The Pro Forma: Garbage In, Garbage Out
I clearly remember one speaker’s comments from a 1985 NAIOP conference. His claim was this: One of the worst things that ever happened to the real estate business was the personal computer.
How Can This Be?
For those who can remember prior to 1980—before the personal computer and in the early days of the financial calculator—real estate pro formas were done by hand. Income-producing properties were evaluated based on current income, and development pro formas rarely went beyond three years.
With the onset of high inflation in the early 80s, pro formas showing annual increases in income became common to achieve high future evaluations, so real estate could compete with high bond rates. Even then you had to get the numbers (rents, expenses, cap ex, etc.) right on the first try because changing them after the initial projection was cumbersome and time-consuming.
Enter the Financial Calculator and the Personal Computer.
With these modern technologies, analysts could not only extend their projections, but they could tweak all of the numbers. In my opinion, this made pro formas much less reliable, not only because values past five (or even three years) are uncertain, but also because small tweaks to multiple variables can really add up to highly dubious projections.
With the advent of Excel and sophisticated software such as ARGUS, IRR-driven decisions, and larger and more complicated transactions, analyst reliance on the personal computer steadily grew and now greatly outweighs the human aspects of decision making.
The problem is that the numbers do not tell the entire story and often miss a significant factor or two.
While I utilize Excel spreadsheet and ARGUS software in my analysis, I rely heavily on market information, property history, surrounding area trends and, above all, gut instincts developed over a 45-year career. I place heavy emphasis on the current financial status of a property and what I think will happen in three years. If I am going to gamble on long-term upside, this is either reflected in the price or requires a more conservative financial structure, built for a long-term hold.
I use my computer every day to make my underwriting easier, but I recognize that it is only a tool and not a substitute for my knowledge and experience or for my clear decision making—based on what “it is” today, not what “it might be” 5-10 years from now.
Do you agree or disagree with my opinion on modern pro formas? Tell me why.