Financial Feasibility

Proving it to your lender

By Jim Oakley

The good old days of scratching feasibility on the back of an envelope aregone. Yesterday's answers are not good enough for today's lenders. If you don'tshow profitability simply and clearly at the outset of your self-storageproject, you might not get another chance to do so. Lenders review severalpackages weekly and pick only the best. You can't go back and change the numbersonce 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 youmake payments during construction?; 2) Can the project pay for itself throughrent-up? and 3) Can you prove the project's feasibility in a monthly format? Anappraisal will prove a facility's worth once it's completed, but you better havea financial business plan to prove how you will make payments during rent-up.

The transition between development and occupancy is critical as a project ismost vulnerable to negative cash flow during this period. Occupancy isincreasing while interest expense is needed. Loan payments are required everymonth, 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 financialevents, tracked on a monthly basis and presented in a one-page summary:construction draws, occupancy level, rental income, operating expense, loanpayments and cash flow. Then a seventh event, overall return, should show theinvestment from conception through hypothetical sale.

Projects are often shot down unknowingly by developers themselves. Such isthe case in Exhibit 1 (page 50). The six vital events are displayed monthlyduring rent-up to unmask where the shortages in cash flow occur.

Notice that by month seven of construction, negative cash flows of -$43,469have accumulated. After the first eight months of operation, the project is in anegative cash-flow position of -$88,689. Surprisingly, this situation is oftenhidden from the developer, even though it's easily curable with proper diagnosisand 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 cancripple your attempts at securing financing unless your financial plan has beenengineered to address this deficiency in advance.

Interest Reserve

Interest Reserve is a financial mechanism used to defeat negative cash flowin the first year of a project. It allows the loan to "make its ownpayments" for a short period. These payments occur in the starting monthsof the loan and are made by increasing the principal balance for each paymentmade.

To determine interest reserve, it is necessary to map monthly cash flow. Thismap is also necessary to prove the need for interest reserve to the lender. (SeeExhibit 2, page 52, which shows the critical monthly loan-payment calculationwith interest reserve and construction draws.) This calculation shows the totalamount of negative cash flow needing to be addressed (-$88,689). In order to putthe development in a positive cash-flow position, $11,311 is added, bringing theinterest reserve to $100,000. (Note: Don't assume spreadsheets calculate thecomplex construction loan. They don't. Such loans require variable take-outdraws and unequal payments. Most important, there is interest reserve, a keyfactor that must be interwoven monthly.) Notice how interest reserve is depletedas it is used to make payments on the loan.

In Exhibit 3, an interest reserve of $100,000 has been implemented. The sameproject is now showing positive cash flow of $18,202 as a result. The loan hasmade 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 theloan package, it is obvious vacancy can be a crippling factor. Construction-loanpayments are being made on units sitting empty for several months. This is a redflag indicating this project should be phased.

Delaying construction of units until they are needed is making better use ofcapital. This becomes extremely clear when cash flow is mapped monthly, as inExhibit 3. When loan payments and absorption are shown on the same page in yourloan package, decisions can more easily be made to maximize the efficiency ofconstruction draws.

By developing the project in two phases, loan payments have been reduced inthe initial months of construction. Instead of payments of $15,023 after fourmonths of construction (Exhibit 3), the payments are reduced to $9,014 (SeeExhibit 4). Now compare the cash flow of Exhibit 1, in a negative cash-flowposition of -$88,689 at the end of month 15, to Exhibit 4, which is in apositive position of $5,126 after the same month. This is an overall differenceof $93,814.

Improved Lender Confidence

In the case of construction loans, lenders generally require collateral orrecourse. When a project is phased correctly, less collateral is requiredbecause less capital is borrowed at any one time. Lenders are then moreconfident about what they have extended until rent-up on the project provesitself. 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 largerthan the construction loan--hence the developer's profit. In Exhibit 3, theconstruction loan is $2,060,250 while the permanent loan is $2,427,292. Thedifference comes from a much higher value determined during an income-approachappraisal. An amount of $367,042 more can be borrowed in this case, which isprofit the developer can put in his pocket. Don't shortchange your profitbecause you haven't made monthly calculations in your loan package or lack aprofessional presentation.

Lay The Groundwork Now

The permanent-loan terms should be negotiated with the lender at the sametime construction financing is secured. Using a full monthly cash-flowpresentation ensures the developer his biggest profit. Seldom do developersnegotiate the term of the construction loan. In most cases, developers don'teven 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 constructionloan to extend the term? In the examples we've used here, the loan proceeds canbe increased from $367,042 to $561,225 if the permanent loan is brought online12 months later. That's 53 percent more profit! What if you extended theconstruction loan by only six months?

Conclusion

Cash flow in the first year of a project should be optimized through the useof interest reserve. Moreover, the timing and amount of the permanent loan canbe the source of greater profits. If you are not using critical financialfeasibility, you don't have the tools to prove your case to a lender, and you'reprobably making "guesses" rather than decisions. Sure, a developer canget financing with a spreadsheet, but is he leaving his real profits on thetable? Taking time to run the numbers and present them in a way that appeals tolenders can make all the difference in the success--and profitability--of aself-storage project.

Jim Oakley is a pioneer and national authority in computer-modelingfeasibility. His methodology was taught at Arizona State University and itsCenter for Executive Development. He has addressed major national conventionsincluding the National Association of Corporate Estate Executives and theNational Association of Real Estate Educators. His articles have appeared inInside Self-Storage, Professional Builder and Lodging magazines. Mr. Oakleyconsults from Prescott, Ariz., and can be reached at 520.778.3654; www.mrfeasibility.com.

Exhibit 1 thru 4