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Talking with Wayne Lemmon about his article: “Pro-Forma 101”

Note from PCJ Editor Wayne Senville: The following is from an interview I had with the late Wayne Lemmon in 2007 about his just published Planning Commissioners Journal article, Pro-Forma 101: Getting Familiar with a Basic Tool of Real Estate Analysis.

Wayne Lemmon

Wayne Lemmon: The proforma is the basic financial analysis that developers do in deciding whether to move forward with a project. A proforma analysis looks at the financial return that a proposed real estate development is likely to create. It begins by describing the proposed project in quantifiable terms, then estimates revenues likely to be obtained, costs that will have to be incurred, and the net financial return the developer expects to achieve.

Senville: In your article one of the areas you focus on is the impact of uncertainty on the rate of return developers look for in putting together a project. Why is uncertainty an important concern for developers, and why does it affect the needed rate of return?

Lemmon: Reward going with risk is basic to business economics, just like the laws of supply and demand. There are lots of investment opportunities available, including just keeping your money in the bank and earning cash returns. I’m willing to make a slightly riskier investment, say, in a mutual fund, if I can get a better return. I might be willing to take an even greater risk if the possible reward is even higher. The only way that I can contemplate a very high risk venture is if the potential pay-off at the end is equally high.

Developers have to decide how to use their money. A ready-to-go, pre-approved parcel can be bought anticipating modest but nearly certain returns. Where the ability to develop a property to its full potential is at risk and might not be achieved, the potential reward needs to reflect that, or the developer will redirect the investment elsewhere.

Senville: What sort of factors can increase uncertainty for a developer?

Lemmon: In the development process, uncertainty comes from not knowing the timetable for starting a project, the amount of development or size of the project that will be approved, and even if approval itself can be obtained. Sticking to a fixed procedural calendar and approval criteria reduces these risks. Opening up the approval process to new considerations and continuing the approval process over an extended time frame increases these risks.

Developers’ Complaints About the Development Review Process

Senville: I’ve heard developers complain that some communities are much harder to deal with than others in terms of the review and approval process. Are there things you’ve found that towns and cities can do to make development review go more smoothly?

Lemmon: Key elements are just as I mentioned — essentially “sticking to the rules.” Public comment and debate needs to have fixed closure times, and approval standards should not change in mid-process. Most builders will willingly work with high and even strict standards as long as they are reasonable and unchanging.

One thing that can help is having frank working meetings with the decision-makers early in the process. If the community’s objectives are known from the onset, a builder will typically try to work to fulfill them. Where problems occur is when a community is pursuing an anti-growth agenda using surrogate means, such as vague design criteria, agenda delays, or excessive environmental regulation.

In these cases, the communities are playing a game of obstructionism rather than dealing with the need to establish a clear and open policy on growth and land use. Everything always works better when policies are known, and the parties approach the process with clear and honest intentions.

Senville: From my own experience serving on a planning commission, and from what I’ve heard from other planning commissioners, there are also concerns that some developers are so focused on the bottom line that they fail to take into account the fact that they’re creating a residential community that will be there for decades to come. Is there anything local planners can do if they want to maximize their chances of getting high quality development? Do developer’s have a responsibility to the broader community they’re building in?

Lemmon: Builders come at all levels of competency and quality. Builders with a concern for their long-term image will tend to recognize a higher standard of performance, while smaller construction operations may be more tightly focused on the daily cash flow. Most of the larger regional and national builders today know that quality sells, and that quality is measured not only in the structures but in the community plan and the entire amenity that is being created. However, zoning laws and building codes are designed to enforce standards that meet minimum requirements, and a development plan that meets the minimums is legally entitled to be built.

In the long term, a builder does better by adhering to high standards, but for some builders, taking the long view is a luxury they can’t afford. At the same time, communities also have a responsibility to periodically review their standards to be sure they are producing satisfactory results. If a community is generally unhappy with projects that meet all legal responsibilities, then the responsibility falls to the town to tune up their requirements to better fit what it’s trying to achieve.

Testing Scenarios Through Use of the Proforma

Senville: One of the most fascinating parts of your article is your explanation of how the proforma can be used, as you put it, “to test other possibilities and ‘what if’ scenarios.” You then set out several different scenarios, including the impact of higher construction costs and the impact of delays in getting the project built — and what this can mean for the bottom line and the project’s financial viability. You also look at the impacts of including affordable housing in a project.

What was most interesting to me was how the proforma identified a way of having a “win-win” solution, where affordable housing could get built, yet the developer still could still make a sufficient profit to proceed. Can you briefly walk us through using a proforma to make this kind of analysis?

Lemmon: If you have any significant experience in development, even in the role of planning and review, you tend to know the factors that most directly affect a project’s profitability, and that is where your attention goes first. Factors such as land price, as well as density and development quantities are huge. Factors such as dollar-per-square-foot costs, while very important, are often slightly less significant because of possible savings elsewhere or other mitigating factors.

If you have a moderately sophisticated feasibility template as a computer system or as a spreadsheet, you can easily keep typing in test values in one factor while literally watching the bottom line to get a desired result. Of course, at the end of this testing, you still have to satisfy yourself that your assumptions or test values are realistic, and that you’re not pinning your hopes for the project on some windfall savings in costs or some other big “IF” that has little likelihood of actually being achieved.

One example of this type of analysis is called solving for “residual land value.” This is where you set your target for rate of return as “fixed,” along with your best estimates of sales values and construction costs, and then vary the land purchase costs so that you achieve your target return. This tells you what value the land has in order to achieve the development project envisioned in the proforma, and this type of analysis is typically done while conducting negotiations for purchasing the site. In a constrained market, you can also set a fixed return target, and vary your sales price assumptions to test for the lowest possible prices that you are willing to accept.

Proforma analysis is just a tool, but a very powerful tool. With skill and creativity, balanced by sober reality checks, you can find your way out of a tight situation, or identify new opportunities.

Editor’s Update: I’m sorry to have to add this note that Wayne Lemmon passed away on January 4, 2009. He was a smart, articulate planner and real estate market researcher. I knew Wayne since the mid-1980s via CompuServe’s “lawsig” forum (moderated by the late Perry Norton) and then through his frequent comments on draft articles submitted for publication in the Planning Commissioners Journal. Wayne also served for many years as a member of the Planning Commissioners Journal’s editorial advisory board.