|Copyright 2014 by Virgo Publishing.|
|By: Jim Oakley|
|Posted on: 11/01/1998|
CRITICAL PATH FEASIBILITY
By Jim Oakley
During the development of a self-storage facility, the most vulnerable time for negative cash flow is between the construction phase and fill-up. While monthly interest accrues, occupancy is trying to catch up. Loan payments are required every month, and to make matters worse, bankers need monthly assurance money on hand to meet these payments. It may make an operator wonder if yesterday's guesses on the back of an envelope are good enough for today's lenders, much less his bottom line.
This is where Critical Path Feasibility--determining the number of completed units that can be profitable during fill-up--comes into play. Construction and financing can then be fine-tuned to occupancy on a month-to-month basis. Historically, this has often involved guesswork without testing monthly "what-if" scenarios. Don't assume popular spreadsheet programs can amalgamate all the necessary financial events simultaneously and monthly, because most don't.
Diagnosis Is 95 Percent of the Cure
It is said the eye of an eagle does more work than the claw. Unmasking the problems that lead to negative cash flow is the first step in resolving it. Critical Path Feasibility puts every financial event involved with the facility under a microscope against the background of interest charges, expenses and rent up. Cash flow during construction and rent up must be projected every month in detail. In order to create a Critical Feasibility map, the following seven key financial events should be tracked together monthly on the same page:
The Case of 'Feeding The Alligator'
Projects are often shot down unknowingly by developers themselves. Such is the case in the "Feeding the Alligator" example, which shows cash flow during construction and fill-up. In Exhibit 1, the seven vital functions are displayed monthly during this period to unmask where the shortfalls in cash flow occur.
Negative Cash Flow
Notice in Exhibit 1, by month 20, negative cash flows of $88,689 have accumulated. After the first 24 months, the project is in a negative cash flow position of $30,126.
The lethal question though, is, where is the $43,469 that will make the loan payments during the first six months and the $45,220 to make payments in the next six months? This question by the banker can cripple financing, unless the Critical Feasibility map has been engineered to address this deficiency in advance.
Surprisingly, this situation often remains hidden from the developer if monthly cash flow isn't calculated in detail. It's easily curable with proper diagnosis and treatment. The assumptions for the case study are as follows:
Unit Mix and Rental Rates
The following case study was selected because it has a heavy mix of climate-controlled units that can often compound the problem, making the demonstration even better. Other income for the facility is projected at 5 percent.
Initially, monthly absorption will be 10 percent, then decreased to 5 percent until it is 90 percent occupied. This is figured through 30 percent expense-to-gross ratio.
Determining the Interest Reserve
Since we have mapped monthly net operating income, we know the project cannot afford $14,293 loan payments until after month 19. Therefore, it helps to have the loan make its own payments until then. An interest reserve amount must be established, meaning the loan will make its own payments to the extent of the interest reserve amount (See exhibit 2, column 6). Notice loan payments are added to the loan balance until month 16 (See exhibit 2, column 4).
The Case of the 'Cash Calf'
In this successful case study, an interest reserve of $100,000 has been implemented (See exhibit 2). In the "Cash Calf," example, the project has a positive position of $18,202 after the first year of operation. The key observation is that in the "Feeding The Alligator" example, the project has a negative cash flow of $43,469 in month 12 and $30,126 at the end of month 24, which is a big difference.
Obviously, delaying the construction of units until they are needed makes better use of capital. To what extent additional units should be phased, is not clear until cash flow is mapped on a monthly basis. Only when all of this becomes self-evident on the same page, can decision makers maximize efficiency of construction draws in relation to occupancy. Several scenario's should be tested for comparison.
Phasing for a "Cash Cow"
In Exhibit 4, the project is split into two phases. Phase I has 60 percent of construction costs and Phase II has 40 percent. Thus, loan payments have been reduced in the initial months of construction. Instead of payments of $15,023 after six months of construction, the payments are reduced to $9,014 (See Exhibit 3, column 6 and Exhibit 4, column 6).
Positive Results for the Lender
Today, a feasibility study isn't really complete unless it determines a critical financial path. If you're not using a monthly critical feasibility map, you're making guesses, not decisions. The case study proves this with an overall difference of $94,089 between the first and last examples. Going from a negative cash flow of $30,126 to a positive cash flow of $63,963 in a project of this size is a monumental difference that can make or break the project in the first year (Compare Exhibit 1 to Exhibit 4).
Through the use of interest reserve and phasing, the project has been made profitable. Moreover, the amount of recourse needed for the loan has been reduced because funds for Phase II are not extended until Phase I proves itself. And this situation is more inviting to the lender because less capital is extended before a project proves itself with occupancy. Also, the construction loan is in place longer, thus the lender has a higher interest-rate loan implemented for a longer period.
You Better Prove It
Requesting a loan with such a fine-tuned interest reserve for a longer period from your banker is not enough. You must prove its necessity with a win-win presentation. Lenders normally review several packages each week and pick only the best. You can't go back and change the numbers after a rejection without losing creditability. If you don't show your banker an enhanced monthly, positive cash flow, you won't get another chance.
An appraisal will prove its worth once it's completed and occupied, but you need a critical feasibility map to prove how it will make its monthly payments to get there.
Jim Oakley is a consultant that specializes in computer feasibility packaging for developers, lenders and investors. His methodology has been taught at Arizona State University and its Center for Executive Development. He has addressed major national conventions including National Association of Estate Executives and the National Association of Real Estate Educators. Mr. Oakley can be reached at (520) 778-3654 or on the Web at www.mrfeasibility.com.