Construction Interest Reserve Modeling
How do you size the interest reserve/accruing interest? Do you manually input and hold it back when sizing or enable an iterative calculation? In my experience, the latter can really screw with the model. In my experience, this is particularly true if you have additional sources coming in to fund construction (ie mezz, preferred equity, public funds, capitalized tax incentive etc)
Enable iterative interest, but certainly would build in a circuit breaker.
You can do a forecasted draw schedule that is either based on a straight line draw between certain months, or that operates as a normal distribution over a certain period of months. I would recommend the first option only be supplemental to the second since more costs are incurred on a ramp-up schedule with only some being a straight line draw. Once you can forecast out your costs you can then figure out what month you are able to start debt service based on a monthly proforma. In the meantime, you can figure out when your equity runs out based on the forecast and what levels of interest you are paying monthly based on the outstanding balance in that month. You can get around the circular reference by enabling a macro that sums up the capitalized interest payments for each month and then adds that back into the costs as a "paste only values" so eventually if you loop that macro 2-3 times you can reach a "limit" that it approaches and can get a fairly accurate forecast of capitalized interest that way.
Thank you both. So how do you ensure that the lenders only exposure is the direct project costs + interest? Meaning we are drawing down the funds but lender will only contribute toward eligible project costs, then the next source steps in. Can get complicated am i right?
I like to start with calculating total debt for each type; Construction, Mezz, A&E. Each section includes all your cost line items (Land, Hard, Soft, Financing etc) at X%LTV to get total loan amount. Ill then take the sum of total interest payments in a separate section and apply a % (normally 60%-80%) to get total capitalized interest. That capitalized interest then gets added as a debt line item at X% LTV & adds to total loan amount. Each debt type has its own capitalized interest calc.
Total loan amount from each debt type drives Sources column. I find it easiest to separate each product on the drivers page, as well as Cashflow page with each having maturity date & payoff date inputs that you can use IF statements on the CF page to set a date for retirement of principal or switching to the next debt product.
So ya you have to be iterative but you can set a circuit breaker at the total capitalized interest calc.
I'll throw my hat in the ring as I've done a ton of thinking and pivoting on this. Back in the day, I used to use the iterative method, but have since moved away from that for several reasons:
1) it significantly bloats the model, especially sensitivities
2) it calculates exactly what you need, and therefore has ZERO buffer in the number
3) does not reflect the reality of a lockbox / cash sweep
What I do now is have some helper calcs and I manually size the reserve to get to a min 1+ month of interest buffer above what the exact iterative amount would be. I then have a lockbox modeled that starts with that reserve amount, and is drawdown (and replenished) until a certain hurdle is met at which point the reserve is released to equity. This is because this is what happens on an opportunistic deal in the real world. The same process is used for each additional tranche of financing as needed (i.e. mezz).
Seems like you've put a good deal of thought into this so curious to hear how you approach modeling NOI during lease-up that offsets interest reserve.
You can link whatever cash flows you’d like into your cash sweep calculation - for my models I use all deal cash flows including NOI until the lockbox period is over. You can enter a manual end to the sweep period or release it automatically based on a test such as DSCR which is what I do. Obviously you can tweak this overall concept in any number of ways that might suit your specific deals better this is more of general framework.
Capitalize as contra income.
Which has been particularly fun this past year...
Nailed it, aside from the skyrocketing rates, folks need to understand what even 1 month of delay / extra interest will do to their deal in today's environment. Having no buffer is borderline insanity, and that's what the circular calc /modeling accomplishes
Really curious to see how this works if you have something you can share. If I’m understanding correctly you’re solving for an extra month of IR then inputting as value to break the iteration? Lockbox really just plays into equity IRR as not showing every dollar above DS getting distributed?
Yes the lockbox is a real drag on IRR but again its how real life works and we try to reflect this as much as possible in our analysis. In most cases with banks, you're not seeing a dime of your free cash flow for a year post completion (aka cash management ending based on whatever tests they give you)
Brosef Stalin out here getting ready to sweep all my cash away for himself and his comrades! :)
This hurdles would be your capital event?
Why would you replenish the reserve account? are you assuming fees at each draw in addition to front end points and accruing interest?
Appreciate that thoughtful reply, agree I also try to refrain from iterative as much as possible.
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