Editor’s Note: see also my discussion with Wayne Lemmon about his article.
Planning commissioners frequently find themselves wishing they knew more about how real estate development really works in terms of dollars and cents. If members of the board had a better appreciation for the push and pull of costs and income, time and risk, and how changing one factor can affect a whole domino chain of other factors, the entire process of real estate development would be more understandable.
To achieve a minimum level of “literacy” about the economics of development requires at least a navigational knowledge of the basic tool of real estate feasibility analysis — the proforma. A proforma analysis is a set of calculations that projects the financial return that a proposed real estate development is likely to create. It begins by describing the proposed project in quantifiable terms. It then estimates revenues that are likely to be obtained, the costs that will have to be incurred, and the net financial return that the developer expects to achieve.
The proforma is the basic “go / no-go” analysis that developers use to decide on whether to move forward with a project. There are few “absolutes” as to how such analyses can be constructed, but there are common practices and techniques that nearly all proformas attempt to provide in one form or another.
By way of a basic introduction to this subject, I have created a simple case study proforma analysis for a hypothetical residential subdivision. Figure 1 shows a simplified summary table from this generic case study. We’ll use this as a guide as we consider some of the challenges developers face in putting a project together — and how several key variables can affect the overall success of the project.
Part 1: What is being proposed?
The first thing that has to be done is to set out in quantifiable terms just what is being proposed to be built. This might take the form of a table of rentable floor areas for a retail center, office building, or warehouse; the number of rooms by type of room for a hotel; or, as in our example, the number of houses by size and model in a residential subdivision.
Architects refer to this as the project’s “program.” This tabulation also sets out the non-income producing space for things like parking, lobby areas, mechanical and utility rooms, and other support space. The quantities of floor areas, spaces, dwelling units in this table are used as the basis for calculating sales or rental income, as well as construction costs.
For our example case study, our hypothetical developer will probably have in mind a group of home plans that may have been used in other communities. The builder can’t precisely anticipate exactly how many units of each plan will be bought, so simple totals and averages can be used. Let’s assume that this project will include a total of 50 homes, and that overall, the home plans are likely to average about 2,200 square feet of finished space, for a total of 110,000 square feet of finished built space project-wide.
Part 2: What revenues will be generated?
To answer this question, the developer will have performed a market analysis that recommends appropriate rents, charges, or sales values. The developer’s experience will also come into play, drawing on knowledge of what comparable projects obtained in rents or sales. The developer may answer this question with a highly detailed market study, or simply pencil in the values being used at another nearby project.
In the example illustrated here, we are proposing to build a 50-unit housing subdivision. The sale prices will vary with each house plan according to each model’s size and features, but in our imaginary market, the homes could be expected to command base prices generally ranging in the high $300,000′s. After adding in estimates and allowances for premiums on choice lots, and customer-selected options and upgrades, the homes in our hypothetical project are shown at the top of Fig. 1 as averaging a total price of $400,000 per unit, generating $20 million in gross sales revenues.
… article continues over next 9 pages with a close look at the various line items that make up the proforma analysis; and then a look at how the proforma can be used to analyze alternative scenarios.