class 3: development financing

Question 1

different phases of development in which Capital will be required

Answer 1

Predevelopment

Land acquisition

Construction

Stabilization

Take-out

Question 2

Predevelopment

Answer 2

The developer must use his own capital or, in some instances, corporate credit

Question 3

Generally speaking, why is there no project specific financing available for the predevelopment stage?

Answer 3

Considered too high a risk by most lenders as there is no certainty the project will be executed

Question 4

some developers will want to delay development in order to do what?

Answer 4

earn a higher promote

Question 5

requirements so that some lenders be willing to lend for the acquisition of land

Answer 5

Typically low LTV (around 60% or less)

Lenders prefer land that already has services (sewer, water, etc)

Land acquisition loans must usually be repaid at the start of the construction loan

Typically variable rate loans based on Prime or
Bankers’ Acceptance rate

Some land banking loans are also available at lower LTVs (50% or less)

Question 6

some developers will want to delay the land acquisition stage in order to do what?

Answer 6

to earn a higher promote

Question 7

Alternatives to traditional loans for land acquisition include

Answer 7

Land purchase option

Vendor take-back

Ground lease: developer leases the land instead of purchasing it

Question 8

Land purchase option

Answer 8

Low cost means of controlling the land during the feasibility assessment stage

Question 9

Vendor take-back

Answer 9

Seller finances the buyer by providing a loan

Question 10

Ground lease: developer leases the land instead of purchasing it

Answer 10

Generally structured as a long-term lease with escalating rent

Avoids large initial outlay of funds

Buildings usually revert to landowner at the end of the lease

Question 11

Lenders rely heavily on the developer’s what in the construction phase?

Answer 11

on the developer’s credit-worthiness and the level of equity investment by both the developer and any equity partner

Equity capital must be injected into the project before the first draw

Often require a certain level of pre-sales or pre-leasing

Question 12

Market players in the construction phase include

Answer 12

Commercial banks

Pension funds

Private investors

Question 13

Amount of construction loan will be based on what?

Answer 13

Amount will be based on total expected cost and anticipated value at stabilization

LTC of 65% or less
LTV of 75% or less

Can include or exclude land values depending on project

Typically, variable rate loans based on Prime or Bankers’ Acceptance rate

Question 14

Prime or Bankers’ Acceptance rate

Answer 14

Interest is capitalized and increases the principal amount outstanding.

Question 15

how is the loan provided in a construction phase?

Answer 15

Amounts are advanced (called draws) as the project advances

Often include developer soft costs

Question 16

what is the max amount of time that construction loans can extend to?

Answer 16

can extend to the period of time it takes to lease-up a property and stabilize its cash flows

Question 17

how are construction loans generally repaid?

Answer 17

Construction loans are generally repaid from the proceeds of sale of the property or from the proceeds of a term loan (the loan of buying the property yourself once it is fully built and ready to be used for renting)

Question 18

what must be injected before the construction loan can be drawn down?

Answer 18

equity

they won’t give any loan amount until after some time

Question 19

what is sometimes included in the construction loan for the stabilization period?

for which type of properties?

Answer 19

Funding for carrying (interest) and operational costs

Multifamily

Condos

Question 20

a mini-perm

Answer 20

Bridge financing arranged if property has not reached its stabilized NOI

Typically floating interest rate loan

Question 21

when is take-out financing arranged?

Answer 21

Once the property has reached its stabilized NOI, or has been delivered to the tenants

The take-out financing is sometimes arranged before the construction financing (Can be required by the construction lender)

Question 22

take-out financing

Answer 22

Reimburses the construction loan

Typically a mortgage loan

Can be fixed or floating rate

Term of 15 years or less

Amortization of 25 years or less

Question 23

investors’ relationship with Equity Return

Answer 23

Most investors eventually move beyond valuation based on a single year’s income to consideration of the rate of return over the expected holding period

When evaluating prospective rates of return among investment alternatives, most investors start with the rate of return on Government of Canada Bonds as the baseline.

Investors add a risk premium to this “risk-free” rate.

Question 24

how to find the expected return of a particular investor?

Answer 24

The total of the GOC bond rate and risk premium

Question 25

yield curve explained

Answer 25

GOC rates are normally lower for shorter-terms than longer-terms

This relationship between rates and maturity is represented in the “yield curve.”

Question 26

The main financial metrics used in development for decision making by equity investors and it’s purpose

Answer 26

Internal Rate of Return (IRR)

This metric uses the cash flow of the property or project

Question 27

Internal Rate of Return (IRR)

Answer 27

This metric uses the cash flow of the property or project

the rate of return of the investment

It is the discount rate which will give an NPV of zero

The IRR is compared to the investor’s hurdle rate (required rate of return)

If IRR > Hurdle rate: investment is made
The greater the IRR the more attractive the investment.

Question 28

the most widely used investment metric in real estate.

Answer 28

IRR

Question 29

In Development three IRR calculations are often made, depending on the investment strategy.

Which ones?

Answer 29

The Development IRR

The Holding IRR

The Total IRR

Question 30

The Development IRR

Answer 30

calculates the return for the initial investment, through the construction and stabilization periods

Question 31

The Holding IRR

Answer 31

calculates the return for the period the asset is held, after the stabilization period

Question 32

The Total IRR

Answer 32

calculates the return for all the above periods combined

i.e., from the initial investment to the sale of the asset

Question 33

Preferred returns

Answer 33

when an investor has first claim on profits (or a specified distribution formula) until he has achieved a certain target IRR

Often given as an incentive for a financial partner to invest

Question 34

Promote

Answer 34

when an investor earns a disproportionate share of the profits

Often given to the investment manager or operating partner as a form of bonus for achieving a higher IRR

Generally applies to profits after the financial partner has achieved his targeted IRR

Question 35

Clawback

Answer 35

when an investor gives up a portion of his return to another investor if a certain IRR is not met

Applies most often to the operating partner or investment manager