Two layers of circular debt

fl-noe's picture
Rank: Chimp | banana points 11

Monkies,

I am a first year real estate analyst at a large development firm in Miami, Florida.
My modeling skills are from my perspective pretty good, I've learnt a ton from the senior guys at my office and I make models as a side gig for other real estate investors and developers.

I create models with circular debt all the time. But only with one loan. Ie 20% equity 80% debt.

I tried to create a model with 20% equity 60% senior debt and 20% mezz but the model will not calculate properly if I have two layers of circular debt in a development model.

I've asked the guys at the office but they are also unable to get past this.

Does anyone have insights on how to model multiple debts in a development model ?

I can share my models via DM.

Thanks,

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Comments (28)

Nov 15, 2017

How'd you start the side gig? Curious as I've also though about doing the same thing,.

We'd probably have to see your model to give you an answer.

Nov 16, 2017

Mostly going to networking events handing out business cards to lenders and guys who are syndicating deals. I pitch the value that by paying me a few hundred bucks they will have a model that will make them look professional and make it easier to raise money, making them thousands.

Nov 15, 2017

i have modeled many many deals with mezz and we always hardcode the senior loan amount and the equity amount.

however, i do think i saw someone take m model and set up the senior and the equity to 'calculate' at X% of the capital stack, and i think it worked ok. the mezz in that case though was simply the remaining gap. so maybe if you allowed one piece of the stack (such as the mezz) to calculate as 'total - X - Y = mezz.' try that.

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Nov 15, 2017

Can you explain how the debt is 'circular'? I do not see how you can have circular debt in models with only one debtor or with a senior and mezz debt...

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Nov 15, 2017

Mezz w/ no current pay and a conventional senior construction loan?

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Nov 15, 2017

okay - that is senior and subordinate debt, not circular debt.

Circular debt is an instance when parties become both a creditor and debtor to each other. For example if A Loans money to B, B Loans money to C, and C Loans money to A. In your example its simply Senior loans to Sponsor, Mezz loans to Sponsor, Sponsor is just a debtor..

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Nov 16, 2017

Circular meaning that the loan size is represented by say 70% of LTC, including interest expense.

As interest racks up the project becomes more expense which means we need more loan to cover it.

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Nov 15, 2017

so don't you fund an interest reserve from the beginning?

I am just having trouble understanding why this is being called "circular' debt - I have never came across this term in a real estate transaction.

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Nov 17, 2017

I am also confused, there is nothing "circular" about this kind of debt. If it's a question of the debt covering interest, then just build an interest reserve in the model.

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Best Response
Nov 17, 2017

Holy shit guys you are overcomplicating this. It's "circular" in terms of the calculation, it's not a type of debt. As the loan amount increases, so does your total interest cost and therefore your interest reserve. The process of iterating this calculation until the interest reserve amount catches up to the increased loan amount is what's circular. Just "enable iterative calculations" in Excel. That's it.

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Nov 17, 2017

unless I'm misunderstanding the terminology.

I believe he means circular logic among multiple tiers of debt. What fl-noe said. If you enable excel to make iterative calculations set at 100 then it should give you what the loan amount would be. If there is an error then you should goal seek the cells to help get it back on track.

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Nov 16, 2017

Deleted, I was misinterpreting his question, my bad.

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Nov 15, 2017

You don't need to use goal seek. That's a pretty inefficient way of modeling a dev loan

Nov 16, 2017

Not if it's a circular reference and you need to reassess the financing based on iterative new assumptions..... If that's not what he is referring to then it's a moot point.

EDIT: I'm referring to the fees, I think we are talking about different things.

Nov 15, 2017

You can enable iterative calculations which solves the problem of circular references in excel. Also, I typically have an equity balance remaining line in my development models. In this case having a mezz balance remaing would be helpful as well.

If you have a line that has your equity balance something like =if(and(project cost>0,equity balance=0),min(project cost,remaining mezz balance),0) should work just fine for your mezz draw funding.

Nov 16, 2017

This might f up your workbook if you are running tables in it though - it's happened to me way too many times.

Nov 15, 2017

Then I would do the exact same thing with the mezz and senior debt

Nov 15, 2017

Assuming you mean capitalizing an interest reserve into the mezz loan, I don't think this is possible without hard-coding one of the variables. Both your senior loan size and your mezz loan size are going depend on your equity draw schedule which can't properly be run without knowing the size of each. Excel can't just calc through it.

This is pretty atypical though. Usually you just see the mezz take out a certain portion of the equity and get paid a current yield that the senior debt is blind to, with no circularity required on the mezz piece.

Nov 16, 2017

I do mean capitalizing the interest into project cost.

My problem was with interest that would capitalize on the mezz loan when there is no FCF to pay for interest expense. So even if I limit the amount of mezz that can be drawn to 10M, when capitalizing interest it the balance will accrue interest to say 12M.

I can see how a goal seek could work. It would find the max amount of loan you can draw so that the peak mezz loan balance would not exceed say 10M.

Lets say we

Nov 17, 2017

To answer your question, I've run as many as 3 layers of debt through development deals (senior, mezz, pref) and the TL;DR version of my answer is - it works if you make it circular, but bloats the model, which can take a while to balance given how circular it is.

What I have started doing to avoid this is running a reserve account for each tier of debt, the reserve amount for which I hard code into the budget. So the deal starts with the total reserve account balance day one, and then it chips away at it until NOI/CF can cover the payments. I run a separate reserve for each tier. If there is cash left in the reserve, I set it to release at a certain date, DSCR/DY or disposition.

In the budget, I have a side calc that shows me how short or overbudgeted the reserve is based on the cash flow, so I just hardcode it to within a small margin (you can goal seek as well as was mentioned). The end result is that the model is no longer circular, which makes it run a lot faster especially for sensitivity tables.

The downside is that the model is no longer fully dynamic (i.e. I can't just plug in a leverage and rate for each tier and have the model spit out the balanced budget for me). That said, if you know how to use it properly after you set it up, the model works a lot more smoothly. It's obviously extra work to set it up this way, but I think it works better overall.

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Nov 16, 2017

Are you funding an interest reserve?

Nov 16, 2017

In essence yes,

Nov 17, 2017

My routine is to size up the reserve and hard code the figure, otherwise model operates slower and you'll waste tons of time running sensis that ordinarily should calculate in no time. Same goes for future funded interest, but it's more of a hassle.