The combination of high inflation and rising interest rates aren’t just making houses more expensive to purchase; it’s making them more expensive to construct. According to the daily count maintained by the US Federal Reserve, the producer price index for building materials increased from the 235 mark in June 2020 to 350 in June 2022, an rise of 49% in only two years. Consumer price inflation is on the rise too, with rates ranging from 5-9% in most developed nations and prompting central banks to increase their the interest rate to counter.
The rising costs of real estate mean that developers need to take on more debt, and they frequently depend on complicated financing structures which can reduce profits. As I’ll show, selecting the wrong option for funding can result in an increase of one to five percent to the cost, which amounts in the hundreds of thousands on a larger project. With commercial construction loans reaching $412 billion by the end of July 2022 within the US in the United States alone, it could cause the real estate industry to lose billions of dollars each year.
One of the best methods for developers to stay clear of this is to develop an economic model prior to agreeing to a financing structure. But, they tend to skip this aspect.
I’ve worked in real-estate finance for over 15 years, and have secured funding for more than 100 real estate commercial projects which include hotels, homes commercial and residential properties. I’ve observed that a lot of developers are focused on focusing their attention on their day-today requirements and don’t have the experience of making major financial decisions and comprehending all the details. They might not make use of modeling in any way or may attempt to create it on their own instead of enlisting the help of an expert in financial modeling.
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They often simplify or make use of incorrect assumptions that could result in a skew of the outcomes. This can become a problem when a developer employs complex finance structures , including junior debt as well as third-party equity. Even for professionals in finance, who are knowledgeable about the structures of structured finance this type of financing could be difficult.
Real property finance is a distinct businessand is difficult to model without knowing the assumptions behind it. Below, I’ll outline three common errors I’ve observed throughout the years, and then explain how clever modeling will help you avoid them.
How Real Estate Projects Are Financed
A real estate development project is normally supported by a combination of senior debt issued by third parties and equity. It is also typical to obtain additional funding from junior debt or third-party equity investors as the project’s costs increase.
Senior debt lenders adopt the “last-in first-out” method of funding projects. This means that they want to see the subordinated finance put into use before they release any funds. The lender who is the senior one then covers expenses until the project is complete after which they are repaid first.
Like most financing structures in the market, senior debt is the highest security and is at the top of the stack with the lowest cost with a low interest rate, and a few charges. Junior debt is characterized by an interest rate that is higher and equity shares in the profits of projects and may also have the benefit of a priority return.
To illustrate the effects on the various combination of financing choices, we’ll take an example of a construction project dubbed “Project 50.” The Project 50 community consists of 50 single-family homesthat are valued at $1 million once construction is completed.
A few assumptions that will help us model:
End-to-end value (also referred to as Gross Development Value, or GDV): $50 million.) 50 million
Cost of buying land Cost to purchase land: $15 million
Total construction cost (excluding the cost of financing) 20 million
Construction Phase: 18 Months
Costs for financing to be established
Real property projects will require an upfront lump sum funds upfront to buy the property. In our case, it is about $15 million. Following that, the developer draws down monthly to pay for construction costs as the project develops.
In general, drawdowns fluctuate from month-to-month because of the fluctuation in expenditures and when inflation happens. To illustrate this piece we’ll assume that Project 50 requires 16 equal drawdowns on the construction cost of $20 million. This means that $1.25 million will be required at the close of each month up to and including the month 16.
Construction costs can be estimated ahead of time from both the builder as well as the lending institution, and the latter using a third-party surveyor in order to oversee the project and approve each month’s drawdown requests throughout the construction.
A construction project typically won’t bring in any money until construction is completed as well as the building is completed for be occupied, which means that it is the case that interest paid by lenders is compounded and accrued over the duration of the venture. Making the wrong choice of financing may result in having to pay more in interest than needed.
One mistake: Using WACC to determine the best Blend
One of the most important metrics used to determine the break-even point of any project is the cost per unit weighted or WACC.
I’ve seen a lot of real estate developers and some funders commit the mistake of selecting the lowest blended rate that is based on the WACC after the loan is drawn to its fullest and prior to sales beginning paying back any debt. This is a tried-and-tested method of maximizing financing in certain financial areas, including structured acquisitions of companies. On the other hand, in a construction project, this technique can cause you to drastically underestimate the cost of financing.
If you’re funding an acquisition all capital is used up in one go. When it comes to real estate development only secondary debt is used in the beginning, while the greater senior debt is fed into the project month after month. That means that the majority of the loan will only be drawn for a couple of months before it is due to be paid back.
2. Overlooking the interest allowance
If you’re thinking about senior loans the lenders you contact are likely to have different model and methods to structure loans. They will typically offer leverage as the percentage of costs or the value at the end. They will then split the loan to pay for construction costs as well as rolled-up interests, and the rest allotted to the site purchase. Even when two lenders have the same loan amount the breakdown of funding and assumptions could differ, and it will affect the final cost.
Let’s review Project 50 and focus on an example where two banks compete to offer senior loans at the same leverage 60% of the GDV.
Both have rates of interest of 7.7%. But let’s imagine that Bank A is much more preoccupied with sales. Maybe it’s optimistic about the impact of a downturn on the market for real estate. It would like to estimate the number of units sold by spreading the sales over 10 months. It is only five units being sold per month. So, it gives the same amount of gross loans but more time and results in more accrued interest. This higher interest allowance will have an effect on the structure of the financing.
3. Failure to model the Exit Strategy
In evaluating a real estate project, the funders must understand the developer’s exit strategy. Construction funding typically is short-term (one or two years) and is intended to be paid back when the construction is completed. Even if a builder holds for the finished project over a longer time, it is usually able to refinance the project to a loan with a lower interest rate after the building is completed.
The competing options to sell or refinancing after construction can be difficult to analyze in relation to other financing options. In the absence of modeling the effect of an plan of exit could cause the borrower to miss crucial aspects which affect the most effective financing structure.
If the builder isn’t financing or selling all the building in one go, the repayment of construction funds usually occurs in a series of individual sales, as it would in a single-family community. houses.
Smart Real Estate Financial Modeling Pays Off
As we’ve learned, only through the development of a comprehensive financial model will you be able to determine the most effective combination of financing options for a real estate development.
In the absence of doing this, it is costly in several ways. When it comes to larger projects, choosing an unsuitable funding model could lead to the need for several hundred thousand dollars on financing expenses. It could also obscure the most efficient exit strategy, which can cause developers to take out millions of dollars in developer loans rather than refinancing or seeking a bulk sale.
As the price of construction and borrowing grow, and the demand begins to decrease it is crucial to be aware of all the options available before proceeding. A financial advisor with practical experience in construction can aid builders to select the most suitable structure finance option for real estate.
Learning the fundamentals
Do you think it is worthwhile to perform financial modeling?
Yes. Financial modeling can provide the necessary forecasts that guide the right choices. Modelling the outcomes allows you to understand the implications of various scenarios and help you choose the most appropriate one.
Why do we require structured financing?
Structured finance is required in cases where conventional loans alone don’t fulfill the needs of the borrower, usually the largest corporation.
How do you define structured finance in the real estate industry?
In the context of real estate the term “structured finance” may involve a combination of lower-interest senior loans and junior debt with higher interest and equity, using cash flow from selling or refinancing properties as collateral.
What is the process of financial modeling?
Financial modeling is the application of certain assumptions to data from the past in order to predict future performance. These models are typically developed using spreadsheet programs.