Real Estate is complicated. Real Estate development is even more complex. The hundreds of variables and decisions that are addressed through any development project all stem from a primary reliance on preliminary pro forma figures generated from the inception of the project. However, these monetary predictions can become cumbersome and overwhelming as developments become larger, more complex, and respond to real world scenarios. Because real estate development is an evolving endeavor, many developers and investors initially rely on "back of envelope" (BOE) calculations as a litmus test as to whether a project is worth pursuing.
A seasoned developer will rely on BOE calculations that focus on the three top facets of any real estate pro forma:
Assumptions; Cash Flow; and Returns.
Development assumptions are the inputs used to generate the values within any financial projections. The assumed variables may number into the hundreds, but examples are a project’s timeline, costs, sales price, etc. Often, these assumptions are not only guessed but rely on extensive market data and intimate knowledge of an area and relationships maintained by a developer. How much will the soft costs be? What will construction cost per square foot? How much time will it take to stabilize the property? These are common assumptions that must be used to generate any reliable BOE financial projection.
There are various components of the Cash Flow aspect of a development pro forma. What costs and expenses will flow out to create the stabilized project ready for sale or lease? Upon stabilization, what recurring cash will begin to flow to investors and how constant will this positive cash flow be? The disposition of a developed asset is typically the largest point of positive cash flow to the developer and investors. Sometimes, framed as a "refinancing of property," this disposition signals the end of a developer’s duties and marks the bulk of a project’s financial return.
A developer or investor must weigh a project’s risk against alternative investment opportunities within the market. For a developer to evaluate this risk, some level of "return" calculation must be provided in any BOE proforma. Whether reflected in an Internal Rate of Return or a Net Present Value figure, there must be some indicator that developers rely on to make investment decisions. To this end, any return calculation will evaluate a project’s total costs and timeline to provide a quantifiable figure that will help justify the risks inherent in any real estate development project.