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Real Estate Financial Modeling: Costly Mistakes to Avoid

The combination of high inflation and rising interest rates aren’t just making houses more expensive to purchase, but making them more costly to construct. According to a daily tally maintained by the US Federal Reserve, the producer price index for building materials increased from 223 in June 2020, to 350 by June 2022–an growth of 49% in only two years. The price of consumer goods is increasing also, at rates ranging from 5-9% in most developed nations which has prompted central banks to increase rates of interest to counter.

The rising costs of real estate mean that developers need to borrow moremoney, and they frequently depend on complex financing arrangements that could eat away at profits. In the following, I’ll explain how choosing the wrong financing option could increase the cost by 1to 5 percent to the total cost of the project, which can amount up to thousands or even hundreds of thousand dollars for a bigger project. With commercial construction loans reaching $412 billion in the month 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 ways to help developers stay clear of this is to develop an economic model prior to agreeing to a financing structure. But, they tend to skip this crucial step.

I’ve been in real estate finance for over 15 years, and have secured the financing for over 100 real estate commercial projects that include hotels, homes and commercial properties. I’ve noticed that many developers are focused on focusing their efforts on the day-to-day needs and are not as experienced in taking a look at major financing decisions and fully understanding the nuanced aspects. They might not be able to take advantage of modeling in any way or may attempt to develop their own model instead of enlisting the help of an expert in financial modeling.

They often simplify or make assumptions that are incorrect and can cause the results to be distorted. This can become a problem when developers use complex finance models that incorporate junior debt as well as third-party equity. Even for professionals in finance, who are knowledgeable about the structure of structured finance, this type of financing can be difficult.

Real real estate finance is an incredibly unique businessand is difficult to model without knowing the assumptions behind it. Below, I outline three mistakes I’ve seen throughout the years, and then explain how clever modeling will help you avoid them.

How Real Estate Projects Are Financed

A real property development project is usually funded with a mix of senior debt issued by third parties and equity. It’s also normal to seek additional financing through junior debt or equity investors as the project’s costs increase.

Senior debt lenders employ the “last-in first-out” approach to financing projects. They expect to see all subordinated financing put into use before they release any funds. The lender who is the senior one then covers expenses until the project is complete and at that point, the loan is repaid in the first.

In the majority of funding models in the market, senior debt is the highest security and is as the first on the list of capital, thereby with the lowest cost which is a lower interest rate and minimal fees. Junior debt is characterized by an interest rate that is higher and equity shares in the profits from the project and can also be the benefit of a priority return.

To show the impact of different combination of financing choices, we’ll consider 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 15 million dollars
Total construction cost (excluding finance costs) 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 instance, this is around $15 million. Following that, the developer will draw down monthly to cover the construction costs as the project develops.

Drawdowns typically differ from month to month because of the fluctuation in expenditures and when inflation happens. To illustrate this piece let’s say that Project 50 requires 16 equal drawdowns on the construction cost of $20 million. That’s a mean that $1.25 million will be required at the close of each month, all the way up to and including the month 16.

Construction costs can be estimated ahead of time from both the builder as well as the loan provider, the latter hiring a third-party surveyor to oversee the project and then approve each month’s drawdown requests throughout the construction.

A construction project will typically not earn any income until construction is finished when the house is prepared for move into, meaning that any interest accrued by lenders is compounded and accrued throughout the life for the construction project. Making the wrong choice of financing could result in paying more in interest than needed.

First Mistake: Not using WACC to determine the best Blend

The most crucial metric to determine the break-even points for an undertaking is the cost per unit weighted or WACC.

I’ve seen a lot of real estate developers, and certain funders commit the mistake of picking the most affordable blended rate that is based on the WACC after the loan has been drawn up to the fullest extent and prior to the sale of property begins making any repayments. This is a tried and true method to maximize financing in certain aspects of financing, including structured acquisitions of companies. But, if you are building a project, this technique could cause you to dramatically underestimate the cost of financing.

When finance an acquisition the entire capital is used up at once. In the case of real estate development, only the second debt is repaid at the time of purchase, while the more substantial senior debt is incorporated into the project, month by month. This means that the majority of the loan will only be drawn out for a few months before it begins to be paid back.

Incorrectly calculating the interest allowance

If you’re thinking about senior loans The lenders you talk to are likely to have different model and methods to structure loans. The majority will offer leverage in the form of the percentage of costs or the value at the end. They then break down the loan into the costs of construction and roll-up interests, and the remaining going to 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 result.

Let’s look back at Project 50 and focus on an example where two rival banks provide senior debt with the same level of leverage 60% of GDV.

Both have an interest-rate of 7 percent. But let’s imagine that Bank A is much more prudent about sales. Perhaps it’s more optimistic about the impact of a downturn on the market for real estate. It is trying to estimate the number of units sold by spreading the sales over a period of 10 months, and only five units being sold per month. This is why it provides the same gross loan , but with the term is longer that results in higher accrued interest. This higher interest allowance will have an impact on the structure the loan.

Error 3: Not being able to model the exit strategy

In evaluating a real estate project, the funders must understand the developer’s exit strategy. Construction financing is usually short-term (one or two years) and is intended to be paid back when the construction work is completed. If a developer decides to hold for the finished project for a longer period, they is usually able to refinance the project to a loan with a lower interest rate when the construction is complete.

Alternatives for selling or refinancing after construction can be difficult to assess in conjunction with other sources of funding. In the absence of modeling the effect of an plan of exit could cause the borrower to overlook crucial details which affect the most effective financing structure.

If the builder isn’t financing or selling all the building all at once, the repayment of construction funds is usually done in small pieces through 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 for a property development project.

In the absence of doing this, it could be 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 effective exit strategy, which can cause companies to invest millions in developer loans rather than refinancing or making a large sale.

As the price of construction and borrowing grow, and the demand decreases it is crucial to be aware of all the options available before proceeding. A financial expert with hands-on experience in construction will assist builders in choosing the best structure finance option for real estate.

Looking to learn about real estate financial modeling? Check out this real estate financial modeling course

The basics of understanding

Does it make sense to do financial modeling?

Yes. Financial modeling can provide the necessary forecasts that guide intelligent decision-making. The modeling of outcomes can help you comprehend the implications of various scenarios and select the best one.

What is the reason we require structured financing?

Structured financing is needed in cases where conventional loans alone don’t satisfy the requirements of the borrower, usually an enterprise with a significant size.

Is structured lending a part of real estate?

In the context of real estate, a structured finance option 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.

How do you perform financial modeling?

Financial modeling is the application of certain assumptions to data from the past in order to forecast future performance. These models are usually developed using spreadsheet programs.