Financial Feasibility

Starting point or best guess?

By Jim Oakley

When adeveloper locates a potential site, he has a gut feeling about its profitability basedupon his experience. The first step is to then establish zoning entitlements and get asite plan approved. Next, he does a market analysis, which formally establishes unit mixand pricing. Meanwhile, construction costs are bid. Finally, when all these factors areknown, 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 someinformal estimates. However, it is not enough to multiply total units times rent rates onthe back of an envelope and then subtract expenses and mortgage payments to arrive at thebottom line. Peter Drucker, management expert, once said, "There is nothing so fatalas the right solution to the wrong problem."

Exhibit 1

Will it Work? What Will Work?

The land-acquisition answer cannot be based upon half a question, but a full picturecan be derived from informal estimates. These estimates must be flushed through the entireconstruction and rent-up process, complete with monthly construction-loan payments. Theanswer to acquisition is a financial scenario, because it must show absorption interactingwith 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-areacoverage? Or what if it is reduced to 35 percent? Does this reduction make the projectfinancially prohibitive? At what point will rental rates support land costs of $2 persquare foot or $5.50? What if interest rates jump 1 percent? Or what if your bankerinsists slower rent-up occurs? The answers to these concerns are three-dimensional becausethey 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 toknow financial criteria and limitations in advance of design. They shouldn't be in theposition of redesigning a financial mistake. Your designers should know before-hand thefinancial sensitivity to construction quality as it interacts with rental rates, unit mixand 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 uponinformal estimates of mix, rates, absorption and financing. Later it becomes a full-colorprofessional portrait when it is locked down with a market study validating rate, mix andabsorption, and packaged with a formal narrative. Several "what ifs?" can betested. The snap-shot can accomplish the initial go/no-go decision and is far less costlythan a formalized financial package for lender or investor. It is the vital core of thedecision.

Anticipating Negative Cash Flow

All projects will have negative cash during the first few months. For bankers, this isan underlying concern during rent-up. A start-up scenario must resolve initial negativecash 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 tounmask where the short-falls in cash flow occur. Notice that by month 12, negative cashflows of -$60,047 have accumulated, and after the first year the project is in a negativecash-flow position of -$15,438. Surprisingly, this dilemma exists in more than 90 percentof 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

Occupancy starts at 10 percent as a result of pre-sales and advertising, which isnormal. Thereafter, occupancy is increased at 5 percent monthly until it reaches 90percent. (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) Canthe 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 theeffect of a loan making its own payments for a short period. These loan payments are madeby increasing the principal balance of the loan for each payment made. This happens forthe first few payments until the "interest reserve" limit is reached. The amountof this limit is negotiable, and if bankers are shown specific monthly cash flow in aproforma, they are far more liberal about increasing interest-reserve limits.

How Much Interest Reserve?

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

Mapping Monthly Cash Flow

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

Exhibit 2

Monthly Assurance To Lender

Lenders are satisfied when they know how a project will pay for itself duringconstruction, 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 monthlyuntil permanent financing is in place.

The Loan Package

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

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

Internal Rate of Return

The internal rate of return (IRR) for this project is 50.49 percent. IRR is acompounding return rate. A helpful translation is to describe the yearly income stream aswithdrawals from a bank savings account having a 50.49 percent interest rate. If theinvestment of $402,825 were put in a bank account with 50.49 percent interest, thisdeposit 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 bejustified to the lender in surgical terms. The permanent loan can be larger than theconstruction loan. This is the developers' profit. While the construction loan is basedupon construction costs, the permanent loan is based upon an appraisal using the incomeapproach. The difference is $272,156, as shown above. However, it must be proved to thelender, 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 becauseyou 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 youstumble to collect your thoughts and present your ratios at the wrong moment, it can bethe most costly two seconds of your loan submission. Be prepared to run additionalscenarios 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 loanpackaging costs, while the real focus should be on financial engineering. Implementingappropriate interest reserve and permanent financing are far more important. Points, feesand analysis costs are small in comparison to the overall savings. In the example, thepoints 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 turnedinto a positive position of $24,504 at the end of the first year. Proper sizing of thepermanent loan lends $272,156 to the developer's bottom line in the second year. Return ofinvestment capital or profit is vital to doing additional projects. With today's high-techlenders, financial feasibility isn't really complete unless it shows the whole picture. Ifyou'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 packagingfor developers, lenders and investors. His methodology was taught at both Arizona StateUniversity and its Center for Executive Development. He has addressed major nationalconventions, including the National Association of Estate Executives and NationalAssociation of Real Estate Educators. Mr. Oakley consults from Arizona and can be reachedat (520) 778-3654; www.mrfeasibility.com.