Development Model - Construction Loan + Mezz
Looking for some help on modeling a ground-up development deal that includes a mezzanine piece. Specifically, I don't understand how to model the reality that part of the mezzanine loan interest is current and part of it accrues.
Say we're in month 6 of construction and the mezzanine loan has been completely drawn down. The only source of funding coming in at that point is the senior construction loan. Would a portion of the senior loan draws fund the mezzanine current interest?
As of now I have the model set up the following way:
Equity funds first, then mezzanine loan, then construction loan. Once the building is operating, any available NOI is used to pay interest on the construction loan. If any NOI remains after that, it pays interest on the mezzanine loan. If any remains after that, it goes to equity. The interest on both the mezzanine loan and construction loan in my model is accruing, but I need to change the mezzanine, as I said, so that a portion of it is paid each month. At sale, loan proceeds pay down the construction loan, then the mezzanine loan, then go to equity.
After construction, what is typically done in development? Should I add in a bridge loan at completion of the project that would take out the construction and mezzanine loans, and then a permanent loan to refi out the bridge loan once the building stabilizes? Trying to be as accurate as possible here.
I don't believe that I have this set up accurately right now so I'd really appreciate some assistance with this. Thanks!
You need to be modeling some form of reserve/escrow type account as most mezz loans (and construction loans) tend to require sufficient reserves as part of the deal. Generally, from loan proceeds (and mezz) and equity there should be some over-capitalization (or accounting for interest as a project cost) that remains "in the bank".
Then in each monthly period, the interest payments are paid from that account and the balance falls. During operations, you can allow funds to refill the reserve to a limit before paying out to equity. Regardless of what you do, be sure to pay the balance of the reserve account out to equity at the final sale or termination of the deal.
Part a) For the mezz, you should have two draw/amortization schedules -- one for the interest paid "current" and the other for the interest that fully accrues. The current pay interest ignores the full accrual interest, but the full accrual interest takes both pieces into account. Yes, you read that right, and yes, it is confusing. It might be helpful to model it and practice on a positive cash flowing asset because it can be confusing to pay interest current when there's no cash flow available to do so.
Some senior construction lenders will underwrite the mezz current pay as a cost and allow their funds to be used toward it, but many/most won't, so it needs to be covered by the interest reserve.
Here's an example: 13% coupon, 6% current and 7% accrual. At the end of the term, you'll have to pay the mezz lender the entire balance from the accrual schedule. Note that while the outstanding balances look the same in Month 1, they'll start growing apart more each month thereafter since the ending balances (aka the starting balances of the next months) are different.
Current Pay Draw, Month 1: -Beginning Balance: $1,000,000 -"Current" Interest: $5,000 ($1MM * 6% / 12) -Ending Balance: $1,005,000
Accrual Pay Draw, Month 1: -Beginning Balance: $1,000,000 -"Current" Interest: $5,000 (Beginning Balance Current * 6% / 12) -"Accrual" Interest: $5,833 (Beginning Balance Accrual * 7% / 12) -Ending Balance: $1,010,833
Part b) Really this depends on your hold period and business plan. If you're doing a 5-, 7-, or 10-year hold, then you should just model a perm takeout loan upon stabilization. For a merchant build, you'd just show a sale at/soon after stabilization.
The perm loan should be able to refi the senior and mezz loans. If you're doing mezz up to 85%+ of cost, then this might not pencil...welcome to the excesses of real estate. A bridge loan at completion is common in actuality but isn't exactly a stamp of approval for the project since you're not taking construction delays, a slow lease-up, missing rents, etc. into account. Good luck getting investment committee approval on that.
Hope this helps.