What account do interest payments come from if your equity account has already been fully deployed?
I'm been practicing some modeling, and I'm not sure how to approach this. Let's say that a real estate development project costs $100 before any interest. The bank gives you $60 and the remaining $40 comes from the equity account. So the total capital adds up to exactly $100.
Typically you only start drawing from the loan once the equity account has been fully depleted. So once you've put your $40 in equity towards development costs, you start drawing from the loan. However, as soon as you start drawing from the loan, you now have interest payments. Suppose that the interest payments amount to $5 over the life of the loan.
So you now have $105 in total costs ($100 from project costs and $5 from the interest). But your sources of funds (equity + loan financing) only add up to $100. So where is this additional $5 dollars coming from? It cannot come out of the equity account, because the equity account has already been depleted (since you must fully use it up before the bank allows you to start drawing from the loan). And it probably wouldn't come out of the loan because it is strange to use a loan to pay off interest on itself. And either way, you still have a missing $5 that must come from somewhere. Do you have a separate account for making interest payments?
On the other hand, maybe interest is included in project costs at the beginning, so the loan would be based on $105 dollars. This way everything would add up. But this wouldnt make sense either, because if the new loan is 60% of $105 instead of $100, the interest payments would be higher, so the total project costs would be higher than $105, and so the loan would have to reflect that, and then you'd have an even higher loan with higher interest payments, and this would continue infinitely. Spencer Burton on A.CRE modeled it so that the loan is based of project costs including interest, but I don't understand how this mathematically makes sense.
So how do you model this?
Thanks for any help
You would carry an interest reserve in your financing equal to a percentage of the amount financed. Yeah technically it could conceivably go on forever if you just kept dumping int res on and recalculating, but since you are paying interest on the draw with both cash and debt (depending on the stage) it becomes a solid number.
In turns of modelling it, turn on iterative calculations and let excel do its thing.
Thanks, do you happen to have a model that does this so I can see the mechanics of it?
Strange as it may sound, the bank does lend you the money to pay them with. The bank is only going to let you play around with $95 out of $100, holding back $5.
But then you wouldn't have enough to complete the project. Do you mean they lend you 105?
The bank knows approximately what the total interest expense is at origination based on the developer's budget, cost draw schedule and and proforma to stabilization. They add the proj. Interest expense to the total capitalization. In you're example total cap is $105. Bank would lend 60% against this amt.
This is straight up wrong
Somewhere in the Sources and Uses / Development Budget there should be an interest reserve line item that accounts for this. If you're anticipating $5 of interest, your project costs are $105 not $100.
You've just discovered the wonderful world of circular references in development modeling. There are ways to do it without circularity but I'd begin by learning how to deal with them. You could try to work out how to do this by pulling apart a full blown model, but I'd recommend first going to somewhere like adventures in CRE or REFM where you can find a simplified training model and tutorial to help you understand the basics first.
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