The pro forma is a financial valuation analysis framework that basically tells you what the property is worth based on whatever you’re going to do to it, or in our case, the property business plan. The pro forma is the central decision-making machine for any real estate project, it is your playbook.
With the pro forma as our guide we can go back out to the real world after we establish the initial valuation framework. We can now talk to our architect about how much space can be physically developed, what can be done to this existing vacant box, based on our intentions and the size layout to be converted into housing, or to instead be repositioned into retail to office and how that would work. The architect can tell us how much square footage that we would have available, plus how much rentable square footage can feasibly and functionally fit, and everything else that we may need to consider for the site feasibility. We might need to get permits from the city, for example, which the architect can tell us based on the design. We then plug this information back into our pro forma and see what it comes to. Does that help our value? At what rates?
We then conduct a study of the leasing market by talking to brokers and research leasing data. If we’re taking a vacant retail space and converting it to an office, what would be the rental value of the office space? And if that rent is higher and makes it feasible, let’s put that into our pro forma to see if the returns are higher or lower..
But wait. We have the design and we have an understanding of the market… but how much is this going to cost? Well, once we have a general sketch from our architect, we then take it to our general contractor or our construction manager and say, “Hey, how much is it going to cost to convert this vacant retail space to office?” From there, they will give us some costs and then we plug that back into our pro forma to look at the new value forecast to again ask ourselves the feasibility of the project. Based on these assumptions, we now know what the what is, the why, and we can come up with the value. It’s a beautiful thing.
What I teach, and what we are experts in, are pro formas, effectively, because the pro forma incorporates and considers all of these factors collectively based on the real world.
Am I going to teach you how to be a good architect to design a space? No. Am I going to teach you how to be a good contractor to build the space? No, but am I going to teach you how to take all of these ingredients and put it into the soup. This is multi-disciplinary. As the developer, or as the lead investor you are the conductor of the orchestra. If your contractor is playing the drums, you want to make sure you’re pulling the best out of them on the drums, but you’re never going to play the drums yourself. This is the same with the violinists, the architect, the percussionists and the broker. Your role is to pull all of these pieces together to be able to make an informed decision on the perceived value of the project.
The last part is money. From your pro forma, how are you going to go and get this money? Well, there are two sources of money: equity and debt. The capital stack is how much equity and how much debt equates to the total cost of the project, which is basically what are the sources of funding and how do they stack up together. Venture capitalists call this the cap table, in real estate, we call this the capital stack.
Your project involves buying a piece of property, spending money to design it, build it and lease it. These are your total costs and are the factors that reflect the total uses of the capital. Therefore, your total sources of capital should always equal your total uses of capital.
Read next… “Finance Principles and Tools for Building a Pro forma”