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Leveraged Breakdowns

REPE Interview Prep: Major RE Sector Cash Flow Profiles and Development Financing

This post is part of our interview prep series, where we teach you to answer common interview questions from a real estate equity investment mindset. The first question here focuses on the key differences between the major real estate sectors. The second two questions shift to focus on construction financing. All three concepts are critical to calculating and speaking through private equity real estate returns. As always, we strongly recommend you practice these questions deliberately, out loud, and with active focus.

How do the cash flow profiles differ between the major real estate sectors: office, retail, industrial, and multifamily?

I would categorize the first three sectors together as long-lease commercial use. The cash flow profiles of industrial, office, and retail properties are all similar and tend to be lumpier. This is because they feature longer term leases, larger leasable areas, and are more capital intensive due to TI allowances, lease commissions, legal costs, and concessions. The cash flows for these properties are largely negative at the beginning due to capital costs, very positive and for extended periods of time during the lease, but can run negative at the expiration of leases due to longer vacancy between tenants. There can also be large changes in revenues when bringing in a new tenant because market rents may have changed since the last time the space was leased.

Multifamily properties, on the other hand, feature only one- or two-year leases, many tenants, quicker tenant turnover, and shorter vacancy between tenants. As a result, multifamily property cash flows tend to be smoother, more predictable, and in-line with the overall market.

Why do development models assume a “perm out” of the construction loan upon stabilization?

Refinancing a construction loan with a permanent loan is a no-brainer since it reduces the cost of debt, marks-to-market the stabilized property’s potentially increased value, and allows the owner to raise the LTV and cash out the net proceeds.

First, perming out a construction loan will reduce the cost of debt on the stabilized project. This is because construction projects are inherently riskier than stabilized buildings. Lenders are aware of this increased risk, and thus charge greater interest rates on construction loans to adjust for their exposure.

Second, the property value of the building could increase once it is stabilized. This is because stabilized assets have far less to prove about their operational performance than a development project.

Third, stabilized properties can support higher LTVs. Thus, equity investors can collect an inflow on the net proceeds at the perm out.

Why do you capitalize loan fees and interest expense during the development period? Why not set aside a reserve?

GAAP rules require that the total cost of completing a project be capitalized, and those capitalized costs depreciated or amortized over an appropriate period of time. Loan fees and construction period interest are considered part of the cost of completing the project, so they should be capitalized. A reserve may be set aside to cover interest expense during lease-up and stabilization, but at that point in the project operations have commenced, and fees and interest expense would be considered operating costs that would be entirely expensed in the current period.

Conquer Real Estate Private Equity with Leveraged Breakdowns

Leveraged Breakdowns teaches you how to build real estate equity investment models from scratch, with our fast-track course REPE Starter Kit and our deeper-dive course Breaking Down REPE. We also offer free interview simulators and case studies. We teach you hard skills like calculating private equity real estate returns as well as soft skills like how to best prepare for interviews. Check us out today, and never hesitate to email us back with any questions you may have on the industry.

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