Interest Reserve in Development Models

When sizing a debt interest reserve in an office development model, or any type of repositioning model, has anyone ever found out a way to avoid circularity in the model? I don't mind having the model iterate to determine the size of the interest reserve based on shortfalls initially, however when I'm running sensitivities using data tables the model slows down significantly. Also sometimes the data tables return a slightly incorrect result if there are too many sensitivities, obviously because of the substantial amount of iterations going on in the background.

If anyone has any suggestions it would be great, thanks

edit: sorry for the multiple posts, couldn't figure out how to delete a thread.

 
Best Response

The key to removing circularity is to understand the causes of the circularity. In development projects, lenders typically require their borrowers to contribute 100% of the required equity before the construction loan can be drawn to cover project costs. The amount of required equity is equal to the total capitalized project costs LESS the total loan amount. The total capitalized project costs include the unlevered costs (i.e. land, construction hard costs, TI/LC, NOI shortfalls, and other soft costs not related to the project financing) PLUS the costs associated with filling out the capital stack, which include financing costs (often dependent on the amounts of equity and debt in the deal) and the interest reserve (the amount of interest that is capitalized in the deal’s project costs).

Typically, circularity in real estate development models results from how the financing costs and interest reserve are calculated. It is possible to eliminate model circularity by projecting out the unlevered costs on a monthly/quarterly basis, and the total of those costs is your starting point for the manual iteration process used to calculate the financing costs and interest reserve. Assuming that the loan amount is sized to a target LTC, the amount of equity that must go in first is equal to (1-LTC). In the first iteration, assume that the total equity funding is equal to (1-LTC) x the unlevered costs. Once this cost threshold has been reached (based on the costs through the date including unlevered costs PLUS the financing costs that are % of loan amount, calculated as fee % x LTC x unlevered project costs), assume the construction loan is drawn to cover the remaining unlevered costs during the duration of the loan term. Assume interest accrues each period on the balance of the loan outstanding including the cumulative unpaid interest. Additionally, assume that the loan is no longer drawn upon after a specified period (e.g. stabilization, end of loan term, etc.). At that point, you have a total cost inclusive of leverage costs. This first iteration will understate the equity that goes into the deal and overstate the amount of debt used in the deal, since the equity was calculated off a lower base amount (i.e. unlevered costs excluding financing costs and the interest reserve). The sources and uses are further refined in the iterations that follow. From the second iteration through the last iteration you run, assume that the equity funded before drawing on the loan is equal to (1-LTC) x the total project costs calculated in the previous iteration, then assume your loan is drawn to cover the rest of the project costs. Running through 10 iterations allows you to eliminate circularity, calculate project costs, and size the capital stack to within pennies of the amounts that Excel would ultimately calculate in 100 iterations with a 0.001 maximum change limit.

Note that the debt sizing iterations should be run separate and apart from the actual model from which you derive your actual levered cash flow and returns. Use the equity funded, total financing costs, and interest reserve calculated in the 10th iteration in your capitalized project costs. Go back to your actual cash flow model (which can assume the same unlevered costs schedule). Assume that the amount of equity drawn in the 10th iteration is the amount funded to cover the costs in the actual model and assume that the construction loan is used to finance the remaining costs after all the equity has been contributed. If done properly, the interest reserve and other financing-related costs that are calculated in the actual cash flow model will be equal to their values in the last manual iteration.

Sorry if this was confusing, but hope it helps. Long story short, it can be done. Thanks a lot.

 

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