What should you include in your pro-forma when doing a real estate development? Renat Yusufov, Managing Partner at Bullpen shares his detailed pro-forma, how should you think about it, and why.

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We have a non pro-forma here for stabilization. This is where it's dealer's choice, being an office product, being multi tenanted, chances are you're going to go through Argus software, you plug in your assumptions, you plug in your rent roll or your expected rent roll, and it basically does the pro-forma for you. Some people have an aversion to it, because it doesn't allow for more flexibility, however, it does allow for more detail, it's the double edged sword. My personal opinion, the more complex your office product is, meaning the more tenants you have, the more nuance you have about leasing, and staggering timelines, the more likely you prefer to go with Argus. It's a little more painful in terms of editing on the fly. But the flip side of it is that it's definitely more accurate than anything you would probably be able to build an Excel. This is a summary of where you expect to land. And a lot of this is actually pulling from Argus, Argus lets you pull in Excel tabs basically as outputs so you can integrate it back into your Excel on both the assumptions, the leasing summary, and the base rent.

And you can change all of these numbers based on various specific locations of each property?
Exactly. And that goes back to your building, and the south side of a certain city and state, you'll talk to the brokers who have experience there, and they'll tell you what the rents will be, they'll tell you how long it'll be on the market before you'll find a tenant, what the terms are, and the big terms being free rent, TILC, so that's tenant improvement leasing commissions, and the time it'll take to find a tenant, as well as the credit. This is really a summary. You'll have different audiences for this model, it's better to have it here than for them to have to run around the tab looking for the specific month, when you stabilize, and what the rent looks like then. I show it as a total dollars per net square foot, and dollars per gross square foot, because this is a construction project. You're building grows, regardless. But you want to show how what rent looks both net and gross.

Same thing with expenses, you would vet this out with probably an asset manager, or somebody who has experienced in asset management. At the very beginning phases of this project, you're going to be talking dollars per foot, or dollars per square foot, as you're getting more refined, as you know exactly what you're building, as you know the market, or as the project matures, you are going to be a little more fine tuned on these numbers. For example, cleaning contracts, once you have a contract in hand signed, you'll know exactly what this number looks like. Until then somebody who has X amount of experience, like whether you hire through Bullpen, whether you have somebody internally, you have a third party doing that for you, they'll be able to tell you, it's $1.5 to $2 a foot.

This is a very simplistic timeline, because it is construction, there are multiple phases. And depending on what your pre development looks like, if you're doing any kind of land assemblage, any kind of permitting, there's going to be different phases. I've seen some relatively complex deals where, depending on the phase, a different equity investor is paying for that part. I try to keep it simple here, just to not make it confusing. You really have a date that you start, I just put it in January this year. And you're saying it's going to take me 24 months to build, the months of stabilization is from August in this case. And then when do you want to sell it. In this case, how many months are you holding it for stabilized value. This is a very personal concept, depending on how you're structured as either a developer, or if you're developer and investor, or if you're a private equity fund who develops, these might be very finite timelines of five years, 10 years, seven years. From a development point of view, chances are you make your money as a developer, on your fees, and on exit. So you're probably just trying to stabilize it and get out, and pass on that value to somebody who wants a built product that they don't need to do anything with, commonly in real estate referred to as leaving meat on the bone for the next guy.

This project specifically starts in January, it has 24 months of construction, in this case, it includes a pre development, 42 months to stabilize, and then you exit six months after that. So years after it's built, you exit.

As far as budget, you have all the individual line items. This is really something you'll vet with your GC, it's like any other cost, like your family's monthly budget. Sources and uses is a summary, we saw it in the first page. This is really a breakout for anybody who needs the details between what you need the day you close versus what you need to build, and where I want to end up with monthly cashflows. This is the engine and if you're an investor or a lender, unless you're really diving in deep, you're not going to be looking at this the first time you see the deal. The goal here is to show every single month from the first month of funding, where the property stands. These are all zeros, because you're in construction phase, there are multiple ways to do this kind of formula. In relation to linking to the durations, I like to do a formula where it tells me like, Okay, month seven, you're still in construction, a lot of these formulas here will actually be driven based on what this cell says. As you're going through construction, 24 months, then it realizes at month 25, it begins the lease up. At 48 months you stabilize, and then whenever you exit is, this will go for 7 years. So one year more so you have a future NOI.

The goal here is, if I want to exit as an investor or as a lender, what is my risk of waiting until before stabilization? At what point during lease up do I hit the yield that I need to be? Or at what point am I operationally profitable? And the last part, the exit, the biggest toggle here is obviously cap rate, you're stabilizing a property and you're selling it for a certain yield. I put at least 6%. In a post Covid environment that we're living in, office is an interesting subject. A lot of opportunity, and a lot of hurt in some cases is happening in the office space. We're seeing a cultural revolution, frankly, on terms of office.

The project I picked here is an open layout, high ceiling, shared amenities. I think this is where office is going, and we are just showing what kind of concept you'd probably be wanting to build today. I was reading the news today and I think 19% of New York City offices are on the market. It's a double edged sword, it is an opportunity, and a tragedy at the same time, depending on who you are. And depending on what kind of company you are as a tenant or as an investment.

Opportunity, in my opinion.
I agree. I think when people leave is when you want to get in. All that is to say the cap rate is going to be a very contentious topic with pretty much every party involved. Nobody is necessarily wrong or right. Keep in mind that this is six years from now that you're estimating what this property will be worth, what buyers will want, where buyers will want to put their money. And the best way to portray this is if you go back six years and read the best of the best. You read the CBRE, the Newmark reports, I will guarantee you most of them are wrong. And that's not because they don't know what they're doing, because that's life. Six years from now, who knows where we'll be, who knows where the Fed will put interest rates, who knows where money will be coming from, if I told you six years ago that most of the world will have negative rates and you can get a mortgage for under 3%, that would be insane. But that's the world we live in today.

And that drives cap rate compression, because people are trying to park their money somewhere. If I tell you to give me $100 and I'll give you $6 a year, that's it. And it's an office product, it's stabilized. You might do it even today, depending on the market. This is where you'll have a conversation about, Look, I stabilize at 21 million NOI this specific one has rent abatements, any other kind of tax rebates, etc. You'll have a conversation about what your NOI looks like. You're always looking at deals on the forward NOI, so that's basically the next 12 months. And you want to buy that profit at 6% yield, because you're comparing it to a bond, you're comparing it to other investments. That's where the cap rate driver comes in, and you cap your gross value, you take out the sale costs, I put them tentatively at 3%. And then you get to your total net sale proceeds in this case. This is your total cost that you built to, and this is what you're exiting for. You want to exit at a higher valuation than you built it for.

How are you 100% sure that someone didn't mess up one little formula that could derail the entire thing?
You want to make sure that the analysts or professional that you have, or contractor, knows what they're doing, and has experience doing this. As a sponsor you are the one responsible for it. If you're the one presenting this, you are the one that should walk through this whenever you have your first model, or if you build it out, walk through it, and review it, check your work. This is true for any business, any aspect of any business. I will note one thing if you're an investor, or a lender, or another third party that receives this model, you aren't the initial owner or the initial builder of it. The goal here is as you're going through the deal, and this is true for lenders specifically. The way a lender works is once they're serious about the deal, about underwriting it, they'll pass it off to an analyst within their own company who will vet this, in sometimes aggressive calls, and sometimes, less aggressive calls, but a complete vetting of the entire engine that I've mentioned. The onus is on everyone that's involved in the deal to take a look and make sure it's accurate. I don't think there's any shortcuts to that. Checking your work goes back to relationships, trusting that the people you're going into business with are professional and accurate about what they do.

If someone wanted to work with you guys on a project, what would they need to provide you? What kind of numbers and information?
The process is we have an employer reach out, our sales representative works with them to take down their initial scope, understanding the kind of product they work, because we don't just do office, whether it's residential, industrial, land use, single family rentals, pretty much all the food groups, location, geographically, what specific skill sets they're looking for outside of underwriting, whether you need leasing skills, you need asset management skills, you need somebody who will be able to be on site. They take down the scope, we go through our pool of freelancers to see who has the skill set, who's available and within the rate that the employer wants to pay. And we make that introduction, there's an interview to make sure that everyone understands the scope, and everyone's comfortable with it. If the relationship is okay, we create a contract and then you can work directly with the freelancer from then on.

In terms of what gets provided to the freelancer, or the professional, if I were the underwriter and if somebody asked me to underwrite this deal for them, the big things I would ask are the location, what they're trying to build, construction costs usually get provided by a client, however, we have some clients that say, Look, I also need help with finding bids from general contractors, can you provide me a shortlist of the best job contractors for this market? Or that you know of, and we can schedule calls with them? So it's really a white glove employee service that you don't have to pay full time. Some employers asked me to help them gather this information, help them understand what the land actually cost on a per foot basis? What should they be willing to pay for it? Generally speaking, high level, this usually gets provided by the employer. Chances are they should know more or less what they're building. It's fine if they don't.

Also the business plan in terms of, what are they building? How much retail are they building, how many office square foot, any kind of amenities, how they're bifurcating it, are they doing a bigger office, what's the wall format, are they smaller ones, how many tenants per floor, etc. This usually helps you have a more meaningful conversation around rents, and the leasing assumptions for either Argus or Excel that you're doing. Those are the two big things that get provided outside of that.

I tend to do the financing myself in terms of assumptions, these are relative to market across the country, or across various markets, especially if you know the market. But if somebody tells me, I have a relationship with this lender, this is going to be their terms. I obviously plug that in. Same thing with the equity, I have a systematic investor that I work with. This is going to be the terms, the waterfall, etc. I plug that in. That's about it. I would say the big ones are the budget and the format.

Because you have so much experience on this, what are the asset classes that you've seen are the most profitable?
We are in a position where we're actually trying to do more academics as well, because we are obviously seeing a lot of projects. And when we think that's going to be beneficial for the entire community that we're building. Profitability is a challenging answer, not to dance around, you're probably seeking low returns, but also lower risk. I would say profitability really depends on who your equity is, and what kind of terms you can get there. I think that has become frankly, a little bit more commoditized. Obviously, rates are a little bit similar across the board, you might want a couple of basis points here and there. In terms of construction costs, everyone deals with them equally, unless you are vertically integrated with a construction company, like some of the bigger guys like Blackstone are trying to do.

Outside of that, the secret sauce comes down to how cheap your equity is, and how creative you can get with it. As far as asset class, volume wise, residential is still by far the biggest volume player in terms of construction specifically. But any kind of value add as well. Office has been tricky over the last year. But that is definitely our second biggest. I will give a little bit of secret sauce here. Medical office and medical use is booming across the country. And it has been since inception, even pre pandemic. Outside of that, industrial acquisition, for the right buyer, not everybody's looking for 30% IRR. Some people are just trying to hit 10, if they hit 10, they're happy and so are their investors.

The big one here is management fee. As a sponsor, you're not just making money off the waterfall, you're making money of operating this for your investors as well. Even if the returns are low, the money might be foreign, it might be coming from a country where there's negative rates, and they're more than happy to get a deal here that's, in our eyes, not very profitable, but from their point of view, it's a safe place to park money. It gives them an extra six or 7%. annually. They'll take it if it's in some parts of California, Texas, Florida, or New York that they view as very secure. Everything has to be compared and apples to apples. It's secure for them. It's higher than whatever they're getting in their country, they're more than happy to park it. So even a 7% deal makes sense.

Do you see higher profits in certain markets?
And my last question on this, do you see higher profits in certain markets? For example, if you get something entitled in San Francisco, it could end up being a great property, however it depends on how long the entitlement takes. Have you seen a trend of for example, Texas, being a better market when it's all said and done, or it's still very relative?

It's something that wasn't included here to avoid complexity. This construction is set to 24 months, if a month of this was construction, and the remainder was pre development, permitting entitlement, etc, that's a tougher pill to swallow. It basically says, Okay, I can spend a year and a half and still not know if I can build this, and all the money might be wasted. Texas is a lot softer in terms of regulation, and entitlement, generally speaking. Obviously, the coastal states are pretty tough right now, New York and California. But you're also getting the security of New York and California. The big one is entitlement.

I would also note, even through the I-95 corridor, and this is just some insight, anything that's for example, industrial zoned is still a booming product. I remember, maybe two, three years ago, people were saying, That's almost tapped out as a market. It's still going. And weirdly enough, with the pandemic everybody started buying more from Amazon, or any other kind of online marketplaces. This is not by any means meant to be used as financial advice. But I do think there's years of backlog in terms of storage, to my own surprise, because I was one of the people that, maybe two, three years ago thought that industrials were close to tapped out, and it's not even close.

Renat Yusufov