Pro Forma means “as a matter of form”
At Camoin Associates, we think about real estate development project feasibility as having three critical components:
- Market Feasibility – is there market demand for the types of uses proposed?
- Community Feasibility – does the community support this project?
- Financial Feasibility – will the financial return on the project justify the investment?
A project needs to have all three of these components to be successful. This article focuses on the third component, financial feasibility, and provides an overview of how pro forma statements are used to determine whether a project makes financial sense.
What is a pro forma?
In its most basic sense, a pro forma statement (or pro forma, for short) is a set of calculations that projects the financial return that a proposed real estate development is likely to create.
Whether you’re building a pro forma scratch or you’re reviewing one created by a real estate developer, it’s important to remember that you’re trying to predict the future. A pro forma is built around a slew of assumptions, which require a substantial amount of market research to accurately develop. Logical, well-researched assumptions make a pro forma defensible. Understanding the impact of each assumption on the pro forma is critical.
Why build a pro forma?
Pro formas are primarily used by real estate developers to project their future cash flows over time, quantify the return on investor equity, and identify where financial risks may arise. But, they are also a useful tool for the public sector to understand why private investors have not stepped in to undertake a project and quantify any funding gap they may need to be filled in order to incentivize private investment. Basic pro forma modeling can help the public sector work better with developers to understand the financial barriers to a successful project and spearhead the public-private partnerships needed to make the project happen.
Pro Forma Checklist
This checklist will help you understand all the assumptions that go into the process:
Land and Site Information
- Land Acreage
- Land/Building Acquisition Costs
- Demolition Costs
- Environmental Remediation Costs
- Hazardous Materials Abatement Costs
- Sitework Costs
- Gross building area and rentable building area by use type (square footage and/or unit count)
- Construction costs (hard and soft) per square foot
- Lease structure – gross lease, triple net lease, other?
- Rent per square foot
- Average square feet per unit
- Stabilized vacancy rate
- Operating expenses – taxes, insurance, management, maintenance, utilities, and repairs
- Income and expense growth factors – by how much will income and expenses grow each year?
- Market absorption (or “lease-up”) rates by use type – time to stabilized occupancy
- Sources and uses of capital
- Loan terms – loan to value ratio, interest rate, amortization period, fees
- Capitalization rate – used to estimate the market value of a property at the end of the holding period based on the net operating income generated
- Sales commission rate
Building the Pro Forma
Once you have all of your inputs, the pro forma model can be built. All these assumptions are arranged into a spreadsheet that models cash flows. Cash flows are typically separated into three categories: development costs, operating cash flows, and financing cash flows.
- Development costs are the hard and soft costs associated with acquiring a site and constructing a building.
- Operating cash flows consist of the anticipated rental income generated from the property and the expenses associated with operating it.
- Financing cash flows show the timing of investor equity and loan proceeds, as well as debt service payments.
Your pro forma should show on an annual basis all cash flows associated with the project. It is typically assumed for the purposes of modeling that the property will be sold at the end of the modeling period, often 10 years.
Evaluating Financial Feasibility
To determine if a project is feasible, two main measures are used:
- Internal Rate of Return (IRR): Measures the return to an investor/developer based on initial investment and projected income. Used to assess whether the return generated is worth the risk of undertaking the project to an investor. If the IRR is below the investor’s target rate of return, the project is not feasible and will require subsidy from other sources. A common “rule of thumb” minimum value for IRR is 15%, though each project has a different risk profile and should be evaluated accordingly.
- Debt Service Coverage Ratio (DSCR): Compares the net operating income of a project to the required debt payments. This metric is used by lenders to determine whether the project will generate enough cash to cover loan payments. Typically, 1.25 is used as a minimum ratio, meaning that net operating income must be at least 1.25 times the debt payment in order for a bank to consider financing the project.
Pro forma analysis is a useful tool for the public sector to understand how developers make decisions on whether to invest in a certain project. Understanding the assumptions that go into creating a pro forma and becoming familiar with real estate jargon can go a long way in negotiating successful public-private partnerships with the development community.
If you are looking for case studies of projects where the public sector used pro forma analysis as part of the planning process, check out Durkee Street in Plattsburgh, NY (https://www.camoinassociates.com/durkee-street-real-estate-market-analysis) and Union Avenue in New Haven, CT (https://www.camoinassociates.com/market-demand-feasibility-study-meadow-st-new-haven-ct).