Financial FeasibilityStarting point or best guess?
Copyright 2014 by Virgo Publishing.
By: Jim Oakley
Posted on: 04/01/2000



 
Financial FeasibilityStarting point or best guess?

By Jim Oakley

When a developer locates a potential site, he has a gut feeling about its profitability based upon his experience. The first step is to then establish zoning entitlements and get a site plan approved. Next, he does a market analysis, which formally establishes unit mix and pricing. Meanwhile, construction costs are bid. Finally, when all these factors are known, a financial feasibility package is created. What's wrong with this picture?

Is the Site Really a Keeper or a Discard?

The basic question of how much you can afford to pay for a site should begin with some informal estimates. However, it is not enough to multiply total units times rent rates on the back of an envelope and then subtract expenses and mortgage payments to arrive at the bottom line. Peter Drucker, management expert, once said, "There is nothing so fatal as the right solution to the wrong problem."

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Exhibit 1

Will it Work? What Will Work?

The land-acquisition answer cannot be based upon half a question, but a full picture can be derived from informal estimates. These estimates must be flushed through the entire construction and rent-up process, complete with monthly construction-loan payments. The answer to acquisition is a financial scenario, because it must show absorption interacting with construction costs, loan payments, leverage and down payment.

Answer These Questions in Your Head

What is the bottom-line profit if the site plan calls for 40 percent building-area coverage? Or what if it is reduced to 35 percent? Does this reduction make the project financially prohibitive? At what point will rental rates support land costs of $2 per square foot or $5.50? What if interest rates jump 1 percent? Or what if your banker insists slower rent-up occurs? The answers to these concerns are three-dimensional because they must simultaneously address absorption, financing assumptions and land costs.

Give Your Architect Parameters

Unit mix is not a design consideration, it is a financial one. Architects deserve to know financial criteria and limitations in advance of design. They shouldn't be in the position of redesigning a financial mistake. Your designers should know before-hand the financial sensitivity to construction quality as it interacts with rental rates, unit mix and allowable square footage, so that design can be financially functional as well as "zoning correct."

The Financial Snap-Shot

A financial snap-shot is still a complete financial calculation, but it is based upon informal estimates of mix, rates, absorption and financing. Later it becomes a full-color professional portrait when it is locked down with a market study validating rate, mix and absorption, and packaged with a formal narrative. Several "what ifs?" can be tested. The snap-shot can accomplish the initial go/no-go decision and is far less costly than a formalized financial package for lender or investor. It is the vital core of the decision.

Anticipating Negative Cash Flow

All projects will have negative cash during the first few months. For bankers, this is an underlying concern during rent-up. A start-up scenario must resolve initial negative cash flow. This obstacle is demonstrated in Exhibit 1.

The Case of 'Shot in the Foot'

This financial snap-shot shows six vital functions displayed monthly during rent-up to unmask where the short-falls in cash flow occur. Notice that by month 12, negative cash flows of -$60,047 have accumulated, and after the first year the project is in a negative cash-flow position of -$15,438. Surprisingly, this dilemma exists in more than 90 percent of development projects as they come on line.

'Shot in the Foot' Assumptions
Construction Costs

63,425 square feet (1,000 for manager)
$24 per square foot
$1,522,200 sub total construction cost
$152,220 developer fee at 10 percent
$1,674,420 total--$26.40 per square foot

Unit Mix and Rental Rates
32 5x5 $30
204 5x10 $43
88 10x10 $66
8 10x15 $79
54 10x20 $98
121 10X25 $112
1 15X25 $125

Occupancy starts at 10 percent as a result of pre-sales and advertising, which is normal. Thereafter, occupancy is increased at 5 percent monthly until it reaches 90 percent. (Note: A full break down of assumptions and cash flow models is available at: www.mrfeasibility.com.)

The Lethal Questions

Where is the -$60,047 that will make the loan payments during the first 12 months? Refer to Exhibit 1 for your answer. Moreover, a banker has three lethal questions: 1) Can the project make its payments during fill-up?; 2) Can you prove it can make its payments, month to month?; and 3) How much is it worth if we have to take it back?

What is Interest Reserve?

Interest reserve is the major factor helping to insure positive cash flow. It has the effect of a loan making its own payments for a short period. These loan payments are made by increasing the principal balance of the loan for each payment made. This happens for the first few payments until the "interest reserve" limit is reached. The amount of this limit is negotiable, and if bankers are shown specific monthly cash flow in a proforma, they are far more liberal about increasing interest-reserve limits.

How Much Interest Reserve?

Historically, interest reserve has been a "guess" without mapping monthly what-if scenarios. Don't assume popular spreadsheet programs calculate monthly interest reserve with mortgage templates. Most don't do these calculations because the construction loan has unequal payments of interest only, and often there are construction-draw holdbacks.

Mapping Monthly Cash Flow

The advantage of mapping monthly cash flow is to determine how much interest reserve is needed. The advantage can be proven to a lender in simple exhibits. In this example, there is -$60,047 during construction and the first eight months of operation. Accurately providing for negative cash flow during this period with a lender can avoid a very compressing first year. In the case of "All Systems Go," an interest reserve of $75,000 had been implemented. (See Exhibit 2.)

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Exhibit 2

Monthly Assurance To Lender

Lenders are satisfied when they know how a project will pay for itself during construction, through occupancy, to fill-up. The example of "All Systems Go" shows positive, critical, financial events during start-up, construction and absorption. Detailed financial mapping is essential to see how positive cash flow is achieved monthly until permanent financing is in place.

The Loan Package

To create an effective lender presentation, six key financial events should be tracked together--monthly, and on the same page. The seventh event should show the investment from conception through hypothetical sale.

  1. Construction Draws
  2. Occupancy Level
  3. Rental Income
  4. Operating Expense
  5. Loan Payments
  6. Cash Flow
  7. Overall Return

Exhibits 1 and 2 have shown the key financial events. To complete the picture, a hypothetical sale with sales costs is calculated in the final year, adding sales proceeds to cash flow in the final year.

End Result 'All Systems Go'
Invest $402,825
Year 1 $24,504
Year 2 $118,762 + $272,156 (loan)
Year 3 $97,829
Year 4 $112,097
Year 5 $127,079 + $1,133,955 (sale)
$1,886,382 total over five years Internal Rate of Return=50.49 percent

Internal Rate of Return

The internal rate of return (IRR) for this project is 50.49 percent. IRR is a compounding return rate. A helpful translation is to describe the yearly income stream as withdrawals from a bank savings account having a 50.49 percent interest rate. If the investment of $402,825 were put in a bank account with 50.49 percent interest, this deposit would allow yearly withdraws equal to the income stream. At the end of five years, there would be a zero balance in the account.

Collecting Developers' Profit

The permanent loan is the major source of profit to the developer, but it must be justified to the lender in surgical terms. The permanent loan can be larger than the construction loan. This is the developers' profit. While the construction loan is based upon construction costs, the permanent loan is based upon an appraisal using the income approach. The difference is $272,156, as shown above. However, it must be proved to the lender, in lenders' lingo, inclusive of net-operating income, debt-consolidation ratio, loan-to-value and the expense-to-gross ratio. Don't short-change your profit here because you don't make a full case.

Talk the Talk, Walk the Walk

If you don't talk this lingo, get a professional to present your package. If you stumble to collect your thoughts and present your ratios at the wrong moment, it can be the most costly two seconds of your loan submission. Be prepared to run additional scenarios for the lender on the spot to reflect more conservative absorption and fill up, or higher expenses or interest rates.

Penny Wise, Pound Foolish

Too often developers focus on trying to minimize loan points, origination fees and loan packaging costs, while the real focus should be on financial engineering. Implementing appropriate interest reserve and permanent financing are far more important. Points, fees and analysis costs are small in comparison to the overall savings. In the example, the points cost about $129 per month because they are added to the loan. Compared to the $188,000 gross income for the project, their cost is minimal.

Take the Cure or Take the Bath

In our example, negative cash flow of -$60,047 at the end of eight months is turned into a positive position of $24,504 at the end of the first year. Proper sizing of the permanent loan lends $272,156 to the developer's bottom line in the second year. Return of investment capital or profit is vital to doing additional projects. With today's high-tech lenders, financial feasibility isn't really complete unless it shows the whole picture. If you're not using a monthly financial map of the vital functions, you're making guesses, not decisions. The difference is hundreds of thousands of dollars to your bottom line.

Jim Oakley is a pioneer and national authority in computer-feasibility packaging for developers, lenders and investors. His methodology was taught at both Arizona State University and its Center for Executive Development. He has addressed major national conventions, including the National Association of Estate Executives and National Association of Real Estate Educators. Mr. Oakley consults from Arizona and can be reached at (520) 778-3654; www.mrfeasibility.com.