A development pro forma is a document projecting the cash flow for a project, including all expected returns and expenses. Pro forma is essential to help developers and investors understand the feasibility and profitability of a build, and is necessary to calculate key financial metrics such as net operating income, cap rate, or overall cash flow. Developers need pro formas to evaluate the cost fundamentals on a project and demonstrate potential returns to investors who will be providing capital to fund the project.
Putting together a pro forma can be a complicated process, and common obstacles include inaccurate assumptions, outdated tools, or fragmented workflows. Evaluating the financial outlook for a project shouldn’t be done with gut assumptions or unreliable data gathered through an ad-hoc process. Teams who rely on outdated and error-prone tools that silo key parts of the process will be at higher risk for derailed budgets or timelines. Modern pro forma software can help bring underwriting and deal management together into one platform that centralizes assumptions, automates forecasting, and replaces static spreadsheets with real-time, version-controlled models. Northspyre Deal is a purpose-built solution that helps teams improve the speed and reliability of financial analysis, allowing you to model and compare different scenarios with cash flow forecasts and financial analysis.
In this blog, you’ll learn the ins and outs of development pro forma, with the strategy-driven steps you need for set-up, risk planning, and validation:
Laying the Foundation for Your Development Pro Forma
As you lay the foundation for your development pro forma, it’s important to understand the core assumptions – land costs, rents, cap rates, timelines, and cost structure. Here’s a closer look at the role each plays in building out your document:
- Land Costs: Land costs include the purchase price of land, as well as associated costs such as environmental remediation, utility installation, and taxes. This is crucial for understanding your project’s ultimate yield on cost.
- Rents: Rental income, which should be calculated as part of your market research, includes projected occupancy rates, lease terms, and rental rates for similar properties and demographics
- Cap Rates: The cap rate on a property is calculated by dividing the Net Operating Income (NOI) by property value and should be included as part of your pro forma process. You can determine the cap rate based on projected income and costs
- Cost Structure: The cost structure on a property includes both operating expenses, such as property management, utilities, and upgrades, and capital expenditures. Be sure to include both recurring and non-recurring costs in your analysis.
Pro forma’s can also be adjusted to your unique use cases, and may vary between asset classes. Here are a few ways your approach to pro forma may change based on the asset class you’re pursuing:
- Single Family Development Pro Forma: Single-use buildings will have a simpler pro forma, but will need to include detailed construction cost information as well as sales estimations for going rates on single family homes in the geographic area where you’re deciding to build
- Mixed-Use Development Pro Forma: Mixed-use development pro forma will be more complex, as the inclusion of residential, office space, retail, or other commercial space means the buildings will have various revenue streams
When you’re compiling baseline data as part of the underwriting process, using a standardized format is key. Northspyre’s Deal Management platform offers functionality to build standardized, shareable models that improve alignment and reduce setup time. Deal management software can be a key strategy for de-risking pre-development projects, automating underwriting workflows and unlocking performance insights and benchmarks necessary to ensure every project performs better than the last.
Highlighting Common Pitfalls
Compiling a pro forma can be a complex process, and you should be on the lookout to avoid a few frequent errors, such as underestimating soft costs or skipping inflation forecasts. Underestimating costs outside of materials and labor can cause your budgets to run over. Inflation forecasts are more essential than ever in the current economy, and ignoring larger market forces can also have a negative impact on your budgets or timelines.
The ability to gather and leverage accurate, up-to-date data is critical for your firm to make accurate forecasts that include hard and soft costs, and to include market shifts in your budgeting scenarios. The current market is especially volatile, and you should be sure to track trends in development when making your pro formas and forecasts.
What to Include in a Development Pro Forma
Most development pro forma will include several key categories. Here are the basic inputs you should include in your development pro forma structure:
- Land acquisition: Finding the right location for your property means evaluating the cost of land, and staying aware of any zoning or regulatory issues that may arise around the land acquired. Be aware of any additional costs related to rezoning, or land remediation.
- Hard and soft costs: Hard costs are anything related to the physical development of a property, such as the physical materials required in the construction of a project, as well as the vendors required to do labor on a project. Soft costs are all of the costs that occur outside of the hard costs of a project, such as professional services or regulatory fees.
- Contingency: Your contingency is the amount of budget set aside to cover unforeseen costs or site conditions. Developers will typically include about 5-10% contingency in a hard cost budget.
- Financing terms: Included in your pro forma will be the financing terms, including the debt and equity required to fund a project, including the loan amount, interest rates, repayment schedule, and any other associated costs such as origination fees
- Lease-up assumptions or absorption: Pro formas will typically include an estimate on how quickly a development will be filled with tenants including associated rental rates, potential downtime, and tenant improvement and leasing costs. Market research is essential for getting a clear picture of how well a property might perform
- Operating expenses and income: You’ll need to include the operating costs for the property, such as property managers, building upkeep, and rental managers in your pro forma
- Exit cap and terminal value: The exit cap rate, also known as a terminal cap rate, is the estimate of the property’s value at the end of the investment holding period, usually when sold. Exit cap rate is found by dividing the projected net operating income by the expected sales price.
Incorporating Risk Assessment and Collaborative Workflows
It’s crucial to incorporate risk assessment into your pro forma process. If you are able to identify budgeting risks and setting up scenario planning, you’ll be able to avoid many of the common pitfalls. The risk assessment process requires identifying different potential hazards, assessing the likelihood each scenario could occur and then identifying strategies to mitigate or eliminate identified risks. Building assumptions into different risk-adjusted outcomes, such as base expectation or best or worst case scenario planning, is also a best practice for developers.
Risk assessment and planning will be more effective when it’s built into your interdepartmental collaboration. Ensuring your team has open and transparent communication among stakeholders makes it easier to share relevant information and address concerns in a timely manner. Technology can play a big role in facilitating risk-mitigation and collaboration across your team. Northspyre’s deal management platform has functionality to support scenario planning and collaborative input tracking across your team. With sensitivity analysis functionality, you can stress test different scenarios with dynamic sensitivity tools so you understand the impact on returns. Meanwhile, you can boost organization-wide collaboration by centralizing deal activities into one place and ensuring everyone – from analysts to executives – are accountable for your deal pipeline.
Tips for Team Alignment
Keeping your team aligned throughout the acquisitions process is essential for ensuring budgets and timelines stay on track.
- You should schedule weekly financial planning and scheduling meetings to make sure all team members are aligned. Establishing a collaborative review process can improve forecasting accuracy, allowing you to make sure team members are leveraging the same data and insights to make decisions and move forward in the right direction.
- Project alignment can also be improved with a shared tool for project communication that allows you to work through obstacles and prevent bottlenecks from derailing your deal. When deal information is decentralized your analysts can spend hours searching spreadsheets, emails, or other files to keep leadership up to date.
- Leadership will also benefit from a centralized dashboard, preventing wasted time searching through inboxes or waiting on updates from team members. Instead, everyone will be able to remain accountable for their individual tasks in the data pipeline.
Explore how a Northspyre Deal can help you make process improvements and get your team on the same page.
Finalizing, Validating, and Refining the Pro Forma
Development pro forma validation is the final step in the process, and will require validating assumptions using current data and advanced real estate deal management software that integrates live cost data. Northspyre Deal can help you iterate as costs, timelines, or financing changes occur, allowing your team to remain nimble even as variables change and your forecast needs to be updated. Real-time dashboards that stay updated with your team’s most recent data can play a key role in helping you get yoru pro forma over the finish line while ensuring accuracy. You’ll also be able to turn your data into a proprietary database of historical and cost data to to inform future investment decisions.
Quality Checks and Integration
The final step of your pro forma process will be conducting quality checks and integrating any of the other tools in your existing tech stack. Here are a few of the key quality controls you should include as you compile your pro forma:
- Peer Reviews: Peer reviews are external consultants who ensure pro formas are accurate, consistent, and in compliance with necessary accounting practices and regulatory requirements
- Audit Process: Audits are essential for your pro forma model to verify the underlying assumptions, calculations, and data used in your financial projections
- Automation Tools: Automation can improve both the efficiency and accuracy of your pro forma modeling reducing the risk of human error and ensuring your data is up to date. Integrating real-time systems to reduce manual errors and keep your documents and data up to date will be helpful for your system.
Real estate model accuracy is important for making sure your pro forma predicts the costs and profitability of your real estate investment. Leveraging technology to complete your quality checks will be essential for ensuring a high level of success.
Development pro forma modeling can be completed in several key steps; compiling your foundational inputs, conducting thorough risk planning and implementing tools to mitigate potential pitfalls, and validating your data for quality control purposes. When your team has access to an up to date, pro forma simple forecast, you’ll be able to boost your firm’s ROI by providing solid financial planning, improved decision making, and the ability to evaluate performance. A well-developed pro forma can improve investor confidence, facilitating your ability to secure funding and repay loans.
Learn more about how Northspyre’s centralized deal management platform can help your team bring underwriting and deal management together in one easy-to-use system.
