What are the key steps in preparing a pro forma for a project?
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The first step in preparing a pro forma is to define the assumptions that will drive the financial model. These include the market conditions, the project scope, the construction costs, the financing terms, the operating expenses, and the revenue sources. You should research and validate these assumptions using reliable data sources, such as market reports, comparable sales, appraisals, bids, and contracts. You should also document and justify your assumptions, as they may be challenged by lenders, investors, or regulators.
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Don't forget to include marketing costs and a contingency buffer. Many developers forget to include a proper marketing budget in their proformas so after they've spent years and hundreds of millions getting a project built, they run out of money to actually market and sell the properties! Ask real estate marketing and sales experts to create a proper budget to include in the pro forma so you don't get stuck sitting on product after it's built!
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Don't be afraid to ask the construction experts their take on labor and material costs and the lead times they are experiencing in the market you are considering; one of the main questions; the use of union trades v. non-union or a mix of both; all of this will be factored into the timeline, and as we know; time is money on any project.
The next step is to build the cash flow statement, which shows the inflows and outflows of cash over the project's life cycle. The cash flow statement has three main components: the development phase, the stabilization phase, and the exit phase. The development phase covers the pre-construction and construction periods, when the project incurs costs for land acquisition, entitlements, design, permits, financing, and construction. The stabilization phase covers the lease-up or sale of the project, when the project generates revenue from rents, fees, or proceeds. The exit phase covers the end of the project, when the project pays off the debt and distributes the profits to the equity partners.
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Under estimating contingency for both hard and soft costs is essential. If adequate contingency makes the project’s returns too thin, than the project is too thin.
The net operating income (NOI) is the income that the project generates after deducting the operating expenses. The NOI is a key indicator of the project's profitability and value, as it reflects the cash flow that is available to service the debt and pay the equity returns. To calculate the NOI, you need to estimate the potential gross income (PGI), which is the income that the project would generate if it was fully occupied and charged market rents. Then, you need to subtract the vacancy and credit losses (VCL), which are the income losses due to vacancies or non-payment of rents. Finally, you need to subtract the operating expenses (OE), which are the costs of maintaining and managing the property, such as taxes, insurance, utilities, repairs, and administration.
The debt service is the amount that the project pays to the lender for the loan principal and interest. The debt service depends on the loan amount, the interest rate, the amortization period, and the loan term. To calculate the debt service, you need to use a financial calculator or a spreadsheet formula that can compute the periodic payments based on these variables. You also need to account for any fees, points, or reserves that the lender may charge or require.
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Be sure to include your CFO in this important piece of the puzzle; he/she will hopefully include you in on a call to any of the stable of lenders considered for the project to get their take on rates and terms as well as the feasibility of obtaining financing.
The equity returns are the amount that the project pays to the equity partners for their investment. The equity returns depend on the equity contribution, the profit distribution, and the exit strategy. To calculate the equity returns, you need to use metrics such as the cash-on-cash return (COC), which is the annual cash flow divided by the equity contribution; the internal rate of return (IRR), which is the annualized return that equates the cash inflows and outflows; and the equity multiple (EM), which is the total cash flow divided by the equity contribution. You also need to account for any preferred returns, waterfalls, or hurdles that may affect how the profits are split among the equity partners.
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Here is where the rubber meets the road; when you have reached this stage your model should be data checked a few times to ensure that the numbers produced are accurate; when calculating returns; oftentimes numbers get "massaged" a bit; due a gut check at this juncture as it really needs to pass the "sniff" test. Discuss your results with your CFO first before it is brought in to the Development Team to ensure his/her buy-in first.
The final step is to review and refine the pro forma, by checking its accuracy, consistency, and sensitivity. You should verify that all the calculations are correct, that all the assumptions are realistic and aligned, and that all the inputs and outputs are clear and logical. You should also test how the pro forma changes under different scenarios, such as changes in market conditions, project scope, financing terms, or exit strategy. You should identify and mitigate any risks or uncertainties that may affect the project's performance or viability.
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see above comments; the different scenario tests performed here are truly "stress tests" and are critical to green lighting any project; don't underestimate your role in this pivotal juncture.
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Current accurate market research is crucial. A new project often out perform comparable projects. But when planning a project realistic revenue assumptions based on a clear understanding of the market is crucial. Revenue assumptions will be the first variable questioned by potential lenders and investors. Revenue assumptions must be realistic and clearly supported.
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