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F E AT U R E

Proforma 101GETTING FAMILIAR WITH A BASIC TOOL OF REAL ESTATE ANALYSIS

by Wayne A. LemmonEditor’s Note: As a planning commissionerI’m sure you’re used to rolling up yoursleeves and getting to work when yourboard meets. I urge you to take the sameattitude in working your way through thislengthy, but highly rewarding, article byreal estate market economist Wayne Lem-mon. Don’t be put off by all the numbersand calculations. If you take the time, you’lllearn a lot – especially if, like many citizenplanners, you’re not very familiar with theworld of development economics.

Planning commissioners fre-quently find themselves wishingthey knew more about how real estate development really worksin terms of dollars and cents. Ifmembers of the board had a betterappreciation for the push and pullof costs and income, time andrisk, and how changing one factorcan affect a whole domino chainof other factors, the entire processof real estate development wouldbe more understandable.

To achieve a minimum level of“literacy” about the economics ofdevelopment requires at least anavigational knowledge of thebasic tool of real estate feasibility analysis– the proforma.

A proforma analysis is a set of calcula-tions that projects the financial returnthat a proposed real estate developmentis likely to create. It begins by describingthe proposed project in quantifiableterms. It then estimates revenues that arelikely to be obtained, the costs that willhave to be incurred, and the net financialreturn that the developer expects toachieve.

The proforma is the basic “go / no-go”analysis that developers use to decide ongoing forward with a project. There arefew “absolutes” as to how such analysescan be constructed, but there are com-

used as the basis for calculating sales orrental income, as well as constructioncosts.

For our case study, our hypotheticaldeveloper will probably have in mind agroup of home plans that may have beenused in other communities. The buildercan’t precisely anticipate exactly howmany units of each plan will be bought,so simple totals and averages can beused. Let’s assume that this project willinclude a total of 50 homes, and that thehome plans are likely to average about2,200 square feet of finished space, for atotal of 110,000 square feet of finishedbuilt space project-wide.

PART 2: WHAT REVENUESWILL BE GENERATED?

To answer this question, the developer will have per-formed a market analysis thatrecommends appropriate rents,charges, or sales values. Thedeveloper’s experience will alsocome into play, drawing onknowledge of what comparableprojects obtained in rents orsales. The developer may answerthis question with a highlydetailed market study, or simply

pencil in the values being used at an-other nearby project.

Gross Sales:In the example illustrated here, we are

proposing to build a 50-unit housingsubdivision. The sale prices will varywith each house plan according to eachmodel’s size and features, but in ourimaginary market, the homes could beexpected to command base prices gener-ally ranging in the high $300,000’s. After adding in estimates and allowancesfor premiums on choice lots, and cus-tomer-selected options and upgrades, the homes in our hypothetical project are shown at the top of Fig. 1 as averag-ing a total price of $400,000 per unit,

PART 1: WHAT IS BEING PROPOSED?The first thing that has to be done is

to set out in quantifiable terms just whatis being proposed to be built. This mighttake the form of a table of rentable floorareas for a retail center, office building, orwarehouse; the number of rooms by typeof room for a hotel; or, as in our example,the number of houses by size and modelin a residential subdivision.

Architects refer to this as the project’s“program.” This tabulation also sets outthe non-income producing space forthings like parking, lobby areas, mechan-ical and utility rooms, and other supportspace. The quantities of floor areas,rooms, or dwelling units in this table are

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mon practices and techniques that nearlyall proformas attempt to provide in oneform or another.

By way of a basic introduction to thissubject, I have created a simple casestudy proforma analysis for a hypotheti-cal residential subdivision. Figure 1 onthe next page shows a simplified summa-ry table from this generic case study.We’ll use this as a guide as we considersome of the challenges developers face inputting a project together – and how sev-eral key variables can affect the overallsuccess of the project.

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generating $20 million in gross sales revenues.

Less Commissions, Fees:

These revenues will be reduced, how-ever, by the costs of selling the homes.Sales commissions will need to be paid tosales agents who may be part of a realestate agency contracted to market theproject, or in-house sales staff, or inde-pendent realtors who bring customers tothe project, or some combination of all ofthese. Legal fees, closing costs, and other“transactional” costs also have tobe deducted from gross revenues.In Fig. 1, we are assuming thatcommissions and fees couldamount to $800,000 leaving NetProject Revenues of $19.2 million.

PART 3: WHAT WILL IT COSTTO BUILD THE PROJECT?

Here, as the saying goes, iswhere the plot thickens.

Land Acquisition:

We can begin with the pur-chase of the land itself, the pricefor which is the result of purchasenegotiations. In complex jointventures, the land owner maybecome a partner in the projectand enjoy a share in the project’sprofits, or take a percentage ofsales. On the other hand, astraight sale for a fixed price is asimpler deal and doesn’t dependon the developer’s performance.

In our case study, the land pur-chase is a simple cash deal withthe land price calculated at$50,000 per home or $2,500,000total. As with any real estate pur-chase, there are likely to be broker andlegal fees, closing costs, and taxes. Forour example, we’ll assume these itemswill add $75,000 to the deal. Under Pro-ject Costs in Fig.1, Land Acquisition isshown as costing $2,575,000.

Planning, Design, & Approvals:

There is then the part of the develop-ment process that is the most visible tomembers of planning commissions. Thisis the planning and approval stage whereconceptual plans for the project are ini-tially created, and quite likely refined and

revised in greater levels of detail as morebecomes known about the site.

During this stage, the developer willengage the services of surveyors, plan-ners, architects, civil engineers, as well asspecialists such as environmental andtraffic engineers. All of this informationmust be assembled and used to create aworkable and marketable plan for theproject, which must then be submittedwith supporting documentation to thelocal planning department.

depending on how the approval proce-dures unfold, actual costs could easilyvary from this estimate.

So far in our project, we have budget-ed over three million dollars, and noth-ing has yet been built. Estimatingphysical construction costs is the nextstep.

Sitework & Building Construction:

Physical construction costs associatedwith the land include rough grading andclearing, constructing roads and utilities,

as well as drainage and environ-mental protection features. Pro-ject sitework costs are highlyvariable, and depend on theunique conditions of each site.These costs are typically estimat-ed with the use of sophisticatedcomputer programs that calcu-late the volume of earth to bemoved, lengths of roads and util-ity lines to be built, and other siteengineering improvements thatwill be needed. For our casestudy, we are assuming Siteworkcosts of $2,850,000.

We next estimate the cost ofconstructing the buildings.Architects, engineers, and con-struction managers can basetheir estimates on detailed histo-ries about what similar projectshave cost to build. For larger,more complex projects, a costestimator (an individual analystor even a professional estimatingservice) may be engaged, usingspecialized computer programsthat calculate the precise quanti-ties of wall siding, windows, tons

of concrete, lengths of pipe and wiring,numbers of plumbing fixtures, and everyother item called for in the project plans.

Developers, however, also have theirexperience from recent and current pro-jects that can be summarized as a total,inclusive cost per square foot (or cost perunit). They will rely on the sophisticatedcosting analyses described in the preced-ing paragraph to verify this cost persquare foot number, and to flag anythingthat might be different about this project.

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Figure 1

Pro-Forma Summary : Hypothetical Residential Subdivision

Project Revenues

Number of Units 50Average Sale Per Unit $ 400,000Gross Sales $ 20,000,000Less Commissions, Fees - $ 800,000_________Net Project Revenues $ 19,200,000

Project Costs

Land Acquisition $ 2,575,000Planning, Design & Approvals $ 600,000Sitework & Building Construction $ 12,175,000Amenities, Off-Site Costs $ 100,000Management & Overhead $ 1,760,500_________Total Project Costs $ 17,210,500

Net Cash Flow Before Financing $ 1,989,500

Financing Interest $ 1,102,400

Net Cash Flow to Developer $ 887,100Cash Investment $ 1,020,600Total Cash-On-Cash Return 86.9 %Annualized Cash-On-Cash Return 19.9 %Internal Rate of Return 22.4 %

If additional information or revisionsto the plan are called for, the services ofthese professionals may have to beextended. For larger projects, developersare also likely to employ the services of alawyer who specializes in land useapproval procedures. In addition, thereare filing and application fees charged bythe local government.

All of these costs can mount up to asignificant amount of money. For ourcase study, we have estimated Planning,Design & Approvals at $600,000, but

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In our example, we will assume avalue of $65.00 per square foot for thebase construction cost. After adding incosts for providing homebuyers’upgrades, selections, and options, thetotal costs for building the homes them-selves are estimated as $8.0 million.

There are also indirect costs and fin-ishing costs that are incurred when thehome is nearing completion. These costscan include such things as permit andinspection fees, final grading, landscap-ing, drives and walks, and hooking upwater and sewer lines. Like other sitecosts, these costs are estimated in detailby site engineers, based on the uniquecharacteristics of each site. We are esti-mating these indirect and finishing costsat $1,325,000.

With all of the above costs combined,the total for Sitework and Building Con-struction in our case study project isestimated at $12,175,000. See Fig. 1.

A couple of observations are notewor-thy before moving on. Earlier, we estimat-ed the costs to actually build the homes tobe $8 million. This is to say, the base“bricks and sticks” cost to build thehomes in our project is only about two-thirds of the total physical constructioncosts for this project – and less than halfof what we will eventually estimate as thetotal project costs. If you are not familiarwith development economics, you maybe surprised to learn that the costs of build-ing construction are often less than half ofwhat it costs to complete a development pro-ject.

Note also that the combined total ofLand Acquisition, Planning Design, &Approvals and Sitework in our project isestimated at just over $6 million. Thisindicates that the costs just to acquire,enable, and prepare the site are expected tocost roughly two-thirds what it will cost toconstruct all the units.

While the ratios just mentioned canvary widely from project to project andare not meant to be regarded as a stan-dard, they do fall within the range ofcosts typically encountered in manydevelopment projects.

Amenities & Off-Site Costs:

There are still more costs to be esti-mated. Projects frequently have featuresthat do not directly generate sales orrents, but are needed for the project to beattractive. In commercial projects, thesemight include plazas, fountains, or otherpublic space amenities. In large residen-tial subdivisions, such facilities mightinclude clubhouses, activity centers,pools, and even golf courses.

Our example project, with only 50units, will initially budget for more mod-est amenities including playgrounds anda system of walking trails, for a total costof $100,000.

For some projects, the developer isasked to pay for improvements that arenot actually part of the site. Suchimprovements might be needed to easetraffic at a nearby intersection, enhance asewage treatment plant, or enlarge awater main. No such off-site costs areincluded in our base scenario, but wewill look at how costs for amenities andoff-site improvements affect profitabilitylater as we look at alternative scenarios.

Management & Overhead:

And the costs keep on coming. At thispoint, we come to a group of costs thatcan be categorized as Management &Overhead. A large, multi-project builderwill have production managers, sitesupervisors, sales managers, and salesand clerical staff on the payroll. Many ofthese people will move from project toproject as communities sell out and newones open. Some supervisory staff maybe overseeing more than one project,allocating their time between the differ-ent jobs.

There are also additional services andexpenses – everything from providingtemporary toilets, to relocating andrefurbishing sales and construction officetrailers, to printing sales brochures andplacing advertisements.

Costs of this nature tend to be a com-bination of: (1) fixed lump sums (i.e. thecost for a site model or sales display),and (2) expenses that continue as long asthe project is under development (i.e.utility costs, supervisory staff). Of partic-

Proforma 101continued from previous page

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ular note is that this second categoryincludes items that are time-sensitive. Forexample, the longer the project takes tocomplete, the longer on-site staff and ser-vices will be needed (and their costsincurred). This can happen if, for exam-ple, the market slows down and thedevelopment takes longer to sell out.

Another form of Overhead that occurswith larger, multi-project builders isreferred to as “corporate overhead.” Thisis the allocation of central corporate costs(administration, office expenses, and cen-tral administrative services) among thevarious projects underway. Every builderdeals with the concept of corporate over-head in a unique way that suits its respec-tive administrative and accountingrequirements. In our case study, we’llassume that corporate overhead is calcu-lated as a fixed percentage of sales.

In Fig. 1, you’ll see that for our pro-ject we have estimated Management &Overhead (including corporate over-head) at $1,760,500.

Total Project Costs:

We can now estimate what it will costto build our proposed project. As seen inFig. 1, the total of Land Acquisition;Planning Design, & Approvals, Sitework& Building Construction; Amenities &Off-Site Costs; and Management & Over-head, is indicated as Total Project Costs,at $17.2 million

PART 4: HOW MUCH MONEYWILL THIS PROJECT MAKE

FOR THE DEVELOPER?

We are now approaching the prover-bial “bottom line” of the feasibility analysis. How much money will this pro-ject make? To see where we stand, wesubtract the Total Project Costs, just esti-mated above, from our earlier estimate ofNet Project Revenues. This yields a valueof $1,989,500, indicated in Fig. 1 as NetCash Flow Before Financing. This is notyet, however, the final bottom line.

Financing Interest:

One remaining cost item is financinginterest. A basic aspect for nearly all realestate is that costs are incurred first, andrevenues come in second. The costs haveto be covered with financing and invest-

ment costs as they are incurred. Both ofthese loans would be repaid with calcu-lated payment allocations per house aseach home sale is closed. Interest chargeswould be incurred on the outstandingbalance of these loans until they are com-pletely paid.

In order to calculate the project’sfinancing needs and the amount of inter-est that will be charged, we have to antic-ipate the timing of when costs will beincurred and when revenues will beavailable to pay the loans back. Thisrequires preparing a cash flow analysis.

Although cash flow tables can look

ment until sales or rents are able to becollected. As this money is advanced,interest charges are added to the costs theproject carries. Interest costs can be amajor factor in the profitability of a pro-ject, particularly if the sales and develop-ment period becomes extended.

Project financing is an area for whichstrategies vary widely, from builder tobuilder, and from project to project.While there is probably no standardapproach, one not uncommon financingscenario would have a land purchaseloan cover a large part (but not all) of theland acquisition costs, and short-termproject financing cover all other develop-


such terms. He left the meeting and thenegotiations in a huff.

Within the week, the attorneysreceived a new letter from the developersaying that they rejected the Town’s latestoffer, but were making the followingcounter-offer – and that was just thebeginning. What followed was an intensesix-week period of offers and counter-offers. This was before faxes, email or PCs– we were doing this with Quip machinesand TI-59 programmable calculators and abrand new delivery service called FederalExpress. With each communication, myjob was to analyze the developer’s latestposition, see what profit margin the pro-ject was likely to generate, and advise theTown as to where, what, and how far topush back.

In the end, a deal was executed thatfeatured a three-fold increase in land priceover what had been the developer’s lastand final offer, as well as full funding for acommunity meeting and activity facility,and substantial highway access improve-ments. The Bridgewater Town Center wascreated, and that project (which includes amajor hotel, office space, and a 900,000square foot shopping mall) now anchorsone of central New Jersey’s major employ-ment and commercial corridors.

Through the hired consultant’s exper-tise, the Town of Bridgewater “knew whento hold ‘em, and knew when to fold ‘em.”The Town was able to bargain fromstrength with knowledge that came fromstudying the basic tool of real estate feasi-bility analysis – the proforma.

Author’s Note:

Bargaining from Strength of Knowledge

In a prior life, I was a worker-bee inthe back room of a national real estateconsulting firm. Four years previously, thisfirm had helped the Town of Bridgewater,New Jersey work through a complexdeveloper solicitation and selectionprocess for a choice tract of land bound bya new interstate and two other major high-ways. With the developer finally selected,the Town turned contract negotiationsover to their in-house counsel, telling theconsultant, “Thanks for your help, we’lltake it from here.” Four years later, it wasthe Town that was being taken. With stillno agreement in place, the selected devel-oper had given the Town a “last and finaloffer.” The consultant was asked by thenewly hired outside attorney to come backinto the process, evaluate this last offer,and advise the Town as to what to do.

There was a dramatic meeting wherethe principal of the development companyflew in from California, and was surprisedto find the consultant back at the table.After regaling the meeting with his visionfor the town and why his deal was best forBridgewater’s future, the new attorneyresponded. Under the consultant’s advice,the Town was rejecting the developer’s“last and final” offer, but was making acounter-offer, which included a five-foldincrease in the sale price for the land. Thedeveloper was aghast, exclaiming how hecould never take on the project under


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very complex, they really are nothingmore than a schedule of when revenuesand expenses are expected to beincurred. Figure 2 (below) shows just aportion of the cash flow analysis that ispart of our case study proforma, focusingon the end of the project’s second yearand beginning of the third year. You cansee the first house closings occurring inYear 3, Quarter 1, generating the project’sfirst revenues and cash flows.

A cash flow analysis also shows theimpact of time on the project’s feasibility.A project that takes longer to build or sell will have more exposure to costs thatare not yet covered by rent or sales rev-enues. On-site staffing costs continue torun, interest costs mount up, and there is an increased chance that prices forconstruction materials and services mayincrease.

Knowing the expected schedule ofwhen costs will be going out and rev-enues coming back in, we can now esti-mate the financing needs for the project.The full cash flow analysis extendsbeyond what can be shown in this ar-ticle, but it includes a financing table thatcalculates the amount of new borrowingthat will be needed each quarter, howmuch interest will be charged on the outstanding loan balance, and howmuch of that balance is repaid from

each home sale.Adding up all the interest charges

from each quarter in the cash flow analy-sis gives us our financing costs. In ourcase study example, our cash flow analy-sis calculates this amount to be $1.1 mil-lion, and this is the amount that is thenlisted in Fig. 1 as Financing Interest.

Of note at this point is adding up theproject costs that are not being financedby lenders. Again, this is highly variablefrom project to project. The approachtaken in our case study is to assume thatlenders will finance 70% of the LandAcquisition costs, which means thedeveloper will be covering the balance.Furthermore, the primary project loanwill probably not be funded until sixmonths into the project, by which timethe land purchase would be completedand initial project approvals obtained.

Thus, during this initial period, costsin excess or preceding the availability ofthe loans will be borne by the developer.This is the cash that the developer has atrisk for the project and is the basis forcalculating the rate of return.

Net Cash Flow to Developer:

The time has come at last to calculatethe project’s profit. In Fig. 1, we subtractthe Financing Interest from the Net CashFlow Before Financing. The result isindicated as Net Cash Flow to Developer,estimated in Fig. 1 at $887,100.

So, is this a sufficiently attractive


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Figure 2

Selected Portion of Summary Cash Flow TableYR 2 Q3 YR 2 Q4 YR 3 Q1 YR 3 Q2

Project Revenues Number Units Closed 0 0 9 9Average Sale Value Per Unit $400,000 $400,000 $400,000 $400,000Gross Sales 0$ 0$ $3,600,000 $3,600,000Less Commissions, Fees $0 $0 ($144,000) ($144,000)Net Project Revenues $0 $0 $3,456,000 $3,456,000

Project CostsLand Acquisition $0 $0 $0 $0Planning, Design & Approvals $0 $0 $0 $0Sitework & Building Constuction $631,500 $1,531,500 $1,963,500 $1,963,500Amenities, Off-Site Costs $0 $0 $0 $0Management & Overhead $77,800 $77,800 $249,200 $247,800Total Project Costs $709,300 $1609,300 $2,212,700 $2,211,300

Net Cash Flow Before Financing ($709,300) ($1,609,300) $1,243,300 $1,244,700

financial return to be worth all the riskand effort?

The developer’s initial Cash Invest-ment is estimated from the cash flowanalysis, and is indicated near the bot-tom of Fig. 1 as $1,020,600 based on thefunding scenario described above. This iswhat the developer must cover from hisown resources until this money isreturned to him with the initial disburse-ments from the project financing. TheNet Cash Flow to Developer is what hisinvestment earns.

As seen near the bottom of Fig. 1,comparing the Net Cash Flow to Devel-oper to the Cash Investment yields aTotal Cash-On-Cash Return rate of 86.9%.This may seem huge at first, but remem-ber that the project will be in its fourthyear before this is achieved. This totalcash return is actually equivalent to arate of return of 19.9% on an annualizedbasis, as indicated at the bottom of Fig. 1.

One final indication of profitability isthe Internal Rate of Return (IRR), shownat the bottom of Fig. 1 as 22.4%. Theimportance of the IRR is that it takes intoaccount the impact of time on an invest-ment and the returns it generates. TheIRR incorporates all of the cash flows ini-tially going out (investment) and thencoming back in (returns) and the exacttiming of each. The IRR then finds thesingle rate of return that mathematicallymatches all of these cash flows to theamount of time that has passed, and thefinal net total of returns received.

Calculating an IRR involves a repeti-tive trial-and-error process, which is whyit is handled as an automatic function inspreadsheet programs. The IRR is a stan-dard indicator of profitability used infinancial analyses that is particularly use-ful for comparing one investment againstanother.1

Rates of return approaching 20% mayseem ambitious, and, in fact, may not beachieved. Viable projects can have returnrates of 15%, 12%, or even less. But lower

levels of return are usually acceptableonly when builders perceive a quickturnaround, or a lower level of risk. Afterall, the feasibility analysis is done beforethe first spade of earth is turned.

The greatest risk in development isthe unforeseen: what is discovered on thesite that was not previously known; newregulations or other factors that addunanticipated costs; or turns in the mar-ket that result in lower sales values orextended sales periods. Annualized ratesof return of, say, 10%, can be achievedwith investments that carry far less risk.Allowing for strong rates of returnreflects the high level of uncertainty andrisk that is inherent with real estatedevelopment.

LOOKING ATALTERNATIVE SCENARIOS

We have now seen the basics of a pro-forma analysis. That’s useful for simplyunderstanding the financial nature of aproposed project. But what moves thisfrom useful to insightful is to use a pro-forma to test other possibilities and“what if” scenarios. A well-constructedproforma spreadsheet can be a powerfultool for such testing.

For our residential subdivision casestudy, let’s use our proforma to see whathappens to the project if we adjust a fewcritical assumptions.

1. Testing Higher Costs

One obvious set of tests is what hap-pens if higher costs are incurred. Increas-es in costs can come from any part of theproject, but for this example, let’s illus-trate what happens with three types ofhigher costs. The first test we’ll do – anda frequent occurrence in real-worldhousing development – is to see whathappens if the basic bricks and stickscost of building the homes increases overwhat was expected. This test is easilydone by just increasing the cost persquare foot for home construction.

Raising the construction cost from$65 to $68 per square foot results inhigher direct costs per unit of $6,600 per house ($3.00 increase times an average of 2,200 square feet per house).


Developers’ Financial Information

Developers should not ordinarily beexpected to present their confidentialfinancial analyses (including expectedprofit margins) when they seek approvalfor their project.

Financial information on a projectbelongs to the business that produces it.Whether or not a business is going tomake a profit, or how much profit it standsto make, is not a criterion for granting ordenying approvals under local land useand zoning ordinances.2

If you are buying a car, the car dealerdoes not have the right to obtain yourbank balance so that he can raise the priceto as much as you can possibly afford. Inthe same way, a planning board is notentitled to know the profitability of a pro-ject so that it can run up a list of amenitiesand community improvements at theexpense of the project.

In the development approval process,the situation is further complicated bybeing conducted in a public forum. Thismeans that anything that a developer submits in response to requests from theboard is subject to public inspection,which could very well include the devel-oper’s competitors. No developer shouldhave to reveal the project’s financial pro-jections. Preserving business secrets is a legitimate interest of any developer. Usually, such proprietary interest is pro-tected by law.

Since such information cannot beobtained directly from the developer, it becomes even more important thatplanning board members have a base levelof sensitivity to the business side of thedevelopment process. This includes havingcurrent awareness of prices, rent levels,and vacancy rates as found in the local,current market. It also means understand-ing how changes to one aspect of a projectcan affect other parts, as well as the pro-ject’s overall feasibility.

2 Note that this is quite a different situation fromwhat I describe in the Author’s Note (on page 11),where the Town was soliciting development pro-posals for municipally owned land and running itsown proforma calculations as part of the negotia-tions process. And, of course, in cases where amunicipality (or other public entity) is the devel-oper or redeveloper, proprietary information con-cerns would not apply.


1 If this brief explanation of IRR still leaves you puz-zled, take a look at a more detailed (but plain English)explanation posted on the Motley Fool web site:<http://www.fool.com/portfolios/rulemaker/2000/rulemaker001030.htm>

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Multiplying this amount by 50 unitsresults in an increased cost of $330,000,which after some additional interest andindirect costs, results in a total costincrease of about $344,000. As you cansee in the top graph in Figure 3 on thefacing page, this reduces the developer’sNet Cash Return from $887,100 to$542,700. The annualized rate of returnis correspondingly reduced from 19.9%to 13.5%.

That in itself may not be too bad, butlet’s say that the builder looks at otherprojects and decides that to be competi-tive, a small community pool is needed.The pool, with mechanical equipment,deck area, and pool furniture, could costabout $125,000, plus $50,000 for a smallbathroom-changing facility. The timingof this facility should be nearer to salesopening so as to serve as a marketinginducement, but can wait until sales areat least started, thus minimizing addi-tional interest costs. Adding the poolreduces the net cash return by another$182,800 to $359,900, with the annual-ized rate of return now dropping to 9.5%.

At this point, however, let us alsoassume that the Town determines thatthe existing water system is operating atcapacity, and that any expansion to thesystem would have to include enhancedpumping capacity, to be paid for by theproject that requires the expansion. Inour “what-if” scenario, let’s say that thisimprovement would cost another$200,000, and that the Town is requiringadequate water capacity to be in placebefore final approvals are given, adding tothe loan amounts and interest costs earlyin the project’s operation.

The developer must now considerwhether the project can sustain this addi-tional cost. Of note is that this cost willbe spent for improvements that are off-site, and not actually owned by thedeveloper or the new residential commu-nity.

Combining the increases in homebuilding costs and costs for additionalamenities and off-site improvementsresults in Total Project Costs increasing



by $705,000 – with no compensatingcost savings or increases in revenues. Theproject net cash return is reduced to justunder $151,000, representing an annual-ized rate of return of only 4.3% and anIRR of 4.5%.

This rate of return is now on a parwith simple CD and bank note interest,and not worth the risk and effortrequired for this project to be built. Ifthese changes prevail without compen-sating savings in other areas or increasedrevenues, the developer is likely to seekother, more profitable, prospective pro-jects in which to invest.

2. Testing Impacts of Time

Building real estate is a huge gamble.You can spend millions of dollars onacquiring the land and preparing the pro-ject, and you can study trends in themarket, but you won’t know for surehow well a project will rent or sell untilyou’re actually open for business.

Sales pace is very often the way inwhich a project’s reality departs fromexpectations. We can use the proformatemplate to look at what happens if theproject sells faster – or alternatively,slower – than the original baseline analysis.

Our original baseline analysisassumed an average sales pace of threeunits per month. What happens if theproject is a huge success? Increasing theaverage sales pace to five sales per monthwould need to be accompanied by alsoaccelerating some other aspects of theproject. For example, the communityamenities would have to be completed bythe time the project sells out. Under thisscenario, there is a savings in costs of$148,600. The Net Cash Return toDeveloper is enhanced by $199,500,which improves the annualized rate ofreturn to 23.2%. With sales going sowell, the builder may also be inclined toraise prices, enhancing the bottom lineeven further.

On the other hand, what happens ifsales are slower than expected? If weadjust the average pace of sales to onlytwo units per month, significant costincreases are incurred. Management and

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$1,000,000

$800,000

$600,000

$400,000

$200,000

$ 0Base

ScenarioHigher

BuildingCost

PlusCommunity

Pool

PlusOff-SiteCosts

$887,100

$542,700

$359,900

$150,900

$1,000,000

$800,000

$600,000

$400,000

$200,000

$0Base

ScenarioFasterSales

SlowerSales

InitialDelays

$887,100

$1,086,600

$591,600 $627,300

$1,000,000

$800,000

$600,000

$400,000

$200,000

$ 0

-$22, 900

-$204, 900

BaseScenario

PriceReductions

5 UnitsAffordable

AffordableHousingProgram

$887,100

$1,067,400

Figure 3

Project Profitability for Alternative Scenarios

Testing Higher Costs

Higher Building Cost

Home construction cost increase from $65to $68 per sq. ft.

Plus Community Pool

Adds $175,000 additional costs to priorscenario.

Plus Off-Site Costs

Adds $200,000 for utility upgrade to prior scenario.

Testing Impacts of Time

Faster Sales Pace

Sales pace increased from 3 per month(base scenario) to 5 per month.

Slower Sales Pace

Sales pace reduced from 3 per month(base scenario) to 2 per month.

Initial Delays

Additional studies to cost $50,000 andresult in 12 month delay.

Base sales pace of 3 per month retained.

Testing Home Affordability

Price Reductions

Average home prices reduced by $20,000per unit.

Designate 5 Units as Affordable

Price 5 units at $160,000.

Affordable Housing Program

Add 6 “affordable” units at $160,000 and 4 market rate units (+10 total).

All market rate unit prices reduced $10,000 each.

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Overhead costs keep running for a longertime, the project carries longer, andinterest costs mount up. This alternativescenario results in a reduction of net cashreturn by more than $295,000 below thebaseline analysis. The project would stillbe profitable, but with a reduced annual-ized rate of return may not be as attrac-tive as an alternative project the buildermight consider.

Another, and very typical, timeimpact would be a delay experienced inthe approval process. If additional envi-ronmental or engineering studies areneeded, there would be the direct cost ofthese additional services. But deferringthe opening of sales significantly wouldalso increase carrying costs at a timewhen there are no offsetting revenues.

If, in our case study proforma, we addabout $50,000 in additional study costs,but also delay the opening of sales by 12months, financing costs jump by nearly$186,000 (to cover the delay in revenuescoming in), and the project’s net cashreturn suffers by nearly $260,000 com-pared to the base scenario.

Clearly, time delays are the enemy ofprofits in real estate development.

3. Testing Home Affordability

Let’s use the proforma template toexplore issues of home affordability. Howcan homes be brought to market that aremore affordable?

In our example, the direct bricks andsticks costs (as well as the approval, per-mit, overhead, and interest costs) arepretty well established and not easilyreduced. Remember that the direct unitconstruction costs are less than half oftotal costs, so reducing the direct con-struction costs by, say, 10% might lead toa savings of perhaps less than 5%.

What would happen if the buildersimply slashed his sales prices by$20,000 for all of the units? This sce-nario is easily run by changing the aver-age sales value. If we implement thischange, corporate overhead costs actual-ly come down since those costs arepegged to sales revenues – an estimatedsavings of about $48,000.

But the $1.0 million drop in total rev-enues from this price reduction is huge.The total impact to the project is that thenet cash return is insufficient to pay all ofthe financing costs, and the project actu-ally loses money, posting a negativereturn of nearly $23,000. And while a$20,000 price savings is not insignifi-cant, it is far from a dramatic break-through in affordability. Simply cuttingprices without commensurate costreductions isn’t supportable by privatesector builders.

Another issue for housing affordabili-ty is the impact of higher costs, such asthose we’ve tested in the previous scenar-ios. Increases in costs are not necessarilygoing to come out of the builder’s profits– he’s equally likely to reach for the pricelist.

For example, to restore the originalnet return of the base scenario afterabsorbing all the increased costs seen inour first set of tests (see Fig. 3, TestingHigher Costs, Plus Off-Site Costs col-umn), the builder would have to increasethe average unit prices by about $16,200.

If the builder feels that such anincrease will be accepted by the market,he would prefer to do that rather thandiminish his profits. Perhaps the builderwill consider a slight reduction in profitswith only an $8,000 price increase. Butadding costs to a project, including pro-ject enhancements or off-site improve-ments that might be requested by theTown, can very easily show up asincreased prices for the homes.

What about more formal affordablehousing programs? Let’s say that theTown that is reviewing the applicationfor our hypothetical development is con-sidering implementing a new policy that10% of all new housing be “affordable,”with prices set as a multiple of medianincome for the area.

Using our proforma template, we cansee how this might work. Let’s first seewhat happens if we simply set the priceof five of the units to an affordable pricelevel established by income formula of$160,000 (compared to the market priceof $400,000). The immediate impact onthe project is dramatic, resulting in a


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costs continue to be incurred without anycommensurate increase in revenues. Thecost meter keeps ticking, but the revenuebell isn’t ringing. This is particularly crucialduring the pre-construction approval period.All of the carried taxes, interest, and profes-sional services (design, environmental, engi-neering, legal) continue to mount if theapproval process becomes protracted. Thisaccumulated burden will all have to befinanced until revenues start coming in,which just compounds the “carry” that pro-ject revenues will eventually have to cover.2. The Consumer Often Pays for

Amenities or Increased RiskOne point I have hoped to convey in this

introduction to real estate proformas is that adeveloper will try to protect his profit marginto a level that is commensurate with the per-ceived level of risk. Planners not familiarwith the development process might thinkthat increased costs come out of the develop-er’s pocket or the project’s profit. That doeshappen, but another likely response is toincrease prices or rents to cover theincreased costs.

If a local board requests more communityamenities, those costs may very well bepassed through to the price sheet (i.e., to thehome buyer / consumer). The same may be

true if a project becomes riskier or morecostly as a result of extended time or uncer-tainties in the approval process. Whether inthe form of higher home prices or, for com-mercial projects, in the form of higher com-mercial space rents (which may be passedalong as higher merchandise and serviceprices), it may be the consumer, not thedeveloper, who ends up paying for increasedamenities or risk.3. Limiting Uncertainty Limits Risk

A developer will perceive a lower level ofrisk if the approval process has fixed stan-dards, a predictable procedure, and a time-line set by a standard schedule. When theapproval process has fixed standards, proce-dures, and calendar, the perception of riskcan be reduced – and so can target profit lev-els. But, when the approval process becomesopen-ended as to the criteria being consid-ered, or incurs a protracted review time, thelevel of risk climbs exponentially. Developerswill correspondingly increase their targetprofit levels to cover this risk.

Board members can help limit risk bystrictly adhering to the existing approval cri-teria, and holding to the stipulated calendarfor hearings, technical reviews, and submis-sion of opposing positions. Keeping riskunder control is in everyone’s interest.

Profits Go With RiskA basic tenet in the businessuniverse is that higher profit

expectations accompany higher perceptionsof risk. High risk investments can only becontemplated when there is a potential forhigher reward.

Real estate development is inherentlyrisky. Unpleasant surprises may await thefirst shovel to hit the dirt. Market trends canchange much faster than the time span need-ed to bring the project to market. A bad hur-ricane season can suddenly place a premiumon plywood prices nationwide. The develop-ment process is fraught with unknowablerisks that are beyond the control of the risk-taker. Clearly, a real estate developer will belooking for a level of profit that is signifi-cantly better than the return on a bank noteor a mutual fund. Risk goes hand-in-handwith reward.

This fundamental relationship betweenrisk and reward leads to three importantprinciples in real estate development:1. Time is Money –

Extended Time is the EnemyFrom our hypothetical case study, we can

see that if the production timeline extends,certain production, operating, and financing

reduction in revenues of $1.2 million,and a loss for the developer of nearly$205,000, compared to the baseline sce-nario. (See Fig. 3, Testing Home Afford-ability, third chart).

However, if more market-rate unitsare allowed, the developer can recoverthe reduction in profits. This could beachieved if, for example, the project’sdensity were increased. Compared to theoriginal baseline scenario of 50 market-rate units, we could add four market-rateunits and six affordable units, thus bring-ing the total unit count up to 60 andachieving the Town’s new policy of 10%affordable allocation.

The increased revenues from theadditional market rate units would coun-terbalance the cost impact of the afford-able units, as well as cover an increase inthe project costs (primarily in buildingconstruction costs) resulting from theadditional units. Moreover, the developermight even be able to trim the prices of


all the market rate units by about$10,000. At the same time, the net cashreturn actually increases from the base-line scenario by $180,300 (See Fig. 3,Testing Home Affordability, last column).

This is the proverbial win-win solu-tion, made possible by a modest increasein project density. Not only do we end upwith a viable project, but we have 6affordable units (one more than original-ly called for), and all of the market rateunits can potentially be made a littlemore affordable. Solutions like this can be found with insightful use of theproforma.

SUMMING UP:

Understanding the basics of the busi-ness of development – like understand-ing the basics of site plans, trafficanalysis, and other essential tools used inthe field of planning and development –will help you be a better informed andmore effective citizen planner.

Knowing how to read a proforma cangive you a better understanding of whatgoes into putting together a project.Through our hypothetical case study, wehave seen how changes in several para-meters – increased construction costs,the addition of amenities, time delays,and various municipal requirements –can affect a project’s bottom line and itsviability. ◆

Wayne Lemmon is areal estate market econo-mist with a degree inarchitecture from CornellUniversity, and urbanplanning from the CityCollege of New York. Hehas 30 years of experiencewith national real estateconsulting firms and development organizations,and is currently the Director of Market Researchfor a regional homebuilder. Lemmon is also amember of the PCJ’s Editorial Advisory Board, andauthored “The New ‘Active Adult’ Housing” in PCJ#51 (Summer 2003). He lives in Somers, NY.

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