Financial Feasibility Two Financial Statements Sources and Uses Project Pro Forma
Upstairs development starts with a good business plan. Construction Costs Develop a well thought out plan that adds value to your building by taking full advantage of the great details available. Carefully estimate construction costs and provide a minimum of 10% contingency. Operating Costs On the income side make a conservative assessment of what rents you can expect and how long it will take to re-lease the property when tenants move out. On the expense side carefully research various costs of rental property management
Development is really three different businesses. I do the financing. I build ‘em I manage ‘em
Which of you wishing to construct a tower does not first sit down and calculate the cost to see if there is enough for its completion? Otherwise, after laying the foundation and finding himself unable to finish the work the onlookers should laugh at him and say, ‘This one began to build but did not have the resources to finish’. Luke 14: 27-30 Develop a realistic budget and include a generous contingency
Developing the Pro Forma Income Rent Roll How much rent for each unit Tenant Contributions Utilities Laundry Parking Vacancy Factor (5 -20%) How long will vacant unit take to rent? Expenses Taxes Likely impact of upstairs investment? Utilities Separate meters or not? Insurance Defacto redlining? Maintenance Common areas and site
Developing the Pro Forma Income Gross Income Less Vacancy Rate Effective Gross Income Less Operating Expenses Net Operating Income Expenses Management By owner or by third party? Other Special assessment district Annual rental unit inspection fee
Developing Sources and Uses Uses Due Diligence to accurately measure: Construction Costs Soft Costs Adequate Contingency Sources This is where Main Street pays dividends. Loan and grant sources available to help fund the project.
Determining Debt Service Net Operating Income NOI is the number that drives project financing. When you have discovered what interest rate and term you can get from a bank you multiple the loan amount X the constant to determine the annual debt service required to service the debt. Loan Sourcing Lenders come in more flavors these days Needed from lender Interest Rates and Term Minimum Debt Coverage Ratio Minimum Loan to Value
Key Formulas Debt Service D/S = Loan Amount X c (or constant) Debt Coverage Ratio DCR = Net Operating Income (NOI) Debt Service (D/S) Fair Market Value FMV = Net Operating Income (NOI) X Cap Rate Loan to Value Ratio is the % of FMV the Bank will loan to Return on Investment e = cash flow owner equity
No acquisition cost – you already own or are buying the building You are a pioneer – there’s little upper floor housing nearby You will be undertaking the project without additional investors You want to improve your financial situation from the project but are willing to accept lower returns on investment than real estate developers You may need bank financing and/or financial assistance from a public or quasi-public source to complete the project You will manage the property yourself upon completion Case Study Assumptions
Annual Operating Pro Forma Income Gross RentRent Collected at 100% Occupancy Tenant ContributionsTenant Contributions towards operating expenses Gross IncomeTotal Income at 100% Occupancy (Vacancy Rate)Adjustment for Vacancy and Collections Loss Effective Gross IncomeAnticipated Cash Actually Collected Expenses TaxesResearch and negotiate with assessor InsuranceDiscuss your project with your provider MaintenanceSnow removal, window washing, common area UtilitiesAre utility expenses paid as part of rent? ManagementAre you going to manage the project or pay someone? ReservesAppliances need to be replaced, Units need repainting Net Operating IncomeCash generated by the project Debt ServiceInterest, principal payments to lender Cash FlowReturn to owner
Case Study Tom projects that each loft will generate a monthly rent of $800. Tom evaluated the costs to separate utilities and has decided to meter each unit for gas and electric. Tom will provide water for the tenants. Parking will be on-street at no cost to either Tom or the tenants. Tom discussed with his local assessor what impact his loft improvements will have on his property tax bill and has budgeted accordingly.
What bankers want... Acceptable level of risk Reducing risk of default and/or foreclosure Lenders want to limit their risk rather than maximize their profits. Lenders are in a high volume – low margin business. The spread between interest paid to entice deposits and interest earned fromloans ranges from 1.5 to 3.5 percent. There is no upside for traditional lenders
Upstairs projects may be difficult for banks to finance because: Lending to pioneers is difficult There may be past failures Housing market is unproven Spaces may be slower to absorb and take longer to fill once they become vacant than more traditional housing Types of locations unfamiliar to many lenders New mixed-use projects in second/third tier markets are rare
How Much Will a Lender Lend? The primary method to repay the loan is cash flow that comes from the project. Lenders really lend to a project’s cash flow rather than to bricks and mortar. The analytical tool used by bankers to assess a project’s ability to repay the loan from project cash flow is the debt coverage ratio (DCR).
Debt Coverage Ratio Debt Coverage Ratio (DCR) is the net operating income of a project divided by the annual payments to pay back the loans needed to build the project. DCR = Net Operating Income (NOI) Debt Service (D/S)
Case Study Tom Case owns a bakery in downtown Biggsville and decides to build out two gourmet residences in the dormant upper floors of his building which he owns free and clear of debt. The cost to complete the project is $150,000
Net Operating Income (NOI) Is the single most important number in a real estate project. Net Operating Income is the projects income reduced by a vacancy factor and the operating expenses of a project such as taxes, insurance, maintenance, and utilities. Gross Rent - Vacancy Rate - Operating Expenses Net Operating Income
Case Study Net Operating Income (NOI) Gross Rent800 X 2 X 12 = 19,200 Less Vacancy Rate 10% (1,920) Less Expenses Utilities 1,200 Taxes 2,400 Insurance 1,200 Maintenance 1,000 Total Expenses (5,800) Net Operating Income 11,480
Debt Service Is the total of annual interest and principal payments needed to retire the debt. A constant table provides different constants for each possible interest rate and loan term combination. Multiplying the constant times the amount borrowed provides the annual debt service. Interest Rate7.0% Term 25 Years Constant.0849
Case Study Tom has $20,000 to invest in the project and would like to borrow $130,000 from his local bank. The bank is offering loans at 7% and is willing to make a loan with a 25 year amortization. Will the bank loan Tom $130,000 based upon net operating income of $11,480?
Length of payback Interest Rate Typical Constant Chart
Case Study Debt Service The debt service for a loan of $130,000 with 7% interest and a 25 year amortization is: $130,000 X.0848 = 11,037 The net operating income of $11,480 just barely covers the annual debt service of $11,037. Will the bank make a loan to the project of $130,000?
Debt Coverage Ratio Recalling our debt coverage ratio formula: DCR = Net Operating Income (NOI) Debt Service (D/S) For Tom’s project: DCR = 11,480 = 1.04 11,037
How Much Will the Bank Lend? This lender, typical of many, requires a DCR of 1.2 The largest loan this bank would make given NOI of $11,480 can be determined in the following manner: D/S = NOI = 11,480 = $9,567 DCR 1.20 Loan $ =D/S = 9,567 = $112,685 c.0848
Not So Fast The bank also considers what happens if the project fails and they foreclose on the project and force the sale of the project as a means to repay the loan. The amount of the loan compared to the value of the completed project is called the Loan to Value ratio. On commercial properties, banks typically look for loan to value ratios in the range of 50 to 70% Banks will lend the amount that meets their minimum requirements for both debt service coverage and loan to value ratio.
The appraisal establishes a cap rate reflecting the perceived risk of a project. Fair Market Value (FMV) is the cap rate divided by net operating income. Loan to Value Ratio
Case Study In Tom’s case the fair market value is obtained by dividing the NOI of $11,480 by a cap rate of.085 or $135,058. The banks policy is to loan to 80% of fair market value it agrees to make Tom a loan of $108,000 which is the amount that meets their minimum requirements for both DCR and LTV. $135,058 X 80% = $108,000
Sources and Uses: Determining The Gap Use of funds Acquisition 0 Arch / Engineer 10,000 Permits 500 Hard Construction 119,500 Appliances 5,000 Contingency 15,000 Total 150,000 Sources of funds Owner Equity 20,000 Bank Financing 108,000 Total Sources 128,000 Gap 22,000
Four Ways to Fill the Gap: Additional owner equity Historic or old building tax credit Subordinated loan or grant Reduce the scope of the project
Case Study Tom’s $20,000 cash and the banks $108,000 loan leaves a shortfall of $22,000 in funding the project. Tom’s city has a revolving loan fund that provides up to $25,000 per project at 5% interest with 20 year amortization. Tom’s debt service will be based on a first mortgage of $105,000 at 7% for 25 years and $25,000 at 5% for 20 years.
Revised Debt Coverage Ratios with gap financing added Revised Debt Service $105,000 X.0848 = 8,914 $ 25,000 X.0792 = 1,980 Total Debt Service = 10,895 Total DCR =11,480 = 1.05 10,895 Bank’s DCR = 11,480 = 1.29 8,914
What is the Gap? Expected income does not provide enough cash flow to service debt and/or provide a return on investment to the owner. The amount of conventional debt a unit can service provides a good measure of when and what level of public intervention is needed to assist with upstairs development.
Removal Costs Demo Costs $8,000 Utility Cuts $1,500 Initial Demolition Costs $9,500 Holding costs Maintenance 10 @ $250 - 2,250 Insurance 10 @ $50 _ - 500 Total 10 Year Cost to Remove $12,250 Inpatient Capital: Ten Year Community Cost of Removal Accumulated blight can be dealt with in two ways
Cost to Renovate 164,900 Sale Price 134,900 Initial Cost $30,000 Property taxes - 10 yrs @ $2,250 + 22,500 Water, sewer Fees - 10 yrs @ $400 + 4,000 Utility tax - 10 yrs @ $150 + 1,500 Total 10 Year Net Cost $2,000 Patient Capital: Ten Year Community Cost of Renovation Finding the initial $30,000 is tough in good times, let alone austere ones but it forces partnership development.
Cash on Cash Rate of Return One of the most widely used way to measure return on investment: e = cash flow owner equity In Tom’s case e = 585 = 3% 20,000 This is not a strong rate of return, should Tom do the project?
More than Cash Flow Tom wants to improve his financial position but project income just barely covers project expenses. The other non-cash benefits to the project encourage him to proceed. There are other financial benefits to owning real estate than cash flow: Tax Benefits Appreciation An upstairs project provides unique benefits: Improving the value of the retail business Lowers first floor utility costs
Appraisal Gap Issue Financing commitment from lenders must be validated by an appraisal.
How Much Debt Can You Service At Different Rents? Monthly Rent per unitAllocation to ExpensesMonthly Net Operating Expenses (NOI) Loan @ 7% 20 Yr Amort 5 Yr Balloon (c =.0931) 35040%21027,068 40040%24030,934 45040%27034,801 50040%30038,668 55040%33042,235 60035%39050,268 65035%42254,458 70035%45558,646 75035%48862,836 80035%52067,025 85035%55271,214 90035%58575,403 95035%61779,592 100030%70090,225 105030%73594,737 110030%77099,248 115030%805103,759 120030%840108,270
Voss Brothers 2006 Avg. Rent $750 Supports $62,300 Unit Cost $160,000 Gap $97,700 Sala Flats 2005 Avg. Rent $650 Supports $54,500 Unit Cost $154,500 Gap $100,000 Ren/Gol 2001 Avg. Rent $700 Supports $58,700 Unit Costs $121,129 Gap $62,429
First Mortgage 1,700,000 Risk Sharing 50/50 insured by IHDA & USHUD Funded by the AFL-CIO Second Mortgage 750,000 Funded by HTF Third Mortgage 275,320 Funded by the City of Rock Island Equity 3,308,870 Historic T.C. 433,210 Affordable (Sect 42) 2,758,466 Deferred Dev. Fee 117,194 Grants 272,000 City Façade 30,000 State Energy 68,000 AHP 175,000 Total 6,307,190 Other 15 year property tax negotiated schedule 30 year lease back of commercial space Typical Lasagna Financing Layered financing increases costs and take longer to assemble.
Incentives to fill upper floor project gaps State Historic Tax Credits Tax Abatement HOME Section 42 Tax Credits Targeted Investment Tax Credits Preservation Design Services Federal Historic Tax Credits New Markets Tax Credits CDBG Section108 loans EDA Local Tax Increment Financing Tax Abatement Façade Programs Revolving Loan Funds Façade Easements Private CRA activity FHLB Property Donations Intermediaries
Start by building your local team of EXPERTS! Accountants/Tax Attorney Historic-building-friendly Architects Construction Lender Code Officials Building local development capacity You don’t have to become a community-based developer to have a big beneficial impact on downtown investment
1998: $180,018 3 jobs 0 housing units 2000: $103,871,045 1,209 jobs 1,074 housing units 2003: $434,347,377 2,286 jobs 1,291 housing units 2006: $546,052,854 1,660 jobs 2,168 housing units Dollars Invested in Missouri: Completed State Projects
Using Housing to build proper mass on in-fill sites Three story massing, mixed use, mixed income, and self contained parking
New Vs Old Both have become important as reconnecting the fabric has become as important as preserving our heritage. Details have to be right
Appropriate new construction twin pillar to preserving existing building stock
Condo vs. Rental Most emerging markets start with the rental market and move to the ownership market
Key issues of small scale condo projects Market Issues Empty nester most important market segment. Security and freedom is important to this audience. Hard to jump past rental market development to condos. Design: Higher quality of finishes expected. Higher levels of sound insulation needed in ownership units. Stairs becomes an issue with the empty nesters. Parking is more important that with rental projects - adjacent and secure parking.
Key issues of small scale condo projects Project Costs Legal and survey costs can be substantial. Cannot use historic tax credits for ownership units. Many rental projects using historic tax credits are designed to flip to ownership after the required five year holding period. Financing Condo docs and surveys compliance with secondary market requirements. Appraisal gap issues aplenty. Property tax assessments can fluctuate greatly. Market pioneers need to feel like they are getting a deal.