Modeling Question (Construction Loan IDC)
Project finance analyst here. I do modelling for energy project, and from what I understand, the way we set up construction loans are similar if not the same as in real estate.
That being said in PF, a construction loan consists of the principle as well as the interest during consutrction. I don't understand why lenders do this, and how they make money off these loans.
Take the classic example of circularity with construction loans: let's say that you need to borrow $100, but there's a 50% fee for every dollar you borrow. Now you need to borrow $150. Again there's that 50% fee, now you need $175 etc... Run this circularity a few times and you get $100 in fees, for a total loan of $200 that you owe the lender.
But why would the lender make this deal? The lender just gave you $200, and at the end of the construction period, you pay the lender $200. If the lender is lending you the interest portion, how does he/she make money??
When the lender “lends” 200 in your example, they only actually disburse 100 to fund capex. No money changes hands on the 100 of interest. They will then receive 200 at the end of the project, and make 100 in profit.
Interest = 5.00%
Month 1 Draw = $100,000; Month 1 Interest = ~$417
Month 2 Draw = $150,000; Month 2 Interest = ???
In a CRE development model, would Month 2 interest factor in the Month 1 capitalized interest? Or is this really up to the loan docs.
accrual =/= cash
First off, your understanding of interest is completely wrong. $100 loan fully drawn will accrue interest at like 5% per year. So if your project takes 1 year to build, you will add $5 to the total cost to build.
Secondly, the number one thing people who write loans care about is how are they going to get their money back. You will never secure or draw on the $100 loan in the first place without showing the lender you have arranged a way to take them out when the project is fully built. Best case you have someone lined up to buy for $120 something that cost you $100 of hard costs to build and $5 of interest to finance, leaving $15 of profit for you. If the take out fails to materialize for whatever reason, then they take the keys to the project you just built with their money.
What about my understanding of interest is wrong? A construction loan is modeled as being the sum of principal and interest/ fees. Say you have $100 (unlevered) in capex drawn over 12 months and IDC is $10. The total construction loan would be sized at $110. That's how energy projects (and RE to the best of my knowledge) are financed in the construction stage. I don't think you understand what I am asking or I am not being clear - would it be helpful if I sent a screenshot of a sample construction draw and loan sizing model? Either way, I think I understand now: accrual =/= cash.
What you mention regarding banks isn't really relevant to my question. Construction loans are almost always paid back at COD and replaced with backleverage. Banks are primarily concerned with this aspect of the project not necessarily operations (assuming repayment at COD).
And btw a construction loan is accruing interest at more than 5% on an annualized basis (SOFR + ~250BPS). Last I checked SOFR was at like 440BPS.
I misread but q also less than clear. If interest is accrued into the loan balance then yes the ultimate takeout is extremely relevant as that's when the lender gets its capital and return (to your core question about how they make money).
Yall love complicating things for no reason. Beginning balance + draws = ending balance. Use beginning balance to calculate interest. You pay interest on what you draw. Size your interest reserve so you comfortably get through construction + ramp. Origination fee and reserve are capitalized so it's already all factored in.
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