Exhibit 1

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CRITICAL PATH FEASIBILITY
Turning construction financing into your advantage

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.

Exhibit 1

THE CASE OF "FEEDING THE ALLIGATOR"
Month Const.Draws Occup.Level Rental Income Other Income Operating Expenses  Loan Pmts. Cash Flow
6 $135,250 $0 $0
7 $200,000 $986 -$986
8 $400,000 $2,455 -$2,445
9 $500,000 $5,361 -$5,361
10 $400,000 $9,007 -$9,007
11 $250,000 $11,924 -$11,924
12 $75,000 $13,747 -$13,747 -$43,469
13 10% $4,275 $214 $1,347 $14,293 -$11,151
14 15% $6,413 $321 $2,020 $14,293 -$9,580
15 20% $8,550 $428 $2,693 $14,293 -$8,009
16 25% $10,688 $534 $75,913 $14,293 -$6,438
17 30% $12,825 $641 $75,913 $14,293 -$4,867
18 35% $14,963 $748 $59,540 $14,293 -$3,296
19 40% $17,100 $855 $59,540 $14,293 -$1,725
20 45% $19,237 $962 $41,678 $14,293 -$154 -$88,689
21 50% $21,375 $1,069 $41,678 $14,293 $1,417
22 55% $23,512 $1,176 $62,517 $14,293 $2,998
23 60% $25,650 $1,282 $62,517 $14,293 $4,559
24 65% $27,787 $1,389 $74,424 $14,293 $6,130 -$30,126

Exhibit 2

CONSTRUCTION-LOAN CALCULATIONS AT 8.75%
"THE CASH CALF"
Month Const. Draws Reserve Charge Total Draw Loan Balance Interest Paid Interest Reserve Loan Payment
6 $135,250 $135,250 $135,250 $100,000
7 $200,000 $986 $200,986 $336,236 $986 $99,014 $0
8 $400,000 $2,452 $402,452 $738,688 $2,452 $96,562 $0
9 $500,000 $5,386 $505,386 $1,244,074 $5,386 $91,176 $0
10 $400,000 $9,071 $409,071 $1,653,146 $5,386 $82,104 $0
11 $250,000 $12,054 $262,054 $1,915,200 $12,054 $70,050 $0
12 $75,000 $13,965 $88,965 $2,004,165 $13,965 $56,085 $0
13 $14,614 $14,614 $2,018,779 $14,614 $41,472 $0
14 $14,720 $11,924 $2,033,499 $14,720 $26,751 $0
15 $14,828 $1,682 $2,048,326 $14,828 $11,924 $0
16 $11,924 $0 $2,060,250 $11,924 $0 $3,012
17 $0 $0 $2,060,250 $15,023 $0 $15,023
18 $0 $0 $2,060,250 $15,023 $0 $15,023
19 $0 $0 $2,060,250 $15,023 $0 $15,023

Exhibit 3

THE CASE OF "THE CASH CALF"

Month Const.Draw Occup.Level Rental Income Other Income Operating Expenses Loan Pmts. Cash Flow
6 $135,250 $0 $0
7 $200,000 $0 $0
8 $400,000 $0 $0
9 $500,000 $0 $0
10 $400,000 $0 $0
11 $250,000 $0 $0
12 $75,000 $0 $0
13 10% $4,275 $214 $1,347 $0 $3,142
14 15% $6,413 $321 $2,020 $0 $4,713
15 20% $8,550 $428 $2,693 $0 $6,284
16 25% $10,688 $534 $75,913 $3,012 $4,843
17 30% $12,825 $641 $75,913 $15,023 -$5,596
18 35% $14,963 $748 $59,540 $15,023 -$4,025
19 40% $17,100 $855 $59,540 $15,023 -$2,454
20 45% $19,237 $962 $41,678 $15,023 -$883
21 50% $21,375 $1,069 $41,678 $15,023 $688
22 55% $23,512 $1,176 $62,517 $15,023 $2,259
23 60% $25,650 $1,282 $62,517 $15,023 $3,830
24 65% $27,787 $1,389 $74,424 $15,023 $5,401 +$18,202

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:

  1. Construction draws
  2. Occupancy level
  3. Rental income
  4. Other income
  5. Operating expense
  6. Loan payments
  7. Cash flow

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:

Land: 2.18 Acres
94,961 Square Feet ($3.48 per foot)
65,116 Total Square Feet
$1,950,000 Total Construction
$29.94 Cost per Square Foot
578 Total Units

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.

SAMPLE CASE STUDY
116 5 x 5 $35 Climate Controlled
147 5 x 10 $55 Climate Controlled
239 10 x 10 $90 Climate Controlled
23 10 x 15 $120 Climate Controlled
18 10 x 20 $160 Climate Controlled
8 10 x 15 $85
4 10 x 20 $110
15 10 x 30 $145
8 Locker $20

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.

Exhibit 4

THE CASE OF "THE CASH COW"
Month Const.Draw Occup.Level Rental Income Other Income Operating Expenses Loan Pmts. Cash Flow
6 $81,150  $0 $0
7 $120,000 $0 $0
8 $240,000 $0 $0
9 $300,000 $0 $0
10 $240,000 $0 $0
11 $150,000 $0 $0
12 $45,000 $0 $0
13 10% $4,275 $214 $1,347 $0 $3,142
14 15% $6,413 $321 $2,020 $0 $4,713
15 20% $8,550 $428 $2,693 $0 $6,284
16 25% $10,688 $534 $75,913 $1,807 $6,048
17 30% $12,825 $641 $75,913 $9,014 $413
18 35% $14,963 $748 $59,540 $9,014 $1,984
19 40% $17,100 $855 $59,540 $9,014 $3,555
20 45% $19,237 $962 $41,678 $9,014 $5,126
21 $54,100 50% $21,375 $1,069  $41,678 $9,014 $6,697
22 $80,000 55% $23,512 $1,176 $62,517  $9,408 $7,874
23 $160,000 60% $25,650 $1,282 $62,517 $8,861 $8,861
24 $200,000 65% $27,787 $1,389 $74,424 $11,158 $9,266 +$63,963

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.

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