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Leveraged Breakdowns

Underwriting a Construction Loan – Repayment Analysis

This is the fourth post in our ongoing real estate private equity case study on how a construction loan is underwritten by potential lenders.  This installment will focus on repayment analysis.  To read the previous posts in the series, click on the links below:  

Post #1Introduction & Setup 

Post #2Borrower Analysis

Post #3Guarantor Analysis

The intent of this article is to describe how a construction lender evaluates repayment probability.  Specifically, the article will review:

  • What repayment analysis is and why it is important
  • What an interest reserve account is and why it is important 
  • The typical sources of repayment for a construction loan 
  • How repayment was analyzed for the case study project, including sensitivity analysis 

By the end of this post, readers will have a greater understanding of how repayment analysis is conducted and should be able to incorporate this knowledge into their interactions with real estate lenders.  In addition, this information could come in handy as part of a REPE Technical Interview.

Let’s start with an overview of repayment analysis.  To jump directly to the summary section, click here.

What is Repayment Analysis and Why Is It Important?

The answer to this question is fairly obvious, but a lender’s primary objective in every transaction is to protect their capital, which means they want a high degree of confidence that they will be repaid before approving a loan.

In order to gain this confidence, they analyze multiple potential sources of repayment for every loan to ensure they have multiple avenues of repayment in the event of unexpected circumstances.  Because our case study involves a construction loan, it is important to note that repayment is analyzed in two parts, the construction phase and the completion phase.  Let’s discuss each in detail.

The Construction Phase 

One of the unique features of a construction loan is that the funds are not advanced in full at loan closing.  Instead, they are advanced in stages or “draws.”  This structure provides advantages for both the lender and the borrower.

For the lender, advancing loan funds in draws allows them to retain more control over the construction process and to ensure that the funds are being used for the appropriate purpose.  They do this by requiring a line item budget from the borrower and they track draws against the budget, and perform inspections prior to releasing funds.

For the borrower, the draw structure means that they pay less interest over the life of the project.  If they were to draw all funds at loan closing, they would have to pay interest on the entire balance until the project is complete.  By obtaining funds in draws, they only pay interest on what they borrow, which reduces interest expense over the term of the project.

But, as we have discussed before, real estate developers are notorious for wanting to minimize the amount of cash invested into a project.  Fortunately, most construction loans offer a feature known as a pre-funded interest reserve account, from which the loan’s monthly payments are made.  It works like this: prior to loan approval, the lender’s underwriting department will make an estimate of how much money will be needed to make the loan’s interest payments during the construction phase.  Then, this amount is added to the construction budget and advanced at loan closing.  Funds are placed in a separate interest reserve account and used to make the monthly payments.

Estimating the interest reserve amount is a bit of an art form because it is highly dependent upon the amount of each draw, the interest rate, and the duration of the project.  As a general rule of thumb, an easy way to calculate the needed interest reserve amount is:

Interest Reserve = ((Annual Interest Rate/12)* # Months of Construction) * 50% of Loan Commitment 

The key takeaway here is this, during the construction phase, the loan’s payments are made from a pre-funded interest reserve account.  There is 100% certainty of this repayment because the funds are advanced from the loan and placed in a separate account which the lender controls.

The Completion Phase

Once a project is complete, the loan balance is fully advanced and must be repaid.  The exact sources of repayment can vary by deal, but typically look like this:

  • Primary Source of Repayment:  Payoff from permanent loan 
  • Secondary Source of Repayment:  Sale or rental of property 
  • Tertiary Source of Repayment:  Guarantor Recourse

In a previous post, we covered guarantor analysis.  In this post, we will concentrate on the first two sources of repayment.  Let’s see how our project stacks up.

Project Recap 

Before we go into repayment analysis, it is helpful to perform a quick recap of the project.

In our case study, the borrower is requesting a construction loan of $130MM for the development of a mixed-use commercial and residential condominium project.  Specifically, the project will contain 300 residential condominium units and a ground floor commercial space for which the developer has executed a lease with a major regional grocery store.  For the purpose of this repayment analysis, the income generated from this lease is excluded.

The condominium units are a for sale product, not a rental product.  This is an important distinction for repayment purposes.  With this in mind, the sources of repayment for this particular project are:

  • Primary Source of Repayment:  Sale of condominium units 
  • Secondary Source of Repayment:  Rental income from unsold units
  • Tertiary Source of Repayment:  Guarantor recourse

Let’s analyze each one of these in detail.

Primary Source of Repayment

As described above, the primary source of repayment for the case study project is the sale of individual condominium units to residential buyers.  At the time of underwriting, 293 of the 300 units have been pre-sold, which means that borrowers have placed a 5% deposit in escrow to reserve their unit.  There is a high level of local interest in the property and it is expected that the remaining 7 units will be sold prior to the start of construction, which would provide for complete repayment of the construction loan before the first shovel of dirt is turned.  This is a rarity in real estate development.

The following table provides detail on repayment via sale of condominium units, both with current presales and total sellout:

Current Loan CoverageAt Sellout
Residential Condo Sales Revenue$148,000,000$160,000,000
Parking Spot Sales Revenue$2,500,000$3,000,000
Storage Unit Sales Revenue$400,000$600,000
Total Revenue Available for Repayment$150,900,000$163,600,000
LESS: Selling Expenses (5%)-$7,545,000-$8,180,000
LESS: Customer Pre-Sale Deposits (5%)-$7,400,000-$8,000,000
Net Sales Proceeds$135,955,000$147,420,000
Senior Loan$130,000,000$130,000,000
Loan Coverage Based on Senior Debt1.051.13

Let’s discuss what is happening in this table.

Residential condo sales revenue comes when construction is complete and individual unit sales start to close.  Remember, the sponsor has already pre-sold all but 7 of the units, so there is some degree of confidence in this revenue figure.  However, each customer has only paid a 5% deposit.  There will almost certainly be some number of pre-sale buyers who walk away from their contract for various reasons and a loss of their 5% deposit will be painful, but not painful enough to make them think otherwise.  It would be better if this deposit amount was higher, say 10%.

Selling parking spots and storage units provides some amount of ancillary revenue, but it is minimal when compared with unit sale revenue.  Combined, these three sources account for the total revenue available for repayment.

From this figure, selling expenses (broker commissions and marketing fees) and customer deposits are subtracted, which leaves us with a net amount available to repay the senior loan.

Based on the current level of pre-sales, revenue covers the requested loan amount at 1.05X.  While this is impressive, it also assumes that 100% of the pre-sold units end up closing when the project is complete.  This is very unlikely to happen.  To protect against this, the lender is front loading the repayment by setting the individual unit “release price” at the greater of 100% of net sale proceeds or 95% of gross proceeds from each unit sold.  In effect, this means that the borrower’s profit won’t be realized until the final units are sold.  This is meant to incentivize them to sell all of the units as quickly as possible.

The remaining 7 units are some of the most expensive in the building and when they are sold, the net sales proceeds rise significantly and cover the requested loan at 1.13X.  Again, this is impressive, but this number implies that all pre-sold units close and that there are no price changes (up or down) between the time of the loan request and the time of project completion.  Both are unlikely to happen.

The key takeaway from the analysis of the primary source of repayment is this.  The pre-sold units cover the requested loan amount at more than 100%, which is very impressive.  When the remaining units are sold, coverage rises to 113%, which should provide the lender with confidence that their loan will be repaid.

However, unit buyers only made a 5% deposit on their unit to secure it.  This is enough to show some commitment to the deal, but not enough to make it very difficult to walk away from the contract should they change their mind.  Some of these sales will almost certainly not close, but the question is how many?  This is where the secondary source of repayment comes into play.

Secondary Source of Repayment  

The secondary source of repayment is the rental of the unsold units.  Ideally, this revenue would be sufficient to repay whatever the loan balance is.  To analyze this, assumptions can be made about how many pre-sales ending up falling through and what the rental rates for the unsold units are.  The following table summarizes this analysis:

Pre-Sale FalloutGross RevenueLess Customer DepositsNet Proceeds (95% Release Price)Remaining Loan BalanceRequired Rental Rate to BreakevenMonthly Rental Rate to Reach BreakevenRental Rate Per SF to Reach 1.25X DSCRRent to Reach 1.25X DSCR

The point of this analysis is to determine the impact of pre-sold units not closing and eventually being rented.  

Using the first line as an example, if 10% of the pre-sold units “fall out”, the gross sales revenue falls to $132MM.  Based on a 95% unit release price, it is estimated that the remaining loan balance would be $11.1MM (far more than the guarantor has in liquidity).  Based on this outstanding amount and the loan terms, it is estimated that the remaining units would have to lease for $1.26 PSF or $1,692 a month to reach breakeven or $1.57 PSF or $2,115 per month to reach the lender’s mandated 1.25X debt service coverage.

We will get into market analysis in a future post, but this table highlights the importance of it because the underwriter would compare these breakeven rents to the going market rate to determine if they are feasible.  In this case, the supply of units in the sub-market is somewhat tight and rents are rising.  Depending upon the finishes, location, and amenities, they currently average $1.80 – $2.00 PSF in rent.

So, this means that a 10% pre-sale fallout could likely be managed, but anything above that results in a “danger zone” of sorts where the going market rental rates may not be sufficient to cover the payments on the remaining loan balance using the interest rate and payment amortization. 

Tertiary Source of Repayment

The tertiary source of repayment is guarantor recourse.  This means that the loan guarantor will be responsible for the loan balance should it not be completely repaid from unit sales.  In a previous post, we performed detailed guarantor analysis.  To read it, click here.

The following table summarizes the guarantor’s financial condition:

Date Year 1Year 2Interim Period
Net Receivables$3,000$2,500$400
Due From Affiliates $5,000$6,800$3,700
Condo Units Held for Sale $0$36,000$3,200
Total Current Assets$10,000$53,000$20,000
Total Fixed Assets $8,700$10,000$10,000
Total Assets$24,700$78,000$48,000
Trade Payables $700$1,100$700
Loans From Related Co.$0$13,700$6,000
Due to Affiliates $2,800$11,300$10,400
Total Current Liabilities $5,800$37,000$22,000
Long Term Debt$7,000$25,000$7,000
Total Liabilities$12,800$62,000$29,000
Net Worth $11,900$16,000$19,000
Net Income($2,000)$3,500$4,100

Should it get to the point where the guarantor has to step in, they provide $19MM in net worth, which includes $9MM in cash.  Based on the fallout analysis, this would not be enough to cover the loan balance with a 10% or greater presale fall out, which is concerning.  In addition, the guarantor has $23MM in “potentially realizable” contingent liabilities, which are loans from other lenders that they also guarantee.  Should any one of those projects run into trouble, the available liquidity could be wiped out, which is also concerning.

However, it is important to note that the guarantor is a US subsidiary of a major private equity firm who has significant resources and could inject additional capital if needed.  

Repayment Summary and Review

The proposed construction loan has three sources of repayment: (1) funds from unit sales; (2) income from rental; and (3) guarantor recourse.  To review, here is how each of them stacks up in this deal:

Primary Source of Repayment:  At the time of the loan application, the developer has presold 293 of the 300 units in the project.  The income from presales alone is sufficient to cover the requested debt at 1.05x.  Once the remaining 7 units are sold, this is estimated to increase to 1.13x.  This is a major POSITIVE.

However, to reserve their unit, potential buyers were only required to make a 5% deposit so there is some question as to how binding the “pre-sales” actually are.  The 5% deposit is enough to be material, but not so much as to make a buyer think twice before walking away from a deal.  Pre-sale deposits of 10% or higher would be more preferable.  This is a NEGATIVE.

The benefit of the pre-sold units outweighs the negative from the smaller than preferred deposits.  Overall the primary source of repayment is considered to be POSITIVE

Secondary Source of Repayment:  Should some of the pre-sold units not end up closing, analysis was performed to see if it is possible to rent the units for enough to make the required loan payments.  Based on the analysis, it is estimated that ~10% of the pre-sold units could fall out and market rents would be enough to cover the remaining loan balance.  This is a POSITIVE.

However, any fallout greater than 10% would require rental rates that are at or higher than market averages, which could jeopardize repayment via rental.  This concern is particularly prevalent because the pre-sold units only required a 5% deposit.  A sudden market downturn or unforeseen issue could make it easy for a high percentage of buyers to walk away from their contract.  This is a NEGATIVE.

The market in which the project is located is hot.  Demand for condominiums is high and inventory is low.  The risk of pre-sale fallout is not deemed material enough to impact approval.  Overall the secondary source of repayment is considered NEUTRAL.  

Tertiary Source of Repayment:  The loan is guaranteed by the US subsidiary of a major private equity firm.  They have $9MM in liquidity and $23MM in potentially contingent liabilities.  If any one of their other projects goes south, it could quickly absorb the availability liquidity and jeopardize the guarantor’s ability to support the requested loan.  This is certainly a NEGATIVE.

The repayment verdict?  Pre-selling 293 of 300 units prior to starting construction is an impressive feat and a testament to the demand for the project.  Given the current sales pace, the remaining 7 units will almost certainly be sold prior to the start of construction, providing 113% loan coverage.  This is unusual for a residential development project and provides a high level of comfort that the loan can ultimately be repaid.

Even though some of these pre-sales are almost certainly not going to close, the market is strong and there is confidence that they can be resold in the open market.  All things considered, the available sources of repayment make a convincing argument for this loan to be approved.

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