Lecture Notes. Dollars and Sense of Building Rehabilitation. Attracting Equity and Debt. National Development Council

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2 Dollars and Sense of Building Rehabilitation Attracting Equity and Debt 2 Lecture Notes 927 Dudley Road Edgewood, KY ph: fax: All rights reserved. Version: August 27, 2013

3 3 (NDC) Nation s oldest not-for-profit organization specializing in community and economic development finance Mission: Increase the flow of capital to underserved communities Provides technical assistance, training and financial and development services Works with more than 80 municipalities and local development organizations across the U.S. HEDC-Corporate Equity Fund syndicates LIHTC with RTCs

4 Partnership with the National Trust 4 Customized NDC s Real Estate Finance coursework to create a two class series and Historic Real Estate Finance certification Covers underwriting, financing, RTCs, LIHTCs, NMTCs, depreciation and taxes First round in 2012/2013, Second round in progress Combination learning (reading, hearing and doing through case studies) Tremendous positive feedback from attendees

5 5 Why Are We Here? Federal and State RTCs at the most can cover around 50% of a project s financing To learn how to attract other capital for real estate development projects Two kinds of capital Debt from lenders Equity from investors

6 6 Why Are We Here? (cont.) To attract debt, you must Understand how lenders evaluate risk Learn to reduce risk of default and foreclosure To attract equity, you must Understand how investors measure return on investment (ROI) Learn to adjust the imbalance between cost and revenues

7 7 Lender s Perspective Lenders are risk limiters, not profit maximizers Lending is a low-margin, high-volume business No "upside" for lenders, fixed returns May not be familiar with the challenges and opportunities related to historic properties Historic properties (by their very nature) are not cookie cutter projects

8 Lender s Concerns when dealing with a historic (and RTC) project 8 Construction Lenders Adequacy of budget and unknown conditions Sufficient construction contingency (10%+) Financial strength/capability of the developer Is there a paid developer fee that can be used as a secondary source of contingency? Financial strength/capability of the general contractor Financial strength of the perm lender and the tax credit investor (if applicable) Often needed to bridge the RTC equity Permanent Lenders Ability to foreclose or remedy lack of payment during the recapture period

9 9 Investor s Perspective Investors are seeking to maximize economic benefits and minimize equity investment Invest in projects yielding the highest ROI Not all investors can utilize RTCs Passive income tax credit Limits on the amount that can be used against active income Alternative Minimum Tax (AMT) considerations

10 Differences between Lenders and Developers/Investors 10 DEVELOPERS LENDERS Optimists Approach Skeptics Entrepreneurs Style Organization Men/Women Build wealth Personal Steady Objective Income Maximize Business Avoid risk Profits Objective

11 Three Benefits of Owning Real Estate 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

12 12 Cash Flow Annual Rental Income - Annual Operating Expenses - Annual Debt Service (payments to lenders) = Cash Flow

13 Economic Development Professional s Job Is to Make Deals Happen in Distressed Areas 13 Get lender to lend by reducing risk Increasing Net Operating Income by reducing expenses Lower the loan to value ratio Encourage developers and investors to invest by increasing ROI to acceptable level Increase the Cash Flow Decrease the Equity Investment Fair ROI but no undue enrichment

14 Tools of Economic Development Finance 14 Term extend the repayment period Rate reduce the cost of funds Leverage increase debt, reduce equity Lower costs Pre-development costs Off-site expenses Environmental Operating expenses tax reduction

15 15 Lender Jargon Security Position 1st, 2nd, 3rd mortgage Subordination Amortization Schedule Self-Amortizing Term Balloon Recourse/Non-recourse Loan-to-Value Ratio (LTV), Debt Coverage Ratio (DCR) Interest only

16 16 Pro Forma Preparing the Annual Operating Budget Pro Forma Income and Expense Statement GROSS RENT Rent Collected At 100% Occupancy + TENANT CONTRIB. Contrib. for Operating Expenses = GROSS INCOME Total Income 100% Occupancy - VACANCY Vacancy and Collection Loss = EFFECTIVE GROSS INCOME Expected Cash Collected - ANNUAL OPERATING EXPENSES Taxes Insurance Maintenance Cash Expenses Utilities Management Reserves = NET OPERATING INCOME Cash Available for Debt Service

17 17 Development Process (cont.) Net Operating Income (NOI) is the most important number in a real estate project Represents overall cash return on capital Determines loan amount Determines value Determines cash return on equity

18 18 Tenants Tenants are the customers for real estate developers Tenant rents repay loans and provide cash flow Tenant s ability to make lease payments is key Not all tenants are willing to consider retrofits Parking is often not readily available for Main Street properties

19 Tenant Leases Are Critical Permanent lenders will not fund without substantial portion of the project committed to tenants Want signed leases, not letters of interest Percentage preleasing requirement depends on market Leases create value 19

20 20 Key Lease Provisions Gross lease Tenant pays rent only Net lease Tenant pays rent and some or all direct operating expenses Common Area Maintenance Pro rata share of common area expenses that tenants pay in commercial centers Parking lot cleaning Marketing Common area utilities

21 21 Calculating Debt Service Multiply loan amount by constant Example payments on $100,000 at 9.0 percent for 30 years Loan amount $ 100,000 x "c x.0966 = Annual D/S $ 9,660

22 Mortgage Constant Annual payment of principal and interest as a percentage of amount borrowed. Constant is always higher than the interest rate Constant represents the lender's return Principal is return of investment Interest is return on investment Where to find constants? Constant charts (provided or Google) Constant is same as Excel PMT function for $1 given loan terms for example, for 7% for 25 years: =pmt(.07/12,25*12,-1)*12 =

23 23 Annual Operating Pro Forma GROSS RENT Rent Collected At 100% Occupancy + TENANT CONTRIB. Contrib. for Operating Expenses = GROSS INCOME Total Income 100% Occupancy - VACANCY Vacancy and Collection Loss = EFFECTIVE GROSS INCOME Expected Cash Collected - ANNUAL OPERATING EXPENSES Taxes Insurance Maintenance Cash Expenses Utilities Management Reserves = NET OPERATING INCOME Cash Generated by Property - DEBT SERVICE Return to Lender = CASH FLOW Return to Owner

24 24 Cash on Cash Rate of Return e = Cash Flow ( CF ) Owner Equity ( EQ ) One of the simplest and most widely used ways to measure return on equity Project CF EQ "e" No Enhancement With Add'l Debt With Tax Abatement Both

25 25 Manipulating Cash-on-Cash ROI Adding Debt (unless totally deferred) reduces Cash Flow but also reduces equity A tax abatement cuts expenses therefore increases Cash Flow Often not every tool is needed on a project Project CF EQ "e" No Enhancement % With Add'l Debt % With Tax Abatement % Both %

26 26 Estimating Equity EQ = Cash Flow e Usually an investor has a minimum return they are seeking Calculates the maximum amount of equity to achieve a specific return

27 27 Capitalization Rates Cap Rates Way of measuring return on all invested capital (debt and equity) Capitalization Rate (R o ) = NOI Sales Price

28 28 Capitalization Rates Cap Rates Example Buyer pays $500,000 for a property with NOI of $60,000 per year R o = NOI Sales Price = 60,000 =.12 or 12% 500,000 R o is return on all capital debt and equity

29 Market Cap Rates Are Used to Determine Value 29 Investors purchase properties for income Higher 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, typical purchaser would pay $1 for every 10.5 cents of NOI

30 Market Cap Rates Are Used to Determine Value 30 Example Property with annual NOI of $20,000 Fair Market Value = NOI = $20,000 R o.105 = $190,500

31 Appraisers Develop Market Cap Rates by Observing Transactions EXAMPLE Sale #1 NOI = 150 R o = 150 =.10 Price = 1,500 1, Sale #2 NOI = 135 R o = 135 =.1139 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

32 32 Cap Rates Vary Among different types of property Among different parts of the country Low cap rate means strong demand for particular type of property or within particular market High cap rate means weak demand for particular type of property or within particular market

33 Permanent Lender Underwriting Ratios Debt Coverage Ratio DCR = NOI D/S Measures project's ability to repay loan from revenues (lender's "first way out") Higher the DCR, lower the risk Typical DCRs: 1.15 to 1.35

34 34 Permanent Lender Underwriting Ratios (cont.) 2. Loan-to-Value Ratio LTV = Loan Amount FMV Measures project's ability to repay loan from sale of the asset (lender's "second way out") Lower the LTV, lower the risk Typical LTV: 75%-80%

35 Lender Ratio Analysis Example Lender offering 11.5 percent, 30 year loans c =.1189 Developer requests $1.2 million loan on following pro forma Gross 200 Vacancy (10) EGI 190 EXP (40) NOI 150 Lender s DCR is 1.25 and LTV is 75% 35

36 36 Maximum Loan Given Lender s DCR Given the Lender's minimum DCR (1.25), the maximum loan is: Step 1: D/S = NOI = 150 = 120 DCR 1.25 Step 2 Loan = D/S = 120 = 1,009 "c".1189

37 37 Maximum Loan Given Lender s LTV Given the Lender s Maximum LTV (75%) and the Market Cate Rate (R o =.1110), the maximum loan is: Step A: FMV = NOI = 150 = 1,350 R Step B: Loan = FMV x LTV =1,350 x.75 = 1,012

38 Key Operating Pro Forma Issues Are the projected rents achievable? Pre-leasing? Verified in appraisal? Reasonable allowance for vacancy? Appraiser's allowance? Are operating expenses adequate but not under- or over-stated? 38

39 Key Sources and Uses Issues Is the developer contributing property to the deal? Is the value reasonable? Construction costs verified in construction contract? If developer is contractor, is profit and overhead reasonable? How was construction interest calculated? Architectural and engineering fees as percentage of construction? Typically higher for RTC projects Is there a developer fee in the budget? Is it "reasonable"? 39

40 40 Case Study The Bach Apartments Vacancy Yr 1: 25%; Stabilizes at 7% Gross Rent 108 Operating Exp year, 8% loan ( c =.1008) R o = 10% Investors demand a 10% return What is Stabilized NOI? If the bank demands a DCR of 1.25 and a LTV of 80%, how much debt can be attracted? How much equity can be attracted? If total project costs ( Uses ) are $570, is there a gap?

41 41 Bach: Calculating Stabilized NOI Gross Rent Vacancy (7%) (8) = Effective Gross Rent Operating Expenses (50) = Stabilized NOI 50

42 42 Case Study The Bach Apartments Vacancy Yr 1: 25%; Stabilizes at 7% Gross Rent 108 Operating Exp year, 8% loan ( c =.1008) R o = 10% Investors demand a 10% return What is Stabilized NOI? If the bank demands a DCR of 1.25 and a LTV of 80%, how much debt can be attracted? How much equity can be attracted? If total project costs ( Uses ) are $570, is there a gap?

43 43 Bach: Calculating Max Loan Amt For DCR: 1.Max DS 2.Loan = Stabilized NOI/DCR = 50/1.25 = 40 = Max DS/ c = 40/.1008 = 400 (396.8 exactly) For LTV: 1.FMV= Stabilized NOI/R o = 50/.10 = Loan = FMV x LTV = 500 x.75 = 375 Therefore, the maximum loan is $375

44 44 Case Study The Bach Apartments Vacancy Yr 1: 25%; Stabilizes at 7% Gross Rent 108 Operating Exp year, 8% loan ( c =.1008) R o = 10% Investors demand a 10% return What is Stabilized NOI? If the bank demands a DCR of 1.25 and a LTV of 80%, how much debt can be attracted? How much equity can be attracted? If total project costs ( Uses ) are $570, is there a gap?

45 45 Bach: Calculating Cash Flow If our maximum loan is $375, then: DS = Loan x c = 375 x.1008 = 38 (37.8 exactly) Gross Rent Vacancy (7%) (8) = Effective Gross Rent Operating Expenses (50) = Stabilized NOI 50 - Debt Service 38 = Cash Flow 12

46 46 Case Study The Bach Apartments Vacancy Yr 1: 25%; Stabilizes at 7% Gross Rent 108 Operating Exp year, 8% loan ( c =.1008) R o = 10% Investors demand a 10% return What is Stabilized NOI? If the bank demands a DCR of 1.25 and a LTV of 80%, how much debt can be attracted? How much equity can be attracted? If total project costs ( Uses ) are $570, is there a gap?

47 Bach: Calculating Equity and determining a gap 47 EQ = Cash Flow / e = 12 /.10 = 120 Sources = Uses Debt + Equity = Total Project Costs = Therefore there is a gap of 75.

48 48 Debt and Equity Vehicles 1. Deferred Mortgage No interest Loan repaid at time of sale/ refinancing or at an agreed to time

49 49 Debt and Equity Vehicles (cont.) 2. Accruing Deferred Mortgage Interest set and accruing until sale/refinance Example: $100,000 loan at 3.0 percent Annual accruing interest: $3,000 Sale in Year 10 Payoff $100,000principal + 30,000accrued int. $130,000

50 50 Debt and Equity Vehicles (cont.) 3. Interest only Mortgage Pay interest on a regular basis Pay principal upon sale, refinancing, or some other event Example: $100,000 loan at 3.0 percent Annual interest payment $3,000 Principal payment of $100,000 at time or sale/refinance, end of term, conversion to other use, etc.

51 51 Debt and Equity Vehicles (cont.) 4. Amortized Mortgage Regular payment of principal and interest Example: $100,000 loan 3.0 percent, 30 years, c =.0506 $100,000 loan amount x.0506 c $5,060 annual debt service

52 52 Debt and Equity Vehicles (cont.) 5. Residual Receipts Loan Loan payments due only if sufficient NOI is available Example: $300,000 1st mortgage for 30 years at 9.0 percent $100,000 2nd mortgage, interest only, 3.0 percent with payments from residual receipts If NOI = $30,000 $30,000 NOI - 28,966 D/S on 1 st $1,034 Available for payment on 2 nd $3,000 Interest Due - 1,034 Interest Paid $1,966 Interest Accrued

53 53 Debt and Equity Vehicles (cont.) 6. Debt Service Guarantee A guarantee to the bank on projected NOI and D/S Example A guarantee to the bank on projected NOI and D/S Lender underwriting will support $100,000 of debt (9.0 percent, 30 years): D/S = $9,700 Project needs $120,000 in debt: D/S = $11,600 Loan program guarantees the difference $1,900 shortfall if the NOI does not materialize Time and amount limit Turned into term loan for amount actually expensed

54 54 Debt and Equity Vehicles (cont.) 7. Credit Enhancement Guarantee of repayment to lender Reduces risk and interest rate Provided by government agencies, insurance companies May be provided as a direct guaranty or letter of credit Costs vary greatly Transfers risk from the real estate project to the guarantor

55 55 Debt and Equity Vehicles (cont.) 8. Joint Ventures Equity position in property No fixed repayment Some pre-agreed upon percentage split or ownership + share in CF + NSP

56 56 Contact information Corey Leon, Field Director Based in Detroit, Michigan and serving the entire Midwest Mobile Fax

57 57

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