Tag: pro forma

• How to think about a development pro forma

  One common mistake that people make when it comes to development pro forma is assuming that feasibility is easily attainable. It’s not. In fact, it’s best to think of a pro forma as a fragile object that is liable to break if not handled properly. So to that end, here’s a non-exhaustive list of things you may want to keep in mind when trying to both forecast and create the future as a developer:

  • As a starting point, you’re safer assuming that your pro forma isn’t going to work. If the numbers look too good to be true or even just really promising — especially at the outset — then there’s a good chance they’re wrong. You’ve likely missed things. Be weary if it feels too easy, especially in our current market, where very little works.
  • Cheap land isn’t enough. Just because your land cost feels cheap, it doesn’t mean that your development project will end up being feasible. There are instances and entire markets where even free land isn’t enough. You might actually need a negative land value. Meaning, a subsidy is required to reach feasibility. This is the case with affordable housing.
  • Drill down into as many line items as possible. Back-of-the-envelope math — where you just plug in a few cost per square foot assumptions — is fine for an initial screening. But if you’re really serious, you need to get deep into the weeds. Run through the entire process in your mind and think about what might happen, and go wrong. Even with this, you will still miss things.
  • Stress test your assumptions. What happens if the city asks you to do X? What happens if the local councillor comes at you with Y? Can your fragile object support them, or will it shatter to pieces? The sensitivity of your fragile object to various stimuli will help you decide whether you want to do the project or whether there’s simply too much risk.
  • Ultimately, real estate development is a creative act. You’ll need to come up with creative solutions, and then you’ll need to will your project to life. This is one way to tell that you’re on the right path. It needs to feel really hard. So if your pro forma also feels this way, then there’s a higher probability that you’re narrowing in on something close to reality.

  2024.10.01

• What’s land worth?

  Generally speaking, the value of a piece of land depends on what you can do with it. If the highest-and-best use is agriculture, then it might be worth $X. But if the highest-and-best use is a supertall skyscraper, then it’s going to be worth a lot more than $X.

  This is why the land component is typically thought of as the residual claimant in a development pro forma. Start with what you can build, forecast your revenues and expenses, and then see what is left over and can be attributed to the land. This is, at least in theory, how the mechanics should work.

  An interesting thought exercise, though, is to consider how different developers might value the exact same piece of land.

  One obvious scenario is that a developer could just get their forecasts wrong. For instance, maybe they understate their costs, which then leads them to believe that they can pay more for the land. In this case, an error makes them the highest bidder.

  In a rising market, there will also be developers who believe that they can almost certainly collect higher revenues in the future. In this case, the most bullish developer often becomes the highest bidder for land. And as long as the market continues to rise, they might not be wrong.

  But things change in a slower or flat market.

  Now the market isn’t there to save you if you happen to overpay for land. It’s a less forgiving environment. But it’s also a market where you really benefit from conservative underwriting and solid execution. Now it’s these groups who are the high bidders.

  And I know that some/many developers prefer it this way.

  2023.09.20

• How to cheapen a new building

  Anyone who has ever worked on a development pro forma will know that the process generally works like this: You start with a bunch of assumptions. You assemble those assumptions in a way that will allow you to determine if the project in question is feasible. And then, you realize that almost everything is more costly than you initially thought and that the project may not actually work. Oh shit.

  In fact, a sure-fire way to know that you’re on the right track is if the numbers sort of don’t work. If the returns look too good to be true, they almost certainly are and you’re likely missing something big and meaningful. As we have talked about before on this blog, development happens on the margin. That means that you have to work at it. You have to be creative. And often you have to find ways to increase revenues and cut costs.

  The common way to find money is through something known as value engineering, which is just a fancy way of saying, “I need to cut costs, so let’s see what I can tolerate losing from this project.” That’s generally how it works. And we do it on every project. You’re trying to find high-cost items with relatively low perceived value.

  This process often gets a lot of criticism because people view it as a distasteful cheapening of a project. But the reality is that it is usually an important part of maintaining project feasibility. You may really want to use that fancy material you can only get from Switzerland, but maybe development charges were just increased and now you need to offset those new costs by finding savings somewhere else.

  This isn’t a perfect analogy, but imagine you were shopping for a new car. You might start out by wanting the fully-loaded version, but then you see the price and realize you can’t afford it. So you decide to start trimming features and add-ons until you get to a place where you feel more comfortable. I would imagine this happens with cars, and I’m not sure it’s right to point to that person after and say, “oh my god, I can’t believe you cheaped out and didn’t buy the fully-loaded version.”

  At the same time, I think it would be perfectly reasonable to argue that you don’t need to spend a lot of money to (1) care deeply about the work that you do and (2) have taste. You can’t fight the economic realities of the world, but you can care and you can be creative. And I don’t think it’s too much to advocate for these things.

  2022.12.07

• Some of the cost drivers that impact new developments

  

  Why do some buildings cost more to build than others? And how is it that some cities, as a whole, seem to build more cost effectively than others? Without getting into the specifics of how different markets work, I thought it would be valuable to outline some of the cost drivers that impact new developments. But keep in mind that this is by no means an exhaustive list. So, please feel free to add whatever I’ve missed to the comment section below.

  • Below-grade parking is hugely expensive. It’s almost always a loss leader. You lose money building it. That’s why parking ratios matter a great deal. If you’re building in the suburbs at 1 to 1 parking vs. 0.2 in the core, you’re simply building more of something that doesn’t make money. There’s also the question of whether you need to build a watertight below-grade, or if you can discharge any groundwater into the municipal infrastructure. Big cost difference.
  • Union vs. non-union construction labor.
  • Building stepbacks add cost and create additional complexity. To build more cost effectively, you really want repetition. But terraces are awesome. I get it.
  • Impact fees, development levies, and other government fees can vary widely across cities. As I’ve mentioned many times before on the blog, these line items can add up to 20-24% of the price of a new condominium here Toronto.
  • Time is expensive. One of the bigger line items in a development pro forma is financing interest charges. The longer things take, the more expensive the housing needs to be.
  • Markets are unique. Quebec, for example, has relatively low electricity rates. For this reason, it’s pretty common for homes in Quebec to use electric heating, which is usually pretty cost effective to install. According to this 2019 study, 68% of Ontario households rely on natural gas heating. In Quebec, the number is only 5%.
  • Depending on what you’re building next to, you may face additional costs. For example, if you’re building right up against a rail line, you may need to construct a “crash wall” in order to safeguard against possible derailments and you’ll probably need to up the STC rating on your windows because of the higher noise levels. These costs will not be insignificant.
  • In theory, land costs are supposed to be the residual claimant in a development pro forma. What that means is that you should back into your land value after calculating your projected revenue and considering all of your other development costs. If your revenue is lower, so too should be your land cost. Land cost as a percentage of total costs will, naturally, vary across different markets.

  Photo by EJ Yao on Unsplash

  2020.09.20

• What will our customers think? Condo vs. rental.

  Condo developers are merchant builders. They build a project and then move on. Because of this, there’s a belief that there’s little incentive to build for durability, in comparison to say purpose-built rental buildings where the developer might continue to own over an extended period of time. While it is true that putting on an operations hat will make you hyper-focused on everything from garbage collection to how you’re going to manage all of your suite keys, there are a few things to consider in this debate.

  One, as developers we certainly think and care a lot about our brand and our reputation, both with our customers and with Tarion (warranty program). We ask ourselves: “What will our customers think if we do this?” Irrespective of the tenure we’re building, we want our projects to be carefully considered. And in the case of condominium projects, we would like our customers to feel excited and comfortable about buying in one of our future projects. That’s the goal. This is no different than any other product that you might buy that doesn’t come along with some sort of ongoing subscription.

  Two, there’s often a spread between condominium and rental values. For example, let’s consider a brand new 550 square foot condominium in a central neighborhood of Toronto and let’s say it would cost you $1,300 psf to buy it today. (Obviously it could be more or it could be less depending on the area and the building.) Now let’s start with a rent and back into a value, using some basic assumptions.

  Unit Size (SF)	550
  Monthly Rent	$2,400
  Rent PSF – Monthly	$4.36
  Rent PSF – Annual	$52.36
  NOI Margin	72%
  NOI	$37.70
  Exit Cap	3.75%
  Value PSF	$1,005

  Here I’m assuming that same suite would rent for $2,400 per month. I’m converting that to an annual PSF rent. And then I’m assuming that if you were managing a whole building of these kinds of units, your operating costs might be somewhere around 28%. Crude back-of-the-napkin math to get to a Net Operating Income (psf). Finally, I’m capping this NOI at 3.75%. We can debate my assumptions and if this were in a development pro forma you might “trend” the rents. But I find this comparison helpful. Here we are getting to a value of around $1,005 per square foot. Less than our $1,300 psf above.

  The point is that the margins are tighter, which helps to explain why for a long time we saw very few purpose-built rentals being constructed in this city. So even though you might argue that the incentives are in place to build for durability, you do have to weigh that against the realities of what you can actually afford to build. Development is filled with all sorts of these tradeoffs. But if you and/or your investors really want a consistent yield, this strategy can work just fine. Personally, I’m a fan of the long-term approach.

  Three, rent control policies can have an impact both on the feasibility of new projects and on people’s ability to actually perform maintenance. If you have a scenario where your operating costs — everything from taxes to utilities — are rising faster than your allowable rent increases, then you’re in a bad situation and you have zero incentive or financial ability to actually invest in the building, despite being a long-term owner.

  Finally, there is nothing stopping a purpose-built rental developer from also being a merchant builder. i.e. Selling the entire rental building once it is done and it has been stabilized. So you could argue that we’re right back at my first point. Whether you’re selling to individual condominium owners or the entire building to one entity, you as the developer have to sit back and ask yourself: “What will our customer(s) think if we do this?”

  2020.07.11

• Acquisition price vs. current market value — which should be your land input?

  If you’ve bought land with the intention of developing it and you now think the value of that land has either gone up or down, there comes the question of what number you should plug into your development pro forma. Do you input what you paid for the land or do you input the current market value of the land? The former is probably more common than the latter, but in my view it’s important to consider both scenarios.

  If the value of the land has gone up, it means that you think you could turn around and sell it for that price today. And that would mean you would be making a profit without doing anymore work and without taking on any additional risk. That’s an option that exists right here and right now (t = 0). What you want to get at in your pro forma, or at least understand, is the incremental profit margin from taking on the risk and brain damage of actually doing and completing the development project.

  To do that, you need to consider the current market value of the land. That way you isolate your land margin from your build-out margin. The one problem with this approach is that the numbers may then tell you not to develop. In a hot market (which is not right now), it is not uncommon for land to get bid up beyond current fundamentals. There’s always someone else who is willing to be more aggressive.

  In this case, you may find that most of the development margin is in the land. And you will start thinking to yourself, “How can anyone afford to pay this much? It doesn’t make sense.” This doesn’t necessarily mean that you shouldn’t develop. But at least it gives you a better understanding of the risk and reward trade-off that you’re about to take on. It might also tell you some things about the market.

  2020.05.14

• Two open real estate development positions

  

  I recently alluded to some life changes on this blog. Well, I am now ready to share: I am leaving my development position at CAPREIT.

  I wasn’t intending to leave. I wasn’t looking to leave. And frankly, I felt conflicted. But sometimes life has a funny way of presenting opportunities that you just have to say yes to. As my mother likes to tell me: “Life is what happens to you while you’re busy making other plans.” More on this in a later post. Stay tuned.

  What I would like to talk about today are the opportunities that this may create for some of you. There are now two open development positions at CAPREIT. Both positions would be based in downtown Toronto (St. Lawrence Market).

  The first opportunity is essentially a Director level role where you would be responsible for growing the development team at CAPREIT. You should be able to lead a team, identify new development opportunities, create pro formas, assemble/manage consultant teams, secure development approvals for complex urban infill sites, and generally lead projects and people through the entire development lifecycle. For more information and to apply, click here.

  The second opportunity is at the Coordinator level. You would be reporting day-to-day to the above person and you should have working knowledge of the development process. For more information and to apply, click here.

  I would just like to add that in both cases you would be working on some very exciting urban infill projects and you would be joining an organization with great people and a great corporate culture. I mean this sincerely. If you have any questions about the two roles, feel free to reach out to me directly. And if you’re in the market, consider applying.

  2016.07.14