Discover the 3 key characteristics of development financings

Today, I am looking at the difference between financing an existing and income generating property versus financing a development project.

 

Some might wonder if there are any differences at all. What should differ? I am going to present you 3 major differences.

1. You finance your own interest

Wait, what do I do? Yes, you read correctly. When financing a development project you as the lender are paying interest to yourself. So, how is that done? You issue a loan to the lender. For lending money you charge some interest. So far, so good. Now, if you have an income generating property such as an apartment, the interest is paid from the rental income generated by the property. However, if you want to develop an apartment, there is no rental income. Therefore, the lender finances its own interest rate.

How does that look in reality?

Actually it works pretty easy. Let’s first look at an income generating financing structure first:

  • Net cold rent per month:                     $ 2,000
  • Operating expenses (15% of NCR)     $     300
  • Interest rate of 2%:                               $       40
  • Cash flow:                                               $  1,660

As you can see, the interest rate is paid by the current income. For the sake of simplicity I assumed no amortization.

What actually do you finance in a development project? There are a lot of costs that you want to get financed. So let’s assume the following situation: You want to develop a small apartment that incurs construction costs of $ 100,000. You want to finance loan to cost of 80%, thus $ 80,000. The interest rate will be 2.0% p.a. This is the summarized information:

  • Construction costs:                             $ 100,000
  • Loan volume:                                       $   80,000
  • Interest rate:                                        $     1,600

Now, if you are the developer, you cannot pay any interest because there is no income generated. Of course you could pay the interest with your equity. But what is actually done with big projects, when interest costs go into millions is the following:

  • Construction costs:                             $ 100,000
  • Interest costs:                                      $      1,600
  • Total costs:                                           $ 101,600
  • Loan volume:                                       $   80,000

Here, the amount of equity needed is $ 21,600, the difference between the total costs of $ 101,600 and the loan volume of $ 80,000 and not just $ 20,000 (the difference between the construction costs of $ 100,000 and the loan volume of $ 80,000).

In reality this means that you are lending $ 80,000 but only $ 78,400 of cash changes hands (or bank accounts). The effect is that you financed the interest yourself.

2. There is no cash flow

This statement sounds blatant and it might actually be. However more than often this is forgotten by any involved party, especially when discussing financing structures or talking about the loan to value. In fact, the loan to value ratio is (generally) less important than the loan to cost ratio. Also think about the other ratios such as the debt yield. Debt yield related net operating income (NOI) to total debt outstanding. Again, without any cash flow, there is no NOI.

Another issue that arises when no cash flow occurs is that there is less margin of error. In comparison to an apartment that does pay rent, a breach of a covenant can be cured by accumulating remaining cash on a special account such as a pledged account. This procedure does not work during the development stage.

This, in combination with a significantly low equity contribution, makes developments quite risky. A thorough due diligence of all involved risks is required.

3. There is no asset

In line with the previous statement that there is no cash flow, saying that there is no asset seems to be obvious. Nevertheless, this fact is a game changer. Just ask yourself if you would rather finance an existing property such as an apartment or a plot of land and someone that tells you about an idea of building something? The right answer would be something like “it depends”.

The important point is to get an accurate picture of the value of the underlying. In one case this might be the market value of an existing apartment. In the other case it might be a potential market value based on architect and engineering studies. With the existing asset you can pay out immediately a large chunk (or all) of your loan amount, whereas with the development you usually pay out according to the costs that occur

Conclusion

In the end financing an existing properties is quite different to financing a development project. Both types of project are very different and involve different kind of risks. Whereas existing and income generating assets have often risks such as vacancy rates, third party usage, and capex backlog, developments definitely exhibit construction cost risk. Other issues can be the team behind the developer. Do they have a good track record and can they deliver? What about the assumptions in the development calculation? What is the assumed exit etc? Like I said before, a good due diligence never hurts. 🙂

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s