CONSTRUCTION FINANCE MODELING FOR INCOME PROPERTY

INTRODUCTION

It is unlikely that a developer will have the cash equity to construct his project without borrowing. Even if he did have the cash, he would still resort to borrowing in order to leverage his own funds so as to increase his rate of return. Also, in order for the general contractor to be successful in borrowing short term funds, when needed, to meet payrolls and material invoices, he frequently must demonstrate that the owner or owner-developer has a firm construction loan enabling him to pay the monthly draws. It is, therefore, generally necessary that an owner or developer secure a loan commitment prior to obligating himself to a contractor, construction manager, or even an architect for any substantial amount of dollars.

Before making loan commitments, lending institutions examine the owner's or owner-developer's balance sheet and revenue and expense statements as well as his record of experience with similar projects in order to determine his financial strength and stability. In addition, the project itself has to be examined in terms of its ability to pay for itself and make a reasonable rate of return for its owner. This latter examination involves some model for valuation based on income production and some model for projecting a rate of return.

When an individual desires to finance a home using a purchase money mortgage, the lending institution evaluates his net worth as well as the cost (and comparable market value) of the home being financed. However, the lending institution also examines the individual's income and expense stream in order to determine the individual's ability to make his monthly payments. Value By Income Approach will be seen to be a highly similar technique.

Lending institutions do not want to become owners by virtue of the borrower's default. They are in business to collect interest on loans. Lenders seek evidence that the project itself will provide the owner or owner-developer with the necessary proceeds to retire the loan as well as an attractive rate of return. Lenders therefore need tools for evaluating projects based on the expected income and expense streams for those projects.

THE METHOD

There is no substitute for a thorough analysis of: (a) current market needs; (b) current and planned construction activity; (c) current rental rates and vacancy rates; (d) population movement; (e) the availability of transportation, schools, shopping and recreation; (f) accurate estimates of site development costs and construction hard and soft costs. All of these items must be meticulously dealt with in a feasibility study. The valuation of a project based on its income production potential can only be a "capstone" for a thorough feasibility study.

The capstone model includes a "Project Value by Income Approach" calculation which, typically, is the "Value" in a "Maximum Loan To Value Ratio" (generally 80%) used to determine the maximum loan amount. Once the maximum loan amount is determined, a calculation called "Income Feasibility" (rate of return) is made.

The following case study calculates a Project Value By Income Approach (Part A) for an assumed midrise office building and then summarizes actual Replacement Cost (Part B) for the same project. Income Feasibility (Part E), which draws upon most of the same data plus debt service, is used to compute a "cash on cash" rate of return (cash coming out as pre-tax profit divided by the amount of cash equity the owner or owner-developer had to take out of his own funds to construct the facility). The rate of return so generated may be likened to the rate of interest earned on the owner's or owner-developer's investment. If a better rate of return could be earned on some other investment, or a similar rate of return on a "safer" investment, the project might never be built. If appreciation is likely, we might do well to consider it (Part F).

CASE STUDY

Kenny Mothy and Rick Ford have applied for a loan to develop a midrise office building. It is necessary to determine the (A) Project Value by Income Approach, (B) Replacement Cost, (C) Maximum Loan Amount Available, (E) Before Tax Rate Of Return, and (F) Appreciated Rate of Return after one year of operation using 5% appreciation per year.

The project is to be a seven story office building with 22,000 SF per floor with a Gross Leasable Area (GLA) equal to 80% of Gross Building Area. Market analysis indicates a rental rate of $18.00/SF per year and a Vacancy Rate of 10%. The building includes a spa and health club which are expected to produce Auxiliary Income of $18,000.00/year.

Electrical power bills are to be prorated on a square footage basis with Rick and Kenny picking up an estimated cost of $24,000.00 per year to cover "public areas" and unoccupied spaces. Rick and Kenny are to pick up the entire water bill, estimated at $2,000.00 per year and the dumpster, estimated at $2,700.00 per year, as well as custodial expenses for all "public areas," estimated at $34,000.00 per year, and maintenance of "public areas" estimated at $89,000.00 per year. Rick and Kenny estimate management expenses (including payroll, prop­erty taxes, insurance, supplies, etc.) to be $156,920.00 per year.

The lender's current terms are 10%, compounded monthly, on 30 year loans and capitalization rates are 11% for land and 10% on improvements. Maximum loan amount is smaller of 80% of Value By Income Approach or 85% of Replacement Cost.

Construction cost is $85.00 per square foot, including Architect fees. Brokerage fees, loan discounts, closing costs and property tax during the construction period are estimated to be $213,000.00. Construction Loan Interest (which will be rolled into the permanent loan) is estimated to be $975,000.00.

EXPLANATIONS

Project Value By Income Approach (Part A): A value is placed on the project by "capitalizing" its Net Operating Income. Usu­ally, land cost and building cost are capitalized at different rates since they involve different risk factors.

A "capitalization rate" is essentially a lender prescribed interest rate. Annual Net Operating Income is divided by the capitaliza­tion rate to determine Project Value (much as annual interest divided by interest rate equals principal).

Revenues (income items) are estimated and combined and Expenses are deducted to arrive at Net Operating Income. Net Operating Income is the amount available to pay taxes, the mortgage, and profit.

The capitalized value of the project's Net Operating Income is its Value By Income Approach. In our case study, the lender will loan a maximum of 80% of this value.

Replacement Cost (Part B): This is the actual cost of producing the project. It includes all construction costs, land costs, interest accumulated during the construction period, architect fees, loan closing and loan brokerage fees, tenant allowance costs, all costs that must be paid to produce the project. The lender will usually require the borrower to pay a certain minimum percentage of this cost from his own funds (else, the borrower might borrow more than it costs to construct the project). In our case study, the lender has set 85% of this value as a maximum loan.

Maximum Loan Amount (Part C): Note here that, in our case study, the Value By Income Approach exceeds the Replacement Cost. In other words, the value of our project as an operating entity exceeds the cost of creating it. Traditionally, a Loan To Value Ratio was applied to the (lower of) Replacement Cost (or to adjusted sales prices of recently sold "comparable" properties) to determine maximum loan amount. The introduction of Value By Income Approach has created an interesting dilemma which has often resulted in owners or owner-developers being able to borrow a higher percentage of cost for their projects.

Income Feasibility (Part E): Here we go back to the Net Operating Income from Part A and subtract the amount actually required (Part D) to make the mortgage payments (note that we still have not allowed for taxes or profit) to arrive at an income comparable to income from other forms of investment. We then divide that income by the actual amount of dollars the owner put into the project from his own funds. This is a "cash on cash" return, similar to cash interest received on a cash investment in a savings account.

Appreciated Rate of Return (Part F): Most real estate develop­ments do appreciate in value. In our case study, the basic Before Tax Rate Of Return was a rather poor 9.49%. The owner or developer might do well to put his money into some lower risk investment and forego construction of this project. However, the Appreciated Rate Of Return, 34.49% (assuming a holding period of one year), illustrates the magic of leverage often available in real estate development.

CONCLUSION

The Project Value By Income Approach and Income Feasibility Analysis can be very powerful tools for both lender and borrower alike. Traditionally, valuations have been made in terms of Replacement Cost or what appraisers believe to be "comparable properties" with no consideration given to income producing potential. The analysis made no serious effort to recognize that it is the income stream produced by the property that ultimately pays the mortgage and produces income for its owner. These two tools, by design, relate the value of the property to its ability to retire its own mortgage and provide a means of measuring the property owner's rate of return on his investment.

Inasmuch as an income producing property is constructed, bought or sold for the purpose of producing income, a method of measuring its value based on that income and measuring the expected rate of return, also based on that income, is essential to the industry. These two tools respond to that need.

It can be seen readily in observing the calculations that accuracy in determining Value By Income Approach and in projecting Income Feasibility is heavily dependent upon the reliability of the data used. Use of these models, therefore, should be limited to those entities who have the necessary resources to gather or purchase quality data.

REFERENCES