Introduction to Operating Proformas

Jack Geary CPM

Jack Geary ConsultingWashington DC/Florida/Massachusetts

Mike Clark HCCP

Alpha-Barnes Real Estate ServicesDallas, TX

What is a Proforma?

pro for ma⋅–noun 1. according to form; as a matter of form; for the sake of

form.2. Commerce. provided in advance of shipment and

merely showing the description and quantity of goods shipped without terms of payment: a pro forma invoice.

• Accounting. indicating hypothetical financial figures based on previous business operations for estimate purposes: a pro forma income & expense statement.

Harold Nassau’s Definition of a Proforma

1. A hopeful, but often fictional financial projection of a property’s operations over time;

3. Developed by people who should know better;

5. Frequently developed without experienced asset management and property management input.

The Proforma Dilemma – The Setup

• Many of the problems faced by asset managers are predestined long before the property leases up - even before the property is in the ground.

The Proforma Dilemma Outcome of a Bad Proforma

• Once the property is built and leased up it is very difficult or impossible for the manager to operate to the property’s cash flow and other proforma projections –

• Even if the manager does everything right.

The Optimistic Proforma

• Intentionally or unintentionally, multifamily affordable housing deals are often underwritten with overly optimistic assumptions.

The Optimistic ProformaThe Consequences

• Improperly underwritten deals saddle the property with operating losses.

• These deals often require sponsors to fund operational guarantees forego anticipated developer and asset management fees.

The Optimistic ProformaThe Realities

• Projecting operating assumptions into the future is tricky – even with all of the right information and intentions.

• Reasonable assumptions impacted by factors that we are not yet aware of.

• The intentional errors and omissions are even more difficult to work through.

Why Does this Happen?Degree of Difficulty

• This is actually a lot harder than it looks. – Sponsors/Developers

(particularly inexperienced developers) often just do not understand the “on the ground” operating and market realities.

Why Does This Happen?Competition

• Fierce competition for limited resources– The competitive nature of deals (particularly

9% Tax Credit deals) creates a front end incentive with sometimes disastrous back-end consequences.

Why Does This Happen?It’s Just Who We Are

• Human Nature - Fees & Deal Junkies– Deals are what motivates and drive many CDC

Directors.– The potential for large fees will drive developers into a

marginal or bad deal.

• Our Mission & Role in the Marketplace – Our Double Bottom Line motivation is more complex

than the for-profit sector.– Sometimes we’re the only one who will do the deal,

and financial return is only one part of the equation.

Key Development PeriodPlanning Documents

• Sources and Uses Statement

• Operating Proforma

Reality Check:• Operating Comps from other

properties. • Market Study & Rent Comps.

Sources and Uses Statement

• Summary of the funding sources and uses of a real estate development project.

Examples of Sources Examples of Uses

•Tax Credits•Tax Exempt Bonds•Conventional Loans•Soft Loans

•Grants

•“Sponsor” Loans & Deferred Fees

•Acquisition •Construction •Legal, A&E, •Developer Fees

•Start-Up Reserves (Leaseup, Marketing, etc.)

•Capitalized Operating and Reserve for Replacement

Example of a Sources & Uses Statement

Sources of Funds

LIHTC $2,000,000Tax Ex Bond $1,500,000HOME Loan $500,000Soft City Loan $200,000Sponsor Loan $150,000NW Grant $100,000 Total Sources $4,450,000

Uses of Funds

Acquisition $650,000Rehab $2,500,000Legal/A&E $550,000 Developer Fee $425,000Capital Reserves $200,000Contingency $125,000Total Uses $4,450,000

The Proforma

• The Operating Proforma is an underwriting projection of how the property is expected to perform financially over a stated period of its life.

• By using basic operating data and trending assumptions, the proforma projects the property’s cash flow and the site’s ability to meet or exceed its operating and debt obligations.

Proforma – An Example

1 2 3 4 5 6

GPR 420,000 428,400 436,968 445,707 454,622 463,714

Vacancy (42,000) (21,420) (21,848) (22,285) (22,731) (23,186)

EGI 378,000 406,980 415,120 423,422 431,890 440,528

Operating Costs 200,000 207,000 214,245 221,744 229,505 237,537

NOI 178,000 199,980 200,875 201,678 202,386 202,991

Debt 180,909 180,909 180,909 180,909 180,909 180,909

Cash Flow (2,909) 19,071 19,966 20,769 21,477 22,082

Note:

Income trended to increase at 3% per year

Expenses trended to increase at 3.5% per year

Elements of the Proforma

The Market Study

Market Study – Rents and MarketabilityDoes the market support the proforma assumptions?– Is our target market appropriate, dependable and supportable

(anticipate business cycles, military base closings, etc.)?

– Value - Will the projected rent levels hold up? Will prospective residents think that the property is worth these rents?

– Local/Submarket Market saturation – New properties now in development not considered on your proforma?

Elements of the Proforma

Income Targets & Restrictions • Rent Levels – Revenue Purposes

– Are the proforma rents limiting the Applicant Window?

– Maximum allowable rents may not be achievable rents!

– How current are the Utility Allowances?

A Closer Look – The Applicant Window

• Market Affordability Window is the window between the (minimum) income required to comfortably pay rent, and the (maximum) rent allowed.

• The larger the Applicant Window, the broader the pool of target applicants to draw from.

Applicant WindowAn Example

Assumptions:Tax Credit Property (Max 60% AMI)• Allow Family to pay ONLY 30% income for Rent • Maximum Rent is based on 60% AMI• AMI is $65,000 – Maximum Rent is $975

– At $975 rent, applicant pool is limited to ONLY those with income of exactly 60% AMI.

– At $950, applicant pool is 58%-60% AMI– At $925, applicant pool is 55%-60% AMI

Elements of the Proforma

Vacancy Projections

• Vacancy Projections– Are the vacancy projections realistic?

– How do the vacancy projections compare to your other properties and the local market?

– How will this property impact the local sub-market and local vacancy – Are you competing against yourself?

Elements of a Proforma

Operating Costs

• Operating Costs are projected for Year 1 Operations and trended to project later years (+2%, +3%, etc.). – At least 3 opportunities for dangerous

assumptions• Base operating costs• Trending assumptions• Expense factors missing (Asset Mgmt Fee, Govt

Fees, etc.)

Underestimating Operating Costs

• Developers often underestimate ongoing operating costs for the following reasons– Poor understanding of stabilized operating cost

realities and costs that can change rapidly;

– Seeking to satisfy funders who do not understand (or are trying to impact) the operating cost environment;

– Cost assumptions may not include resident services that are critical to the Nonprofit’s mission;

– Seeking to maximize NOI to borrow more money.

NOI and Debt

• Net Operating Income (NOI) determines the amount of mortgage debt (hard debt) that a property can carry.

• NOI can be incorrectly projected (or manipulated) by incorrect proforma assumptions and projections.

• This is a tempting target for developers.

RefresherDebt Service Coverage Ratio

• Debt Service Coverage Ratio is a measure of a property’s ability to cover its debt after operating costs.

• DSCR = _NOI_ Hard Debt

• Incorrect revenue or expense projections will lead to an incorrect DSCR Projection.

A Closer Look

Calculating the Debt Capacity

NOI = Maximum Annual Debt Service DSCR

Solve for Total Debt Capacity (PV) in Excel (Functions)• pv = Total debt capacity (Amount you can borrow)• nper = Number of payments (30 yr = 360)• rate = Interest Rate (rate/12 if paying monthly)• pmt = Monthly Debt Payment (ADS/12 if paying monthly)

A Case Study –West St. Apartments – Louisville, KY

• CDC developing 50-unit property.

• LIHTC (60% AMI).

• Asset Manager provides rent reasonableness, vacancy and operating cost projections.

The Asset Manager’s Assumption

Asset Manager’s Assumption

Monthly Rent Assumption $675

Vacancy Assumption 6.0%

Operating Cost (per unit) $ 4,100

Anticipated Operating Results

GPR $405,000

Vacancy $ (24,300)

EGI $ 380,700

Operating Costs $205,000

NOI $175,700

Annual Supported Debt:

$159,727 (1.10 DSCR)

Debt Capacity (30 yr @ 6%) $2,220,097 (30Yr / 6%)

The Developer’s Approach Push the Envelope – Maximize Borrowing

• The Developer is not happy with the Asset Managers Projections – Property could not get a $300K soft loan from the City and needs to borrow $2.5Million to make this deal work.

• How about a few small changes - – Property should rent for $700 instead of $675.

– New property should be able to minimize vacancy – take the 6% to 5%.

– HFA says that properties in Kentucky average $4,000 per unit. Why should we forego debt capacity by carrying $4,100. Lower cost projection to $4,000.

The Developer’s ApproachPush the NOI Envelope to Maximize Debt

Aggressive Assumptions

Monthly Rent Assumption $700

Vacancy Assumption 5.0%

Operating Cost (per unit) $ 4,000

Anticipated Operating Results

GPR $ 420,000

Vacancy $ (21,000)

EGI $ 399,000

Operating Costs $200,000

NOI $199,000

Annual Supported Debt $ 180,909 (DSCR - 1.10)

Debt Capacity$2,514,510 (30 Yr / 6%)

Squeezing Up the Debt Capacity

Monthly Rent – Year 1 $675 $700

Vacancy Rate 6.0% 5.0%

Operating Costs – Year 1 $4,100 $4,000

Debt Capacity (6.0% rate, 30 Year Term)

$2,220,097 $2,514,510

+13%

Impact on the Applicant Window

Minimum Income 54% AMI 56% AMI

Maximum Income 60% AMI 60% AMI

•Lower rent schedule increases the applicant window by about 1/3.

•Larger Applicant Pool = Higher Occupancy & ability to be more selective in screening your applicants.

Impact on Cash Flow

• Increased debt level means higher debt service.

• Annual Debt Service cost

under Developer’s Plan is $16,000 higher each year than the Asset Manager’s plan.

What if We Don’t Reach the Aggressive Projections?

• Difficulty renting – vacancy loss in Year 1 was 14% - Property ended up lowering rents to $685 and vacancy stabilized at 6%.

• Operating costs, at about $4,100 were pretty close to the conservative projection.

• Occupancy started off well, but then a nearby plant closed, stabilized vacancy has been 6%.

Actual Cash Flow vs. Underwriting Projections

-$20,000

-$10,000

$0

$10,000

$20,000

$30,000

1 2 3 4 5 6 7 8 9 10

Year

Cas

h Fl

ow

Projected

Actual

What can Asset Managers Do?

Get In The Game

• Get a seat at the table – early

• Be prepared to make the argument & back it up – data, examples, comps.

• Ask to do the first proforma.

• Be prepared to be abused!

Understand and Test the Marketing Assumptions

• Reasonable Rents?

• Does the market pool seem sufficient– Look at your own waiting lists

• Sufficient Applicant Window?

• Will you be competing against yourself?

Benchmarking

• Understand your own data– You know better than anyone what it takes to

run your own properties.– Do your homework!

• Push back at the “lowballers”– Ask to see their backup data

• Beware of Operating Cost “Parrots”

Playing Well With Others

• Don’t defer so easily– Those development folks aren’t quite as smart

as they want you to believe that they are!

• Educate – Make sure that the Executive Director

understands the consequences:• Cash Flow Deficits to be covered, Guarantees;• Deferred/Uncollected Fees;• Loss of credibility and impact on future deals.

Other Issues to Review

• Sufficient Reserves?• The administrative cost of multiple

partners and the concept of “free money.” (Practice Safe Partnerships).

• Understand the benefits of density and scale.

• What can local government do to help – Taxes, fee waivers, infrastructure, maint.)

The Other Side of the Coin

• If our costs are much higher than everyone else – figure out why.

• The Cost of Mission.