Architect As Developer: 03
03: Proforma Lingo — For Sale Projects
This is Part:03 of the AAD Series. Check out Part:02 if you haven’t already.
Ok, it’s time to start talking about Proformas. We’ll dig in to actually creating a proforma very soon, but for this week (and the next) we’ll have to settle for a little ‘ol boring foundation work first; we need to learn the lingo of proformas. I’m assuming many of you are familiar with lots of these terms, but it’s always good to cover them so that we can at least ensure that we’re speaking the same language.
I intend to discuss this in two sections; one section for proformas that are geared towards For Sale projects, and another section that is geared towards For Rent projects. They each have some unique terms that really don’t come into play in the other.
This week I’ll focus on For Sale Proformas.
Ah yes, before I forget, some people with much more experience or knowledge than me may find my explanations or definitions a bit too simplistic or even basic. That’s ok, and they’re probably right. This level of understanding is what works for me and I encourage those who really want to go down the rabbit hole of financial terms to do so. Start here if you like.
For Sale Proformas — Essential Terms
Total Development Cost (TDC)
This is the total cost of the project and includes:
1. Land Cost
2. Hard Costs
3. Finance Costs
4. Soft Costs
Hard Costs (HC)
This is the cost of construction. Simple really.
Do note, however, that I have seen all kinds of versions of this cost. Some people include site utilities in this cost, such as the cost of new water meters; some people don’t. It doesn’t matter really. Just make sure water meters are included somewhere. This goes back to my comprehensiveness vs accuracy point I made in Post:02. You make your Hard Costs whatever you want them to be.
Finance Costs (FC)
This is the price you pay for money, be it money from investors, or money from banks. No one gives you something for nothing. Finance costs include interest on Land Loans, interest on Construction Loans, interest owed on investor equity (although it is called out separately in the proforma).
Soft Costs (SC)
If it’s not a Land Cost, a Hard Cost, or a Finance Cost…it’s a Soft Cost. At least that’s how I work my proformas. You can always do it as you wish. Soft Costs include consultants, permits, fees, legal costs, insurance, marketing, and on and on.
This is the amount you’re “short” in order to have enough equity to do a project.
Most banks, when you take out a construction loan, like to see that you (or your development team) have, let’s say, 25% of the funds on hand needed to do the project. They’re willing to fund the other 75%. If you have only 20% of the equity, you have a 5% equity gap.
Total Development Cost: $4M
Loan Amount: $3M (75% of TDC)
Cash on Hand: $800k
Equity Gap: $200K ($1M needed to complete 25% of TDC)
So, if you need to be at 25%, you need to find that $200k somewhere. Sometimes you can borrow this $200k from someone else. This is often called a “bridge loan” because it helps you “bridge” the gap. (These clever names are awesome aren’t they?)
This is a breakdown of what the Equity is being used for and where it is coming from. So using the $1M from above:
- Acquisition Equity: $500,000. This is what you use to tie up land.
- Carry Cost Equity: $300,000. This is what you will need to pay for everything (land loan interest, architect, permits, fees, etc) until you can get to the Construction Loan.
- Equity Gap: $200,000. The cash you need to show the bank you have in order to close the on the construction loan.
Moral of the story: Get a better land loan!! Then you don’t have use your entire $500,000, and you may not have an Equity Gap of $200,000.
Carry or Carry Costs
As mentioned above, these are the costs you have to “carry” from the time you acquire the land to the time you get a construction loan. This includes many of your Soft Costs, but may include other things as well.
An investor looking to lend you money is going to basically want to know, “How much will I make?” and “When?” There are many ways to skin that cat, but here are two very common terms you will hear in this regard.
Investor Preferred Rate
This is a rate of return that you negotiate with them in return for them lending you money. It could be 5% (give me their email please!), it could be 10%, or it could be 30%. This is totally up to you and them, and this rate will ultimately be determined by how good a negotiator you are.
This is what you offer an investor AFTER they get their original investment with a Preferred Return. It could be a profit split of 60/40 where you get 60% of the profit (after preferred returns), and they get 40%, or 50/50, or 70/30, or whatever. Again, this will be determined by how good a deal you can negotiate.
Reminder: Tell you investor he or she CAN lose their money. Neither of these are guaranteed.
Return on Investment (ROI)
Simple formula to calculate the profitability of an investment.
ROI = (Total Gain-Original Investment)/(Original Investment)
Example: You invest $100, and you get $150 back.
ROI = (150–100)/100 = .5 or 50%
Note: One of the weakness of this simple formula is that it doesn’t take time into account. It may take 20 years to make that $50. That’s a pretty shitty return if you look at it that way.
Example of Investor Return:
Let’s say you have an investor and you negotiate of Preferred Rate of 10% and Profit Split of 60/40 (60 for you, 40 for them).
- You borrow $100,000.
- At the end of the project, after all expenses and everyone’s been paid, except for the investor, there is $500,000 left.
- Project will take two years.
How does that get divided?
- Investor gets his 10% first, because he gets preferential treatment (I’m not sure that’s why it’s called Preferred, but that’s how I remember it). So he get’s $110,000.
- That leaves $390,000. That is the profit.
- You get $234,000 (60% of $390,000).
- Investor gets $156,000 (40% of $234,000).
So how did the investor really do?
- He or she put in $100,000.
- They ended up with $266,000 ($110,000 + $156,000).
- That is a Return On Investment (ROI) 166% in two years!! Not bad. They may tell their friends all about you.
Self Explanatory. The loan you get to pay for construction. There is actually a lot more to this, like how they work, how to get one, points, extensions, fund control, reserves, etc. But I’ll leave it at that for now.
Those squirelly bankers will try to lend you the least amount of money they can, so they will give you a loan based on different criteria, whichever is lower. As always I’m simplifying here, but that’s the gist of it.
Loan To Cost (LTC)
Loan amount a bank will give you in relation to the cost of the project. This is based on a percentage. These days we usually get 75% LTC. Back in the nutty heyday of 2006 let’s say, some banks were doing 90%. That means, if your TDC was $4M, the banks were lending you $3.6M!! Crazy.
Loan To Value (LTV)
Loam amount a bank will give you in relation to the value of the project. This percentage is always lower than LTC. That’s because your project should be worth more than it cost right? I hope so, or you’re doing something wrong. Typically, we see 60% LTV.
“Who determines the value?” This post is long enough already. Don’t ask.
LTC vs LTV
Banks will lend you the lesser of the two. Let’s see an example.
- Cost is $4M. LTC is 75%. Loan would be $3M.
- Value is $6M. LTV is 60%. Loan would be $3.6M.
- Therefore, bank will lend you $3M…the lesser of the two. Ta-Da!!
Ok, my head hurts just writing this, so I hope I haven’t done the same to you. The financial terms surrounding a deal are vast, and I’ve only touched on the biggies. You would have to go somewhere and take a course given by a true expert to really learn all of them and learn them well.
I’ve covered these in a very elementary way that allows us to have a pretty well-informed conversation however. To be honest though, that’s about as intimately as I know this stuff anyway. It’s worked for me up to this point, so I hope it does for you as well.
04:Proforma Lingo — For Rent Projects.
Lease type deals have a different set of terms in addition to those above. Since they usually earn returns slowly over time, the terms are a bit more involved. I’ll do the best I can to explain them.
P.S. A special thanks to my friend Jon Dilworth who helped me with this post. He’s an actual Real Estate Development graduate from the University of Michigan. I wanna be him when I grow up.
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