LECTURE 10: DEVELOPMENT FINANCING II Overview The Construction Loan A Shopping Center Example The Permanent Loan Development Project Financing: Progress Payments Precompletion Marketing The Construction Loan Monthly Draw Method: The amount drawn down on the construction loan each month is based on the work completed during the preceding month. Short-term interest rates - usually floating rates such as the PLR - are used. The developer bears the interest rate risk during the construction period. A Shopping Center Example Leasable area = 110,000 sf Cost of land = $2.5M Development period = 12 months Construction loan: Loan term =12 months 75% drawn in first 4 months, 25% in last 8 Interest rate = 12% Construction loan fee = 2% Shopping Center Example Permanent loan: Loan term = 10 years (to repay) Debt amortization = 25 years (to compute monthly payments) Interest rate = 12% Permanent loan fee = 3% Anticipated holding period after completion = 5 years Shopping Center Example Total construction costs to be financed = $8,309,000 Draws required (assumed to be at the end of month): Months 1 to 4 = $1,557,938 Months 5 to 12 = $259,656 What is the estimated interest cost on the construction loan? (Assume estimates are accurate) Total Construction Loan Amount Month Costs Interest Total Draw Ending Balance 0 $0 $0 $0 $0 1 $1,557,938 $0 $1,557,938 $1,557,938 2 $1,557,938 $15,579 $1,573,517 $3,131,455 3 $1,557,938 $31,315 $1,589,253 $4,720,708 4 $1,557,938 $47,207 $1,605,145 $6,325,853 5 $259,656 $63,259 $322,915 $6,648,768 6 $259,656 $66,488 $326,144 $6,974,911 7 $259,656 $69,749 $329,405 $7,304,316 8 $259,656 $73,043 $332,699 $7,637,015 9 $259,656 $76,370 $336,026 $7,973,042 10 $259,656 $79,730 $339,386 $8,312,428 11 $259,656 $83,124 $342,780 $8,655,208 12 $259,656 $86,552 $346,208 $9,001,416 Total $8,309,000 $692,416 $9,001,416
Interest Costs Part of Loan The total loan amount is the cumulative balance due at EOM12 ($9,001,416). It comprises the estimated construction costs ($8,309,000) and total interest or interest carry ($692,416). Interest charges on the outstanding monthly loan balance are assumed to be taken down as part of the construction loan. Actual versus Estimated Costs We have assumed that all cost estimates are accurate as to amount and timing of draws. Actual and estimated costs differ due to progress of work unanticipated changes in interest rates Once the construction loan limit is reached, the developer must source additional funds equity partners or gap lenders Sources of Construction Risks Material and labor costs overruns Unfavorable weather conditions Poor estimating procedures Lack of management expertise Risks with general and sub-contractors Interest rate risks Policy changes Permanent Loan Total loan amount = $9,001,416 Debt service per month = $94,805 3% Permanent loan fee = $270,042 Yield to permanent lender = 12.55% What is the return on the project for the developer? Incorporate the debt into the cash flow projections from leasing. Estimated NOI depends on market analysis and tenant mix. Pro-Forma Statement of Cash Flows - Operating Period EOY 2 3 4 5 6 NOI 757,300 1,599,632 1,695,099 1,796,275 1,903,498 Debt service 1,137,661 1,137,661 1,137,661 1,137,661 1,137,661 BTCF (380,361) 461,971 557,438 658,614 765,837 At EOY2, a further cash injection is needed. Cash Flow from Sale at EOY6 Assume the developer/investor sells at EOY6. Sale price $16,035,003* less Selling expenses 320,700 Mortgage balance 8,610,143 BTER(Equity Reversion) $7,104,160 * Assumes 6% appreciation p.a. from initial total project cost of $11,982,287
Equity Requirements At t=0, the equity outlays are Land Acquisition $2,500,000 Permanent loan fee 270,042 Construction loan fee 180,028 Total $2,950,071 At t=1, the equity outlay Costs not financed $30,800 Profitability Analysis Year 0 1 2 3 4 5 6 Equity (2,950,071) (30,800) BTCF-Operations (380,361) 461,971 557,438 658,614 765,837 BTCF-Sale 7,104,160 Total BTCF (2,950,071) (30,800) (380,361) 461,971 557,438 658,614 7,869,997 BTIRR = 21.33% BTNPV @ 21% = $47,050 Development Project Financing: Progress Payments Other than using equity and bank borrowings, can developers of residential projects access other sources of funds? Yes, progress payments from precompletion (or predevelopment marketing). Housing Developers (Control and Licensing) Act Cap 130, 1985 & Housing Developers (Project Account) Rules, 1990. Conceptual Outline Developers may market projects before completion. In Singapore, qualified developers can begin selling as soon as the building plan approval has been obtained. Purchasers who commit to buy are required to pay progressively according to the stage of completion of the project. Schedule of Progress Payments Stage Completion of Event % of Price 1 Obtaining Option (Booking fee) 5 Signing of SPA 15 2 Foundation work 10 3 Reinforced concrete framework 10 4 Brick walls 5 5 Roofing/Ceiling 5 6 Doors & window frames, electrical 5 wiring, plumbing & internal plastering Schedule of Progress Payments Stage Completion of Event % of Price 7 Carparks, roads and drains 5 8 Temporary occupation permit & 25 Architect s Certificate of completion (Notice to take vacant possession) 9 Legal completion of the SPA 2 Certificate of Statutory Completion 8 12 months from date of notice to 5 take vacant possession
Project Account All licensed housing developers are required to open a Project Account with a bank or FI. One Project Account is required to be opened for each housing project or each phase of a major project. All revenues from sales of units shall be paid into the Project Account. Any money borrowed to carry out the project shall be deposited into the Account No withdrawal from the Account save as authorized by the rules. Withdrawals must be supported by architect s certificates. All monies in the Project Account does not form part of the property of the developer in the event of liquidation. The developer can withdraw all monies from the Account after the completion of the SPAs. Implications for Developers Developers cash flows can be improved in that inflows from progress payments can be applied towards construction costs. Developers can lock in the sale price. Developers can reduce financing costs. Managed properly, progress payments can provide interest-free financing! Example A developer has just purchased a piece of land for development into residential properties. Land cost paid at t = 0 is $3m. Development cost = $10.8m over 4 years Development period = 4 years Paid for land by equity but will take a construction loan at 8% interest. Example Development can sell for a projected amount of $20m. Required rate of return on project = 20% Commissions and marketing costs are estimated to be 2% of the sale price. Precompletion marketing allowed to commence only at EOY1. Construction Loan Year Costs Interest Total Draw Ending Balance 0 $0 $0 $0 $0 1 $1,800,000 $0 $1,800,000 $1,800,000 2 $3,600,000 $144,000 $3,744,000 $5,544,000 3 $3,600,000 $443,520 $4,043,520 $9,587,520 4 $1,800,000 $767,002 $2,567,002 $12,154,522 Total $10,800,000 $1,354,522 $12,154,522
Without precompletion marketing The developer can sell the units only on completion of construction (TOP) at EOY4. Only when the units are sold at EOY4 can the construction loan be repaid. Gross Revenue $20,000,000 less Selling Expenses 400,000 Net Sales Proceeds $19,600,000 Without precompletion marketing Cash outflow at EOY4 = $12,154,522 Realized Profit $ 7,445,478 PVF @20%, 4 years 0.4823 PV of Profit $ 3,590,605 less Land cost (Equity) $ 3,000,000 NPV $ 590,605 With precompletion marketing Assume all the units are sold at in year 2. Assume the progress payments are paid in the following proportions: EOY2 40% EOY3 40% EOY4 20% Assume that commissions and marketing costs are spread over year 2 to 4 at 2% of the progress payments. Cash Flows (Precompletion Marketing) Year 0 1 2 3 4 Const Costs $0 $1,800,000 $3,600,000 $3,600,000 $1,800,000 Gross Revenue $8,000,000 $8,000,000 $4,000,000 Sales Costs $160,000 $160,000 $80,000 Net Proceeds $7,840,000 $7,840,000 $3,920,000 Loan Balance $1,800,000 $0 $0 $0 Net Cash Flow $0 $0 $4,240,000 $4,240,000 $2,120,000 Computing Net Cash Flows and NPV with Precompletion Marketing Net cash flow at EOY2 = Net Proceeds - (Loan Balance at EOY1 + interest) - Costs at EOY2 = $7,840,000 - $1,800,000(1.08) - $3,600,000 = $2,296,000 NPV = $2,070,525 Differences in NPV NPV (with precompletion marketing) > NPV (without precompletion sale) Differences due to: savings in interest on construction loan time value of money since purchase monies received earlier differences in selling prices (possibly)
Should developers always opt for precompletion sales? Cost of debt - Interest rate on construction and permanent term loan Expected path of property prices - In a rising market, the developer loses out in terms of foregone higher revenues by preselling Signaling paradigm - Developer with a good project may hold back marketing to signal that the property is good Implications of precompletion sales for purchasers Buyers can lock in a lower sale price in a rising market. Buyers lose out on interest on payments. Moral hazard: Will developers deliver a good product once it has been sold? Adverse selection: Are buyers paying for lower quality units?