You will find that any real estate investment, either development or acquisition, will involve a “pro forma” financial analysis.
In this article we will discuss:
- what is a pro forma
- why the pro forma is important
- And – if you work with real estate investors – why understanding the pro forma matters to you!
What is a pro forma?
Pro forma is defined as “based on financial assumptions or projections”, according to Miriam-Webster. In the world of real estate the pro forma analysis – pro forma for short – is a financial analysis tool that helps an investor think about the future potential of a project. The pro forma is always looking into the future.
The pro forma analysis is made of four basic parts:
- revenue
- expenses
- time
- risk
At the most basic level, the pro forma will include revenues minus expenses over a period of time. Risk will be included as a factor of all assumptions made about future cash flows. Most pro formas are built in spreadsheet computer programs, but you can also make a pro forma on a sheet of paper or using a sophisticated computer program like ARGUS that is made for real estate analysis.
Revenue includes all inbound cash flow including things like rent and sales proceeds. There are other forms of revenue as well, such as leasing fees, parking fees, and other forms of property income, but the bulk of the annual revenue in a real estate asset will come from rent.
Expenses are the capital and operating expenses of a property. Capital expenses include cost of new construction, cost of upgrades to an existing building, and replacement of building components like the roof or HVAC system. Operating expenses include the cost to keep the building running including maintenance, taxes, utilities, and management expenses.
Time is included in the pro forma analysis both in the duration of analysis as well as the timing of certain events. The duration of analysis can be measured in months or years. A typical pro forma spans a ten year period. Timing can also have a huge impact on the proforma. Timing of items like when construction is complete, when a property is refinanced, when a major tenant moves in or leaves, and when a project sells, all matter.
Risk is a part of many of the inputs in a pro forma and can show up as a growth rate, certainty of a change, and magnitude of a change. These are all assumptions that can have a large impact on an analysis. Growth can include how your rental rates or expenses change over time including positive growth and negative growth. Certainty can include the likelihood of a future event taking place, such as a new tenant moving in, an existing tenant staying, or the timing or rent and expense changes. Certainty can increase if there is a contractual obligation for an event, like a rent increase, duration of a lease, or service contract. Magnitude risk could include fluctuations in a sale price or cap rate as well as changes in future expenses like construction cost.
Why is a pro forma important?
A pro forma will be required any time a financial transaction is evaluated. A developer wants to understand the potential performance of delivering a new project. When putting together a development idea, the development team can also build multiple versions of the pro forma to analyze different project types for a given site.
A pro forma is also a critical communication tool when other investors are involved. A bank or equity investor will want to understand how their money will perform and what it will be used for. They will also want to have a good understanding of the risks and assumptions involved in the deal.
Pro formas and consultants
If you are a consultant in the A/E/C industry working with development and investment clients, understanding the pro forma is critical. As a consultant you may be asked to provide input assumptions for the pro forma. These assumptions could include cost of construction or future market rate assumptions.
If you are not involved in helping to build the pro forma, it is also critical that you understand the pro forma. All A/E/C consultants can impact the project through four levers of value. All of those tie back to the pro forma. Take time to understand your clients assumptions and goals. Make sure you understand their business and how you can provide value. If you don’t know how a design change impacts your clients pro forma, you can always ask!
Conclusion
You will find that there is an art and science to a pro forma analysis. The format and math involved can be pretty straight forward. However, the inputs typically involve a lot of gut feeling and personal conviction.
If you are interested in learning more about how pro formas work, you should build your own! I recommend you pick a real project you are familiar with and start building. When you hit a roadblock, reach out to colleagues who are familiar with the project inputs. If you don’t know someone who knows the answer, make a new friend. Most people enjoy explaining their work to others. When in doubt you can also search YouTube.
If you have any questions on how to start, feel free to reach out at [email protected]!
