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
I build ‘em I do the financing. I manage ‘em Development is really three different businesses.
Develop a realistic budget and include a generous contingency 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 It's in the Bible
Developing the Pro Forma Income Expenses Taxes Likely impact of upstairs investment? Utilities Separate meters or not? Insurance Defacto redlining? Maintenance Common areas and site 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?
Developing the Pro Forma Income Expenses Management By owner or by third party? Other Special assessment district Annual rental unit inspection fee Gross Income Less Vacancy Rate Effective Gross Income Less Operating Expenses Net Operating Income NOI
Developing Sources and Uses Uses Sources This is where Main Street pays dividends. Loan and grant sources available to help fund the project. Due Diligence to accurately measure: Construction Costs Soft Costs Adequate Contingency
Determining Debt Service Net Operating Income Loan Sourcing Lenders come in more flavors these days Needed from lender Interest Rates and Term Minimum Debt Coverage Ratio Minimum Loan to Value 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.
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
Case Study Assumptions • 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
Annual Operating Pro Forma Income Gross Rent Rent Collected at 100% Occupancy Tenant Contributions Tenant Contributions towards operating expenses Gross Income Total Income at 100% Occupancy (Vacancy Rate) Adjustment for Vacancy and Collections Loss Effective Gross Income Anticipated Cash Actually Collected Expenses Taxes Research and negotiate with assessor Insurance Discuss your project with your provider Maintenance Snow removal, window washing, common area Utilities Are utility expenses paid as part of rent? Management Are you going to manage the project or pay someone? Reserves Appliances need to be replaced, Units need repainting Net Operating Income Cash generated by the project Debt Service Interest, principal payments to lender Cash Flow Return 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 fromloansranges 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 Rent 800 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 Rate 7.0% • 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?
Typical Constant Chart Length of payback Interest Rate
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.
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.
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.
InpatientCapital: Ten Year Community Cost of Removal 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 Accumulated blight can be dealt with in two ways
Patient Capital: Ten Year Community Cost of Renovation 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 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? Rule of Thumb
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/Gol2001 Avg. Rent $700 Supports $58,700 Unit Costs $121,129 Gap $62,429 Real Cost Data
Typical Lasagna Financing • 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 Grants272,000 • 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 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
Building local development capacity You don’t have to become a community-based developer to have a big beneficial impact on downtown investment Start by building your local team of EXPERTS! • Accountants/Tax Attorney • Historic-building-friendly Architects • Construction Lender • Code Officials
Dollars Invested in Missouri: Completed State Projects 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 20% + 25% = Success
Using Housing to build proper mass on in-fill sites Three story massing, mixed use, mixed income, and self contained parking
New Vs Old Details have to be right Both have become important as reconnecting the fabric has become as important as preserving our heritage.
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