On a Construction loan... When submitting a construction budget to a lender...
After you have calculated the amount of operating shortfall reserve (in monthly cash flows), do you build in a cushion on top of this? If so, what is your calc method?
The example I am looking at projects an operating shortfall of approximately $100K but they are requesting $400K for the operating shortfall. In the example interest reserves are separate and they are also highly inflated in the budget over what is shown in the monthly cash flow projections.
I can't see why a lender would sign off on this--in other words, the shortfall would just be the cumulative negative income for the project until it's in the black. The calculation is simple and it would be challenging to hide a $300k delta on such an item. Now, if this shortfall includes some sort of start-up reserve, then we would have this as it's own line item. The real way to provide a cushion on your shortfall reserve and ensure you don't run out is 1) underwrite conservatively, so when the deal performs better than expected, you don't run out of money, and 2) set your contingency up appropriately.
People may disagree with me, but whenever I am sizing our construction loans, I am actually the exact opposite and attempt to be as aggressive as possible for lease up timing, therefore creating a smaller interest / operating reserve. Reason being, unless you have an amazing project, odds are your lender will make you fund equity dollars "first period," therefore make you fund all required equity before the lender funds all costs going forward...
By using my logic, if you are (reasonably) aggressive in your leaseup timing, you are therefore creating a smaller reserve, therefore creating a slightly smaller budget, and will gain access to the cheaper cost of capital (ie. loan proceeds). Worst comes to worst and you end up depleting the interest / operating reserve, you can just replenish it with equity on the back end.
I agree with this. On most of our construction deals, the sponsor wants to be aggressive on the interest reserve because the lender will pad it anyway. So if you go out with a padded number, lenders will just pad it more. It's what they do, their job is to minimize downside risk.
Thanks guys. I agree, the contingency is there to cover such things. Lenders do tend to pad the reserves. And yes, if you run out you just fund equity at the end. All good thoughts. Thank you everyone.
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