New construction development projects, whether 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’s an essential tool in a real estate developer’s toolbox and can supplement GAAP reporting.
Pro forma statements are financial documents based on assumptions and hypotheticals, not on reality. Businesses use them to make and showcase financial decisions. They may or may not include a balance sheet or other financial statements that summarize the future status of the business.
If you’re thinking about building any new construction project or acquisition/rehab, be it anything 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 you’ll take. Developers use pro formas to help negotiate with equity partners, structure financing with potential lenders, and create project specs 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.
Like an architect communicating their design through blueprints, the developer communicates internally and externally through their pro forma.
Here are a few important things to consider when creating a pro forma.
Why is flexibility so important when building an investment-grade pro forma for a new construction project?
- When starting with a blank slate, you have countless options and decisions to make. Your pro forma, by analyzing different scenarios, gives you the best way to maximize your investment. For example, which is a better use of your capital, rental or condo? Should it be with 100 units or 150 units? These decisions, which can have enormous impacts on your financial bottom line, are analyzed with your pro forma before any shovel hits the ground.
- Your project is always changing. As you go through the early development process—through due diligence, financing, design, and entitlements—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 make a robust, yet flexible pro forma when questions like these pop up?
- The land seller has another parcel we can buy. What if we change our 80-unit multifamily project to 120 units? How will that impact our financial returns?
- There’s a new update with the entitlements. We have to push our construction start date back another four months. How does that impact our investment?
- We need to adjust our unit absorption assumptions because our competition across the street had a harder time filling up their units than we originally thought. What does a slower absorption period look like financially?
These questions and concerns come up every day when developing a new property. Because of this, a flexible, well-built pro forma will save you time, money, and numerous headaches as you develop your project.
There are two parts of your development pro forma where spending time and effort up front on your structure will save you time later in the development process.
Know the right timing
Create a timing schedule in your pro forma that can be adjusted quickly as timelines change.
When starting a new construction project, developers typically have a general understanding of the project schedule. For example, they’ll anticipate design lasting four months and construction completion in 14 months. Despite early projections, project timing always changes. Construction may actually take 18 months while design lasts only 2.5 months. You’ll want your pro forma to adjust quickly to these changes because timing affects your bottom line.
When starting your pro forma, create a timing section in your assumptions tab that feeds into your entire financial model. When timing changes, you can quickly adjust this piece. If your cash flow timing feeds from these inputs, they’ll automatically adjust and save you hours of retooling your pro forma.
Three essential elements for your development pro forma
Every pro forma has three elements that guide 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 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 start. As a project develops, these assumptions get more and more refined. Here are typical types of assumptions that drive a pro forma.
- Timeline. When will the key stages of the project start, continue, and end (typically: analysis, design, construction, lease-up, stabilization, and disposition)?
- Costs. 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 bill of sale.
- Sources and uses. What financing structure is in place and what will that money be used for?
- General inputs. What are the physical characteristics of the project that drive development potential (number of units, lot size, zoning constraints)?
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 expenses will occur to produce a finished building or space that’s ready to be leased or sold?
- Stabilization. If the property is producing cash flow, what are the estimated revenues and expenses one incurs to operate the stabilized property?
- Disposition. If looking to sell once stabilized, what are the anticipated terminal value and sale conditions?
Every development is analyzed with respect to its estimated return on investment over time. Returns allow the developer to understand the relative risk of a project and compare that risk to 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 refinement and rebuilding process. Yet, if one sticks to the framework outlined above, that process can become easier to navigate and, over time, much less messy.
Building your own pro forma
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.
There are a few strategies for starting and building a development pro forma:
- Build from scratch
- Reuse an existing pro forma
- Use a hybrid model
Building a pro forma from scratch is time-intensive, but is an excellent method for understanding the ins and outs of a potential project in intimate detail. Don’t get overwhelmed by the need to get everything in place right away. Start with what you know, and expand from there.
Get what you already know in the “assumptions tab,” like site size and zoning. Then, estimate a rough development and construction schedule and create a preliminary building scope.
To reuse an existing pro forma, follow a template built by another person or company and customize it for your project. 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.
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—a hybrid model.
The best way to implement this strategy is to find a quality, well-built pro forma, and keep it minimized in the background. When you hit a roadblock 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 overnight. 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, give one of the strategies above a try and jump in.