Creating a new market

Financial FeasibilityTwo 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

Development is really three different businesses.

I do the financing.

I build ‘em

I manage ‘em

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

Develop a realistic budget and include a generous contingency

Developing the Pro Forma

IncomeRent Roll How much rent for each unitTenant Contributions Utilities Laundry ParkingVacancy Factor (5 -20%) How long will vacant unit take to rent?

ExpensesTaxes Likely impact of upstairs investment?

Utilities Separate meters or not?Insurance Defacto redlining?Maintenance Common areas and site

Developing the Pro Forma

IncomeGross IncomeLess Vacancy RateEffective Gross IncomeLess Operating ExpensesNet Operating Income

ExpensesManagement By owner or by third party?Other Special assessment district Annual rental unit inspection fee

NOI

Developing Sources and Uses

UsesDue Diligence to accurately measure:Construction CostsSoft CostsAdequate Contingency

SourcesThis is where Main Street pays dividends.

Loan and grant sources available to help fund the project.

Determining Debt Service

Net Operating IncomeNOI 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.

Loan SourcingLenders come in more flavors these days

Needed from lenderInterest Rates and TermMinimum Debt Coverage RatioMinimum Loan to Value

Key FormulasDebt Service D/S = Loan Amount X c (or constant)

Debt Coverage RatioDCR = Net Operating Income (NOI) Debt Service (D/S)

Fair Market ValueFMV = Net Operating Income (NOI) X Cap Rate

Loan to Value Ratio is the % of FMV the Bank will loan to

Return on Investmente = cash flow

owner equity

• 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

Case Study Assumptions

Annual Operating Pro FormaIncome

Gross Rent Rent Collected at 100% OccupancyTenant Contributions Tenant Contributions towards operating expenses

Gross Income Total Income at 100% Occupancy(Vacancy Rate) Adjustment for Vacancy and Collections

LossEffective Gross Income Anticipated Cash Actually CollectedExpenses

Taxes Research and negotiate with assessor

Insurance Discuss your project with your providerMaintenance 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 fromloans ranges 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 1,200Taxes 2,400Insurance 1,200Maintenance 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?

Length of paybackIn

tere

st R

ate

Typical Constant Chart

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.

• 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.

Loan to Value Ratio

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 fundsAcquisition

0Arch / Engineer 10,000Permits 500Hard Construction 119,500Appliances 5,000Contingency 15,000Total 150,000

Sources of fundsOwner Equity 20,000Bank Financing 108,000Total 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 = 1,980Total Debt Service = 10,895

Total DCR = 11,480 = 1.0510,895

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.

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

Inpatient Capital: Ten Year Community Cost of Removal

Accumulated blight can be dealt with in two ways

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

Patient Capital: Ten Year Community Cost of Renovation

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 FlowTom 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 IssueFinancing commitment from lenders must be validated by an appraisal.

How Much Debt Can You Service At Different Rents?

Monthly Rent per unit Allocation to Expenses Monthly Net Operating Expenses (NOI)

Loan @ 7% 20 Yr Amort5 Yr Balloon (c = .0931)

350 40% 210 27,068

400 40% 240 30,934

450 40% 270 34,801

500 40% 300 38,668

550 40% 330 42,235

600 35% 390 50,268

650 35% 422 54,458

700 35% 455 58,646

750 35% 488 62,836

800 35% 520 67,025

850 35% 552 71,214

900 35% 585 75,403

950 35% 617 79,592

1000 30% 700 90,225

1050 30% 735 94,737

1100 30% 770 99,248

1150 30% 805 103,759

1200 30% 840 108,270

Voss Brothers 2006 Avg. Rent $750Supports $62,300Unit Cost $160,000Gap $97,700

Sala Flats 2005 Avg. Rent $650 Supports $54,500 Unit Cost $154,500Gap $100,000

Ren/Gol 2001Avg. Rent $700 Supports $58,700Unit Costs $121,129 Gap $62,429

First Mortgage 1,700,000Risk Sharing 50/50 insured by IHDA & USHUDFunded by the AFL-CIOSecond Mortgage 750,000Funded by HTFThird Mortgage 275,320Funded by the City of Rock Island

Equity 3,308,870Historic T.C. 433,210Affordable (Sect 42) 2,758,466Deferred Dev. Fee 117,194

Grants 272,000

City Façade 30,000State Energy 68,000AHP 175,000Total 6,307,190

Other

15 year property tax negotiated schedule30 year lease back of commercial space

Typical Lasagna Financing

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

Start by building your local team of EXPERTS! Accountants/Tax Attorney Historic-building-friendly Architects Construction LenderCode Officials

Building local development capacity

You don’t have to become a community-based developer to have a big beneficial impact on downtown investment

1998: $180,018 3 jobs 0 housing units2000: $103,871,045 1,209 jobs 1,074 housing units2003: $434,347,377 2,286 jobs 1,291 housing units2006: $546,052,854 1,660 jobs 2,168 housing units

Dollars Invested in Missouri: Completed State Projects

Using Housing to build proper mass on in-fill sites

Three story massing, mixed use, mixed income, and self contained parking

New Vs Old

Both have become important as reconnecting the fabric has become as important as preserving our heritage.

Details have to be right

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

Condo projects

Key issues of small scale condo projects

Market Issues• Empty nester most important market segment.• Security and freedom is important to this audience.• Hard to jump past rental market development to condos.

Design:• Higher quality of finishes expected.• Higher levels of sound insulation needed in ownership units.• Stairs becomes an issue with the empty nesters.• Parking is more important that with rental projects -

adjacent and secure parking.

Key issues of small scale condo projects

Project Costs• Legal and survey costs can be substantial.• Cannot use historic tax credits for ownership units.• Many rental projects using historic tax credits are designed to

flip to ownership after the required five year holding period.

Financing• Condo docs and surveys compliance with secondary market

requirements.• Appraisal gap issues aplenty.• Property tax assessments can fluctuate greatly. • Market pioneers need to feel like they are getting a deal.

Live Work Projects

Live Work Projects

Not for profit consultants and developers:

Artscape, Toronto

Artspace, Minneapolis

Live Work projects work at all price points

$300 – 500 rent per month

$300,000 – 500,000 per unit

Upper floor office space

Calumet, MI

Lodging Industry Upstairs

Upstairs food, beverages, and entertainment

Overhead Parking

Upside Economics: Often more income opportunity upstairs than down

Come Early!2014 Main St Conference Flower Day Weekend May 18 & 19