A 15% Return on Costs = 100% Financing

In today’s real estate financing market, is it possible to get a construction loan equal to 100% of your land and project costs? The answer is yes; it is possible and I have done it multiple times over the last few years. How? Well, consider this approach.

You are a Developer. You have good banking relationships, good credit and a good track record. Most importantly, you have a good idea for a project you are considering.

As you begin running your numbers to determine your “Free and Clear Yield on Costs” and your “Loan vs. Equity” ratio, you first determine the scheduled rents for your project at 5-10% below the current rents achieved for similar product in the trade area. If you think you can achieve the higher rents, great. But, you want to make your “Go – No Go” decision based on more competitive (thus lower) rent assumptions. Remember, Murphy and his law are still alive and well…

Next, you use a conservative 8% vacancy factor and estimate stabilized operating expenses after completion at 5-10% above the historical expense factors that your research has determined for this product. When you finish your proforma, you determine your NOI (aka free and clear yield on costs) for the project.

Then you run your project cost proforma and estimate ALL your costs conservatively including a healthy contingency factor (remember Mr. Murphy?). You take absolutely no fees, overhead expenses or other money out of the project to go in your pocket. You act as your own general contractor (an owner/builder) or use the “3 deep, open book, fixed fee” contractor formula for more complex projects.

When you have all your cost projections complete, you multiple the bottom-line costs by 15% to determine the “Free and Clear Yield on Costs” (aka NOI).

Yahoo!!!! The 15% yield on costs is equal to your projected NOI.

If it turns out to be less, start to tweak your cost numbers; value engineer your project, re-bid your consultants, subcontractor and material costs, renegotiate your land costs and generally do whatever you can to lower your projected costs within reason. Don’t assume higher rent projections and don’t kid yourself on construction costs. Be realistic, negotiate hard but fair and keep your pencil sharp untill you get to the magic 15% yield.

You see, the “15% = 100% formula is the key to “Creation of Value” in Real Estate Development. Here is an example of how the formula works:

  • Developer # 1 can build this property for $1,000,000. A 15% yield on costs will generate $150,000 per year. The banks will generally appraise a project at a 10-cap rate, which will value the project at $1,500,000. Simply put, you have a projected equity of $500,000 upon stabilization. You have created value!
  • Many Banks will consider underwriting a construction loan at a 66.66% Loan to Value ratio ($1,000,000) especially when you are not making a penny along the way. Therefore, NONE of your own cash is being used and none of the Bank’s loan funds are going in your pocket. You achieve a 100% loan to cost ratio or, better put; you finance 100% of your costs.
  • Developer # 2 can build this same property for $1,200,000 but he is budgeting for Developer Fee’s, Overhead, and other money to go in his pocket. His yield on costs is the same $150,000 but now only 12.5% per year. If the same Bank will lend Builder #2 the same 66% of costs ($1 Million), he would have to tie up $200,000 of cash while bringing in 2.5% overall less return for the same project.

A mentor, friend and partner of mine, Colby Sandlian, S.E.C., CCIM, has a great perspective to consider; “It is much more profitable to develop a few great properties and get the 15% return and 100% financing than to do many average properties for less.”

In the next issue of the Observer, I’ll provide some real time experiences and ideas as to how to make the formula work. In the meanwhile, go create some value somewhere and figure it out as you go along!!!

Editor’s Note: Phil Corso, S.E.C., teaches a two-day education program entitled “Broker Estate Building” together with Mark Johnson, S.E.C., CCIM. The program is based upon the original class created and taught by Colby Sandlian, S.E.C. and Cliff Weaver, S.E.C. in the 1970’s and ’80’s. Totally rewritten to reflect the realities of the real estate business today, the program is offered nationwide. For additional information, contact either Phil or Mark or visit the S.E.C. Education Foundation web site: www.secedfoundation.com.

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