Dan Carmody / Gary Ferguson February 4, 2009

Transcription

1 Real Estate Financing Part One Understanding the Basics IDA Institute New Orleans, LA February 1, 2009 Gary Ferguson Downtown Ithaca Ithaca, New York Dan Carmody Eastern Market Corporation Detroit, MI Recent market conditions indicate real estate development is one room in Dante s Inferno. But, hey, these days what business sector isn t? Now is the perfect time to be planning projects for when the economy gains traction Real estate development, like all businesses, begins with understanding market dynamics and building a business plan that demonstrates market and financial feasibility IDA Institute / New Orleans 1

2 Besides we can t spend all our time at the beach... Why is the public sector concerned about real estate development To attract private investment into distressed and underdeveloped communities: Provide jobs Increase tax base Change perceptions Prove a market Why Are We Here? To learn how to attract capital for real estate development projects IDA Institute / New Orleans 2

3 Two kinds of capital Equity from investors To Attract Equity, You Must Understand how investors measure return on investment (ROI) Learn to adjust the imbalance between cost and revenues Debt from lenders To Attract Debt, You Must Understand how lenders evaluate risk Learn to reduce risk of default and foreclosure Today s Investor Assessing Risk in 2009 Why doesn t investment occur without public assistance? Investors see inadequate return on investment (ROI). Lenders see unacceptable level of risk. The amount investors are willing to invest and the amount lenders are willing to lend are not sufficient to complete the project creating a gap that must be filled if the project is to go forward. Investor s Perspective Investors are seeking to maximize economic benefits and minimize equity investment They invest in projects yielding the highest ROI IDA Institute / New Orleans 3

4 Economic development projects offer low return on investment (ROI) Returns low relative to cost: lower rents higher vacancy higher operating costs uncertain appreciation May require higher equity investment because of lenders perception of higher risk. Lender s Perspective Lenders are risk limiters, not profit maximizers Lending is a lowmargin, high volume business No "upside" for lenders, fixed returns Making loans is a lot like making hay Economic development projects appear riskier Pioneering project Past failures Unproven product Questions about rents and vacancy rates Uncertain overall property market (i.e. high foreclosure) Unfamiliar locations rural, deteriorated neighborhoods IDA Institute / New Orleans 4

5 Economic development professional s job make deals happen in distressed areas Get lender to lend by reducing risk Encourage developers and investors to invest by increasing return on investment to acceptable level Fair return on investment but no undue enrichment It takes three to dance Differences between lenders, developers, and economic development officials Developers Lenders ED Officials Approach Optimists Skeptics Optimistic / Skeptics Style Entrepreneurial Regulatory Bureaucratic Personal Objective Build wealth Steady income Build better places Business Objective Maximize profit Avoid risk Build tax base and jobs Three Benefits Of Owning Real Estate 1. Cash Flow 2. Tax Benefits 3. Appreciation To most investors, cash flow is the most important because it is the most tangible and most immediate. Location, location, location... IDA Institute / New Orleans 5

6 Cash Flow Defined Annual Rental Income Annual Operating Expenses Annual Debt Service (payments to lenders) =Cash Flow The lender isn t overly interested in aesthetics or best use - just the buildings cash flow Tax Benefits: Deferral and Reduction Depreciation defers taxes Protects passive income from taxation Postpones payment of taxes Converts ordinary income into capital gains Residential: 27.5 years Commercial/Industrial: 39 years Tax Credits reduce taxes Historic tax credits Low income housing tax credits New Markets tax credits Energy Tax Credits State Historic Tax Credits State Affordable Housing Tax Credits Appreciation Appreciation represents the increase in value over time Current Value Purchase Price Improvements Appreciation in Value In the long run, real estate almost always increases in value In the short run, real estate is a cyclical business with peaks and valleys There are exceptions to every rule... IDA Institute / New Orleans 6

7 The Process of Development Time IS money Pre Development Project Management Financing Lease Up Or Sales Construction The Development Process Moves from general to specific Market Feasibility Financial Feasibility Project Financing Major actors in the development process Developer Lender ED Official Appraiser Specialized legal and accounting Some times its beautiful music Other times not so much... IDA Institute / New Orleans 7

8 Developer Obtains site control Finds use for site Finds tenants Secures financing Oversees construction Manages property Takes risks Desired benefit market ROI or better The image of developers shifts over time Lender Provides bulk of financing construction lender permanent lender Risk averse Desired benefit: adequate return with minimal risk Sometimes the villain, sometimes the hero... Appraiser Establishes value for lender Verifies developer s assumptions Confirms market feasibility Part scientist/part artist Not an easy job thinking about the value of things 10, 15, 20, or 30 years from now... IDA Institute / New Orleans 8

9 Economic Development Professional There are many roles which a public sector or quasisector economic developer can play: Clearinghouse: providing market data and information about loans and incentives helps reduce the time a developer spends in the pre development phase. Recruiter: help in assembling tenants for the project. Expediter help in navigating permitting processes or obtaining incentives. Partner / Developer economic development projects are often done by partnerships between for profit partners and local community based developers. Specialized accounting and legal skills Real estate deals have become increasingly complicated whether or not they involve public sector incentives. Identifying local specialists with skill sets in the legal and accounting aspects of real estate development is crucial. The learning curves for sophisticated financing tools are steep. Most state housing finance agencies can providelists of firms that have participated in previous deals that have received allocations and brought projects to completion. Risks Predevelopment Risk Project never makes it to construction lack of financing regulatory process political opposition Construction Risk Project cannot be completed within budget contractor does not finish job cost overruns, change orders Zoning and building permits can be major obstacles. IDA Institute / New Orleans 9

10 Risks Operating Risk Insufficient revenues to pay operating expenses and debt service Rents lower Vacancies higher Operating expenses higher Key Developer Issues Does the developer have experience with this type of project? Real Estate development Is a specialized business Does the developer have the financial strength to cover cost overruns or operating losses? How much equity Is the developer willing to contribute? Does the developer bring key tenants to the deal? Some developers just build Walmart s while others just build Walgreen s Development is really three different businesses. I do the financing. I build them I manage them IDA Institute / New Orleans 10

11 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 Error on the side of QUALITY Invest time and money on the front end to 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: IDA Institute / New Orleans 11

12 Annual Operating Pro Forma INCOME Gross Rent Rents collected at 100% occupancy Tenant Contributions Contributions to cover operating expenses Gross Income Total income 100% Occupancy (Less vacancy factor) Vacancy and collection loss EFFECTIVE GROSS INCOME Expected Cash Collected $100 OPERATING EXPENSES Taxes Insurance Maintenance Cash Expenses Utilities Management Reserves TOTAL EXPENSES Anticipated operating costs ($30) NET OPERATING INCOME Cash Generated by Property $70 DEBT SERVICE Return to Lender ($50) CASH FLOW Return to Owner $20 Calculating debt service Multiply loan amount by constant Example: payments on $100,000 at 9% for 30 years Loan amount $100,000 "c x.0966 Annual debt service 9,660 Constant represents the lender's return Principal is return of investment Interestis return on investment What Is a Constant? Annual payment of principal and interest as percentage of amount borrowed. Depends on interest rate and term. Example A 30 years at 9% Constant ("c")=.0966 or 9.66% Example B 30 years at 3% Constant ("c")=.0506 or 5.06% Interest Rate Term IDA Institute / New Orleans 12

13 Cash on Cash rate of return "e = Cash Flow Owner Equity One of the simplest and most widely used ways to measure return on investment. Measures return on equity. Capitalization Rates Cap Rates Way of Measuring Return on all Invested Capital (Debt and Equity) Capitalization rate (R o ) = NOI Sale Price Example: Buyer pays $500, for a property with NOI of $60,000 per year. R o = NOI Sale Price = 60,000 =.12 or 12% 500,000 R o is return on all capital debt and equity Market cap rates help determine value Investors purchase properties for income Higher net income means higher price Market R o is the number of cents of NOI demanded by typical Investor for every $1 of purchase price If Market R o Is.105, the purchaser is willing to pay $1 for every 10.5 Cents of NOI Example: Property with annual NOI of $20,000 Market Value = NOI = $20,000 = $190,500 R o.105 IDA Institute / New Orleans 13

14 Market Cap rates are the main indicator of value for income properties Investors Appraisers Lenders FMV = fair market value FMV = NOI R o Appraisers establish market cap rates by tracking recent transactions Example Sale #1 NOI = 150 R = 150 =.10 o Price = 1,500 1,500 Sale #2 NOI = 135 R = 135 =.1139 o Price = 1,185 1,185 Sale #3 NOI = 200 R o = 200 =.1143 Price = 1,750 1,750 Sale #4 NOI = 175 R o 175 = =.1167 Price = 1,500 1,500 Sale #5 NOI = 121 R o = 121 =.1210 Price = 1,000 1,000 Appraiser concludes Market R o =.1150 Cap Rates Vary Among Different Types of Property Among Different Parts of the Country High Cap Rate Means Weak Demand for Particular Type of Property or within Particular Market Low Cap Rate Means Strong Demand for Particular Type of Property or within Particular Market Cap Rates Change As the Cost of Money (Interest Rates) Change As Investor Confidence Changes Risinginterest interest rates > higher cap rates, lower values Lower investor confidence > higher cap rates, lower values Rising investor confidence > lower cap rates, higher values Lower interest rates > lower cap rates, higher values IDA Institute / New Orleans 14

15 Permanent Lender Underwriting First Way Out: Repayment from Project Revenue expressed as a ratio of net operating income to debt service or the debt coverage ratio. Typical DCR: Debt Coverage Ratio DCR = NOI D/S Gross Rent Vacancy = Effective Gross Rent Operating Expenses = Net Operating Income Permanent Lender Underwriting Second Way Out: Repayment from the sale of the asset. The underwriting requirement is the ratio between the loan and the estimated market value of the project or the loan to value ratio. Typical LVR: 75% to 80% Collateral Risk LVR= Loan amount Fair Market Value Goal: Resale Value > Loan Balance Case Study A Mr. W. Right 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 The Mayor of Biggsville IDA Institute / New Orleans 15

16 Case Study A assumptions: No acquisition cost W already owns the building W is a pioneer there s no loft style housing nearby W will be undertaking the project without additional investors W wants to improve his financial situation from the project but is willing to accept lower returns on investment than real estate tt developers W will need bank financing and/or financial assistance from a public or quasi public source to complete the project W will manage the property yourself upon completion Annual Operating Pro Forma Income Gross Rent Tenant Contributions Gross Income (Vacancy Rate) Effective Gross Income Expenses Taxes Insurance Maintenance Utilities Management Reserves Net Operating Income Debt Service Cash Flow Rent Collected at 100% Occupancy Tenant Contributions towards operating expenses Total Income at 100% Occupancy Adjustment for Vacancy and Collections Loss Anticipated Cash Actually Collected Research and negotiate with assessor Discuss your project with your provider Snow removal, window washing, common area Are utility expenses paid as part of rent? Are you going to manage the project or pay someone? Appliances need to be replaced, Units need repainting Cash generated by the project Interest, principal payments to lender Return to owner What bankers want... Acceptable level of risk Reduced risk of default and/or foreclosure Lenders want to limit their risk rather than maximize their profits Lenders are in a high h volume low margin business There is no upside for traditional lenders IDA Institute / New Orleans 16

17 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). Case Study A net operating income (NOI) Due Diligence Accurately estimating NOI is the single most important number in a real estate project. Mr. W. Right projects that each loft will generate a monthly rent of $800. W evaluated the costs to separate utilities and has decided to meter each unit for gas and electric. W will provide water for his tenants. Parking will be on street at no cost to either Tom or the tenants. W discussed with his local assessor what impact his loft improvements will have on his property tax bill and has budgeted accordingly. Case Study A 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 In this example vacancy and operating expenses are 30% of income. IDA Institute / New Orleans 17

18 Case Study A Debt Coverage Ratio (DCR) W 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 with a 25 year amortization. How much will the bank loan W based upon net operating income of $11,480? The debt service for a loan of $130,000 with 7% interest and a 25 year amortization is: $130,000 X.0849 = 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? Case Study A Debt Coverage Ratioatio (DCR) Recalling our debt coverage ratio formula: DCR = Net Operating Income (NOI) Debt Service (D/S) For W s project: DCR = 11,480 = ,037 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.0849 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. On commercial properties, banks typically look for loan to value ratios in the range of 60 to 80%. Banks will lend the amount that meets their minimum requirements for both debt service coverage and loan to value ratio. IDA Institute / New Orleans 18

19 Case Study A Loan To Value ratio (LTV) The appraisal establishes a market cap rate reflecting the perceived risk of a project. Fair Market Value (FMV) is the cap rate divided by net operating income. In W s case the fair market value is based on a cap rate of.085: FMR = $11,480 = $135, The banks policy is to loan to 80% of fair market value. $135,058 X 80% = $108,000 Based on this policy the bank agrees to make Tom a loan of $108,000 which is the amount that meets their minimum requirements for both DCR and LTV. Case Study A Determining The Gap Sources and Uses 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 Ways to Fill the Gap: Additional owner equity Cut project costs Sell or save taxes via historic or old building tax credit Subordinated loan or grant Reduce the scope of the project Gap 22,000 Case Study A debt service revisited W s $20,000 equity and the banks $108,000 loan leaves a shortfall of $22,000 in funding the project. W s city has a revolving loan fund that provides up to $25,000 per project at 5% interest with 20 year amortization. W 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 Service $105,000 X.0849 = 8,914 $ 25,000 X.0792 = 1,980 Total Debt Service = 10,895 Total DCR = 11,480 = ,895 Bank s DCR = 11,480 = ,914 IDA Institute / New Orleans 19

20 Case Study A Return on Investment One of the most widely used way to measure return on investment: e = cash flow owner equity In W s case e = 585 = 3% 20,000 This is not a strong rate of return, should W do the project? There are other financial benefits to owning real estate than cash flow such as tax benefits and appreciation. An upstairs project provides unique benefits such as improving the value of the retail business and lowering first floor utility expenses. Decision time go or no go? W 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. Let s DoIt Case Study B Lender Ratio Analysis Joe the Developer is considering building a multitenanted retail project Lender offering 7.0%, 25 year loan (c=.0849) Joe seeks a $1.1 million loan on following pro forma Gross $200,000 Vacancy (10,000) = EGR 190,000 Expenses (90,000) = NOI $100,000 IDA Institute / New Orleans 20

21 Case Study B Debt Coverage Ratio D/S = Loan x c = $1,100,000 x.0849 = $93,390 DCR = NOI = 100,000 = 1.07 D/S 93,390 Lender s DCR = 1.20 The NOI will not support a loan of $1.1 million since the debt coverage ratio does not meet the banks underwriting standards. Case Study B Debt Coverage Ratio The NOI can support a loan in the amount of $981,543 per the rate and term of the loan and the banks underwriting criteria: D/S = NOI = 100, = $83, DCR 1.20 Loan = D/S = 83,333 = $981,543 c.0849 Case Study B Loan to Value Ratio Lender Knows That a Market R o =.085 FMV = NOI = 100,000 = $1,176,470 R o.085 LVR = Loan Amount = 1,100,000 = 94% FMV 1,176,470 Lender s LVR = 80% Therefore: Loan = FMV x LVR = 1,176,470 x.80 = $941,176 IDA Institute / New Orleans 21

22 Permanent Lender Ratios With Both Ratios The DCR ratio indicates a loan amount of $981,543 The LVR ratio indicates a loan amount of $941,176 The Loan Amount That Meets Both Ratios Is $941,176 So developer wants $1,100,000 But bank will only loan $941,176 Filling the Gap Joe the Developer still seeks $1,100,000 and asks the City to finance the difference of $158,824 from its revolving loan fund (RLF). The loan program provides subordinate financing at below market interest rates. At this time the city is offering 30 year term loans at 5% (c=.0645) Lender Ratios on City Loan LVR Ratio Calculation for blended loans Loan Amount (Bank) + Loan Amount (City) Fair Market Value = 941, ,824 1,176,000 LVR = 94% IDA Institute / New Orleans 22

23 What is the overall debt coverage ratio? DCR = NOI D/S (Bank) + D/S (City) = 100,000 79, ,244 = 100,000 90,150 DCR = 1.11 Everybody is happy Joe the Developer gets the financing to do his deal he even saves a little interest. The bank meets its underwriting requirements with ihregard to DCR and LTV because the city subordinates its position as a creditor to the bank. The city is happy because the project creates jobs and expands the tax base and it still gets a return on its investment. I like when everybody happy, just like at Yalta... Case Study C Easy, a non profit development corporation, is about to embark on its first real estate development opportunity and is curious about the impact of bank lending ratios on loan amounts. They have approached two banks with funding proposals and the lenders have given Easy the following requirements. Conversion of office building to residential lofts IDA Institute / New Orleans 23

24 Case Study C: Compare two loans Money Laundry S&L is willing to provide a 30-year term at nine percent interest, so long as the project provides a loan to value ratio (LVR) of no more than 75 percent and a debt coverage ratio (DCR) of at least Deep Pockets National offers a eight and a half percent interest rate and a 15-year term with a 25 year amortization schedule. Its maximum LVR is 80 percent. Its minimum i DCR is Easy estimates that the project will have net operating income of $100,000. A local appraiser has informed Easy that the market cap rate is nine percent. Assignment How much is each financial institution willing to lend Easy? Understanding real estate math... Builds relationships with the development community Helps define the roles which municipal governments and non profits can play in community based development. Leads to inventorying available incentives from a wide variety of sources Helps us package appropriate incentives which we will discuss in detail in the next section. For More Information contact: Gary Ferguson gary@downtownithaca.com Dan Carmody dcarmody@detroiteasternmarket.com dcarmody@detroiteasternmarket.com IDA Institute / New Orleans 24