New construction development projects, large, small, infill or otherwise, all start with a proforma.
What is a proforma? A proforma, Latin for “for the sake of form,” is a financial model that is an essential tool in a property developer’s toolbox and can complement GAAP reporting.
Pro forma statements are financial documents that are based on assumptions and hypotheses, not reality. Companies use them to make and present financial decisions. They can include a balance sheet or other financial statements that summarize the future status of the company.
If you’re thinking of starting a new construction project or an acquisition / rehab, be it from a single tenant industrial property to a 100-acre mixed-use master plan, building your pro forma is one of the first Steps you take ‘I’ll take. Developers use proformas to negotiate with equity partners, structure financing with potential lenders, and create project specifications with architects and engineers. Better still, developers use proformas to decide how big (or small) and how fancy (or simple) a given project will be.
Like an architect communicating his design through blueprints, the developer communicates internally and externally through his proforma.
Here are a few important things to keep in mind when creating a proforma.
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Why is flexibility so important when creating an investment grade pro forma project for a new build project?
- When you start with a blank chalkboard, you have tons of options and choices to make. Your proforma provides you with the best way to maximize your investment by analyzing different scenarios. For example, what is a better use of your capital, rent or condominium? Should it be with 100 units or 150 units? These decisions, which can have a huge impact on your bottom line, are analyzed with your proforma before a shovel hits the ground.
- Your project is constantly changing. As you progress through the early development process – through due diligence, financing, design, and entitlements – information about your project becomes more available and solidified. When your project changes, so does your proforma, which affects your investment and risk in the project.
How do you create a robust yet flexible proforma when questions like these arise?
- The property seller has another property that we can buy. What if we convert our multi-family project with 80 units to 120 units? How will that affect our financial returns?
- There is a new update with the permissions. We have to postpone our start of construction for another four months. How does this affect our investments?
- We need to adjust our assumptions about unit absorption as our competition across the street had a harder time replenishing their units than we originally thought. What does a slower absorption phase look like financially?
These questions and concerns arise every day when developing a new property. Because of this, a flexible, well-structured proforma can save you time, money, and numerous headaches in developing your project.
There are two parts to your development pro-form in which you spend time and effort in advance of your structure in order to save time later in the development process.
Know the right time
Create a schedule in your proforma that can be quickly adjusted as the schedules change.
At the beginning of a new construction project, developers usually have a general understanding of the project schedule. For example, you assume a planning period of four months and completion of the construction in 14 months. Despite early forecasts, the timing of projects keeps changing. In fact, it can take 18 months to build while the design only takes 2.5 months. You want your proforma to adapt quickly to these changes as the timing will affect your bottom line.
At the start of your pro forma program, use the Assumptions tab to create a timing section that feeds into your overall financial model. If the timing changes, there is a quick way to adjust this piece. If your cash flow timing is fed by these inputs, they will automatically adjust and save you hours of retooling your proforma.
Three essential elements for your pro forma development
Each proforma has three elements that guide its design, structure, and use. Whenever you have a new project in the books and faced with a mountain of untidy information, start with these three proforma elements and jump in.
Proformas are essentially models that show us what we think will happen in the future. They are based on many assumptions that are initially unknown. As a project develops, these assumptions are refined. Here are typical types of assumptions that drive a proforma.
- Timeline. When will the most important phases of the project begin, continue and end (typically: analysis, planning, construction, leasing, stabilization and disposition)?
- Costs. What hard and soft costs are associated with construction, planning, financing, etc.? Eventually, you may need a proforma invoice, which is a preliminary sales agreement.
- Sources and Uses. What is the financing structure and what is the money used for?
- General inputs. Which physical properties of the project are driving the development potential (number of units, lot size, zone restrictions)?
2. Cash flow
Once the assumptions are made, estimating cash flow is the next step. Below are the typical phases of a project to consider when creating this part of the proforma.
- Stem and construction. What are the costs of producing a finished building or area that can be rented or sold?
- Stabilization. If the property generates cash flow, what are the estimated income and expenses that will be incurred in operating the stabilized property?
- Arrangement. If you are looking to sell after stabilization, what is the expected final value and terms of sale?
Each development is analyzed over time with regard to its estimated return on investment. Returns enable the developer to understand the relative risk of a project and compare that risk to other investment alternatives. Typical returns for the proforma are:
- Internal rate of return (IRR)
- Net present value (NPV)
Proformas are always developed iteratively. They’re usually edited, updated, and refined as a project gains momentum and becomes more real. They go through a constant refinement and remodeling process. However, if you stick to the framework outlined above, this process can be easier to navigate and a lot less messy over time.
Create your own pro forma
Building investment grade development on a pro forma basis is a huge undertaking. It is something that is built in stages, torn apart, rebuilt, torn apart again and rebuilt again. Still, it doesn’t have to seem so daunting for one important point:
Every proforma starts somewhere – usually with a blank page.
There are a few strategies for starting and building pro forma development:
- Build from scratch
- Reuse an existing proforma
- Use a hybrid model
Building a proforma from scratch is time consuming, but a great way to understand the specifics of a potential project in minute detail. Don’t be overwhelmed by the need to get everything set up right away. Start with what you know and expand from there.
On the Assumptions tab, get what you already know, like site size and zoning. Then estimate a rough development and construction schedule and create a preliminary construction scope.
To reuse an existing proforma, follow a template created by someone or a company and customize it for your project. This strategy can backfire if you spend more time repairing and patching the template than it would create from scratch.
Pro forma templates usually have the greatest value in teaching you how to create your own model. To do this, use the proforma template as a reference, but create your own from scratch – a hybrid model.
The best way to implement this strategy is to find a high quality, well-built proforma and minimize that behind the scenes. When you come across 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 discover patterns, methods, tricks, and styles that you can then incorporate into your own modeling toolkit.
The most important thing about financial models is that they are not created overnight. It can be intimidating to want to develop a project but not know how to draw it properly. Since development is a high risk endeavor, proformas are essential to get the process started and mitigate the risk. So if you’re stuck getting your proforma off the ground, try one of the strategies above and jump in.