How Developers Determine Whether a Project Works

Developers do not decide to build expensive housing. They build a spreadsheet, and the spreadsheet decides whether anything gets built at all. That spreadsheet is the pro forma: a projection of what a building will earn, what it will cost to operate, what it will cost to build, and what is left over for the people who financed it.

By the end of this lesson you will be able to read a simple pro forma line by line, understand the handful of ratios lenders and investors use to judge it, and see why a project whose required rent is above what the market will pay does not happen. The numbers below are for our illustrative 100-unit building and are assumed, not observed.

Revenue: from potential rent to actual income

The pro forma starts at the top with gross potential rent: every unit, at its projected rent, for twelve months, with nobody missing a payment. No building achieves that. Some units sit empty between tenants and some tenants fall behind, so the pro forma subtracts an allowance for vacancy and credit loss. What remains is effective gross income, the revenue the building can realistically expect.

Operating expenses and net operating income

Running a building costs money every year: property taxes, insurance, a management company, repairs, utilities for common areas, and replacement reserves set aside for roofs and boilers that will eventually wear out. Together these are operating expenses. Subtracting them from effective gross income gives net operating income, the single most important line in the pro forma. It is what the building produces before anyone who financed it is paid.

Cost: what the building has to earn against

Below the income lines sits the total development cost: land, hard costs for construction, soft costs for design, permits, and fees, plus financing costs and contingency. In our illustration it is $24,000,000, or $240,000 per unit. The whole question of the pro forma is whether the net operating income is large enough relative to that cost.

The pro forma at $2,150 rent

The ratios that decide

From those lines come four ratios. Each answers a different person’s question.

Yield on cost answers the developer’s question. It is net operating income divided by total development cost: $1,851,000 ÷ $24,000,000 = 7.71%. It says what return the building generates on every dollar spent to create it, before financing.

Cap rate answers the buyer’s question. It is the rate at which the market values a stream of net operating income. If buyers of stabilized apartment buildings are paying prices equal to NOI divided by 6.0%, then our building is worth $1,851,000 ÷ 0.06 = $30,850,000 once finished. The difference between yield on cost and cap rate is the development spread. Here it is 7.71% minus 6.00%, or 171 basis points. That spread is the reward for taking on the years of risk described in Lesson 1; if it is too thin, an investor would rather buy an existing building than build one.

Debt service coverage ratio answers the lender’s question. It is net operating income divided by annual debt service: $1,851,000 ÷ $1,183,231 = 1.56. The lender wants to know how far income could fall before the loan payment is at risk. A ratio of 1.56 means income could drop by roughly a third before it no longer covers the payment.

Cash-on-cash return answers the equity investor’s question. It is cash flow after debt service divided by the equity invested: $667,769 ÷ $8,400,000 = 7.95%. Investors also look at internal rate of return, which accounts for the timing of every dollar in and out over the whole hold, including the eventual sale. We leave IRR for Lesson 6.

Yield on cost = NOI ÷ total development cost = $1,851,000 ÷ $24,000,000 = 7.71%
Value at a 6.0% cap rate = NOI ÷ 0.060 = $30,850,000
DSCR = NOI ÷ debt service = $1,851,000 ÷ $1,183,231 = 1.56
Cash-on-cash = ($1,851,000 − $1,183,231) ÷ $8,400,000 = 7.95%

Running it backward: required rent

Developers usually run the pro forma in reverse. Start with what the capital requires: $1,183,231 of debt service plus $672,000 of equity return (8% on $8,400,000), or $1,855,231 of net operating income. Add $600,000 of operating expenses. Divide by 0.95 to allow for vacancy. The result, $2,584,454 of revenue, spread over 100 units and 12 months, is $2,154 per unit per month. That is the required rent: the rent at which the math just closes.

When the math does not close

Now suppose the market study says comparable new apartments in this area lease for $1,900, not $2,150. Rerun the lines. Gross potential rent becomes 100 × $1,900 × 12 = $2,280,000; effective gross income $2,166,000; net operating income $1,566,000. Yield on cost falls to $1,566,000 ÷ $24,000,000 = 6.53%. DSCR falls to $1,566,000 ÷ $1,183,231 = 1.32, which many lenders would still accept. But cash flow to equity falls to $382,769, a cash-on-cash return of 4.56% against an 8% target. At a 6.0% cap rate the finished building would be worth $26,100,000, barely above its $24,000,000 cost, leaving almost no reward for the years of risk it took to build.

Nobody in that scenario decides to build unaffordable housing. The investors decline, the developer cannot raise the equity, the lender never closes, and the site stays what it was. This is the point that explains a great deal of housing economics: new buildings appear only where achievable rent meets or exceeds required rent. Where it does not, the shortage persists, not because anyone chose it, but because the arithmetic did not permit the alternative.

It also explains why the pro forma is where policy lands. A fee, a parking requirement, a delay, or a rate increase does not show up as a line called “less affordability.” It shows up as a higher total development cost or a higher debt service, which raises the required rent, which either the market pays or it does not.

Next lesson. The pro forma tells us the rent a new building needs. Lesson 4: What Determines Rent? explains how that required rent relates to the rent the market will actually pay, and why the two are set by different forces.