By Jim Oakley
The good old days of scratching feasibility on the back of an envelope are gone. Yesterday's answers are not good enough for today's lenders. If you don't show profitability simply and clearly at the outset of your self-storage project, you might not get another chance to do so. Lenders review several packages weekly and pick only the best. You can't go back and change the numbers once you have been turned down without losing credibility.
The Lethal Questions
A banker has three lethal questions he wants you to answer: 1) How will you make payments during construction?; 2) Can the project pay for itself through rent-up? and 3) Can you prove the project's feasibility in a monthly format? An appraisal will prove a facility's worth once it's completed, but you better have a financial business plan to prove how you will make payments during rent-up.
The transition between development and occupancy is critical as a project is most vulnerable to negative cash flow during this period. Occupancy is increasing while interest expense is needed. Loan payments are required every month, and bankers need assurance that money is on hand to meet them.
The Loan Package
An effective loan package should include documentation of six key financial events, tracked on a monthly basis and presented in a one-page summary: construction draws, occupancy level, rental income, operating expense, loan payments and cash flow. Then a seventh event, overall return, should show the investment from conception through hypothetical sale.
Projects are often shot down unknowingly by developers themselves. Such is the case in Exhibit 1 (page 50). The six vital events are displayed monthly during rent-up to unmask where the shortages in cash flow occur.
Notice that by month seven of construction, negative cash flows of -$43,469 have accumulated. After the first eight months of operation, the project is in a negative cash-flow position of -$88,689. Surprisingly, this situation is often hidden from the developer, even though it's easily curable with proper diagnosis and treatment.
The deal-breaker question your banker will ask is, "Where is the money (that -$88,689) that will make the loan payments?" This question can cripple your attempts at securing financing unless your financial plan has been engineered to address this deficiency in advance.
Interest Reserve is a financial mechanism used to defeat negative cash flow in the first year of a project. It allows the loan to "make its own payments" for a short period. These payments occur in the starting months of the loan and are made by increasing the principal balance for each payment made.
To determine interest reserve, it is necessary to map monthly cash flow. This map is also necessary to prove the need for interest reserve to the lender. (See Exhibit 2, page 52, which shows the critical monthly loan-payment calculation with interest reserve and construction draws.) This calculation shows the total amount of negative cash flow needing to be addressed (-$88,689). In order to put the development in a positive cash-flow position, $11,311 is added, bringing the interest reserve to $100,000. (Note: Don't assume spreadsheets calculate the complex construction loan. They don't. Such loans require variable take-out draws and unequal payments. Most important, there is interest reserve, a key factor that must be interwoven monthly.) Notice how interest reserve is depleted as it is used to make payments on the loan.
In Exhibit 3, an interest reserve of $100,000 has been implemented. The same project is now showing positive cash flow of $18,202 as a result. The loan has made its own payments to the extent of the interest-reserve limit.
Vacancy is Expensive
When the six vital events of the project are exhibited on one page in the loan package, it is obvious vacancy can be a crippling factor. Construction-loan payments are being made on units sitting empty for several months. This is a red flag indicating this project should be phased.
Delaying construction of units until they are needed is making better use of capital. This becomes extremely clear when cash flow is mapped monthly, as in Exhibit 3. When loan payments and absorption are shown on the same page in your loan package, decisions can more easily be made to maximize the efficiency of construction draws.
By developing the project in two phases, loan payments have been reduced in the initial months of construction. Instead of payments of $15,023 after four months of construction (Exhibit 3), the payments are reduced to $9,014 (See Exhibit 4). Now compare the cash flow of Exhibit 1, in a negative cash-flow position of -$88,689 at the end of month 15, to Exhibit 4, which is in a positive position of $5,126 after the same month. This is an overall difference of $93,814.
Improved Lender Confidence
In the case of construction loans, lenders generally require collateral or recourse. When a project is phased correctly, less collateral is required because less capital is borrowed at any one time. Lenders are then more confident about what they have extended until rent-up on the project proves itself. And having less recourse to provide can make or break a project.
Securing a permanent loan can be a major source of profit to the developer, but it must be justified to the lender in his own terms: net-operating income, debt-coverage ratio, loan-to-value, etc. The permanent loan should be larger than the construction loan--hence the developer's profit. In Exhibit 3, the construction loan is $2,060,250 while the permanent loan is $2,427,292. The difference comes from a much higher value determined during an income-approach appraisal. An amount of $367,042 more can be borrowed in this case, which is profit the developer can put in his pocket. Don't shortchange your profit because you haven't made monthly calculations in your loan package or lack a professional presentation.
Lay The Groundwork Now
The permanent-loan terms should be negotiated with the lender at the same time construction financing is secured. Using a full monthly cash-flow presentation ensures the developer his biggest profit. Seldom do developers negotiate the term of the construction loan. In most cases, developers don't even bother calculating the best time to bring the permanent financing on line, much less propose it to the lender.
Is there an advantage to paying higher interest and points on a construction loan to extend the term? In the examples we've used here, the loan proceeds can be increased from $367,042 to $561,225 if the permanent loan is brought online 12 months later. That's 53 percent more profit! What if you extended the construction loan by only six months?
Cash flow in the first year of a project should be optimized through the use of interest reserve. Moreover, the timing and amount of the permanent loan can be the source of greater profits. If you are not using critical financial feasibility, you don't have the tools to prove your case to a lender, and you're probably making "guesses" rather than decisions. Sure, a developer can get financing with a spreadsheet, but is he leaving his real profits on the table? Taking time to run the numbers and present them in a way that appeals to lenders can make all the difference in the success--and profitability--of a self-storage project.
Jim Oakley is a pioneer and national authority in computer-modeling feasibility. His methodology was taught at Arizona State University and its Center for Executive Development. He has addressed major national conventions including the National Association of Corporate Estate Executives and the National Association of Real Estate Educators. His articles have appeared in Inside Self-Storage, Professional Builder and Lodging magazines. Mr. Oakley consults from Prescott, Ariz., and can be reached at 520.778.3654; www.mrfeasibility.com.