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 one of your own from scratch.
They best way to implement this strategy is to find a quality, well-built pro forma, and leave it minimized in the background. When you hit a road block and need guidance, open the template to understand how and why certain inputs or formulas were used. Over time you start to recognize patterns, methods, tricks, and styles that you can then graft into your own model building tool kit.
The most important thing to understand with financial models is that they aren’t built over night. It can be intimidating to want to develop a project, but not know how to properly underwrite it. Since development is a high-risk venture, pro formas are essential to getting the process started and mitigating risk. So if you’re stuck on getting your pro forma off the ground (no pun intended), give one of the strategies above a try and jump in!
Photo: @alviseni