Real Estate Financial Modeling: Costly Mistakes to Watch Out For
The combination of inflation and rising interest rates isn’t just making real estate more expensive to buy—it’s also making assets more expensive to build. According to a running tally kept by the US Federal Reserve, the producer price index for construction materials rose from 235 in June 2020 to 350 in June 2022—an increase of 49% in just two years. Consumer price inflation has been rising as well, at rates from 5% to 9% in most developed countries, prompting central banks to raise interest rates in response.
Rising costs mean real estate developers have to borrow more, and they often rely on complex funding structures that can eat into profits. As I’ll illustrate, choosing the wrong funding option can add between 1% to 5% to the final price tag—which works out to hundreds of thousands of dollars for a larger project. With commercial construction loans topping $412 billion in July 2022 in the US alone, that could cost the real estate industry billions of dollars every year.
One of the most effective ways for developers to avoid this is to have a thorough, well-built real estate financial model before committing to a funding structure; however, they often overlook this step.
I’ve worked in real estate finance for more than a decade, securing financing for hundreds of commercial real estate projects, including multifamily, retail, industrial, and office properties. I’ve noticed that many developers tend to focus their attention on day-to-day demands and have less experience evaluating major financing decisions and understanding all the nuances. They may not take advantage of a real estate development financial model at all, or they may try to do it themselves rather than hiring an expert, such as those at Realty Capital Analytics.
The models developers try to build themselves often oversimplify or use inaccurate assumptions that skew results. This issue can be exacerbated when a developer uses complicated capital structures that include junior debt and third-party equity. Even for financial professionals, who are familiar with the mechanics of structured finance, this kind of funding can be tricky.
Real estate finance is a unique business, and it’s difficult to model without understanding the underlying assumptions. Below, I go over three (3) common mistakes I’ve witnessed over the years and explain how smart modeling, and hiring the right professionals, can help you avoid them.
How Real Estate Projects Are Financed
A real estate development project is typically funded using a combination of third-party senior debt and equity. It’s also common to bring in further funding from junior debt and/or third-party equity investors as project costs mount.
Senior debt lenders take a “last-in, first-out” approach to funding projects. This means they expect to see all subordinated capital invested before they release any funds. The senior lender then funds costs to project completion, at which point it gets repaid first.
As in most funding structures, senior debt has the strongest security and ranks first in the capital stack, thus carrying the lowest cost burden: a relatively low interest rate and few fees. Junior debt carries a higher interest rate, and equity participates in the project profits and sometimes also carries a priority return.
To illustrate the effect of various combinations of these financing options, let’s use a simple hypothetical construction project called “Project 5280.” The Project 5280 community consists of 50 single-family homes, each worth $1 million when construction is complete.
Some assumptions for our example:
· Total end value (also known as Gross Development Value or GDV): $50 million
· Cost to purchase land: $15 million
· Total construction costs (excluding financing costs): $20 million
· Construction phase: 18 months
· Financing costs: TBD
Real estate projects require a lump sum of funding upfront to acquire the site. In our example, this is $15 million. After that, the developer makes monthly drawdowns to cover construction costs as the project progresses.
Typically, drawdowns can vary from month to month as outlays change and build-cost inflation occurs. For the purposes of this article, however, let’s assume Project 5280 requires 16 equal drawdowns from the $20 million construction cost—meaning $1.25 million will be needed at the end of each month, up to and including month 16.
The construction costs are forecast upfront by both the developer and the lender, with the lender employing a third-party surveyor to monitor the costs and sign off on monthly drawdown requests during the project.
A construction project in many cases won’t generate any revenue until the construction is complete and the property is ready to occupy, which means the interest charged by lenders is accrued and compounded over the term of the project. Choosing the wrong blend of financing can mean paying more interest than necessary.
Mistake 1: Misusing WACC to Determine the Best Blend
A key metric for identifying the break-even point for a project is the weighted average cost of capital, or WACC. I’ve seen many real estate developers and even some funders make the error of choosing the cheapest blended rate based on the WACC when the senior loan is fully drawn and before sales start repaying any debt. This is a tried-and-true method for optimizing funding in some areas of finance, such as structured company acquisitions; however, on a building project, this shortcut could lead you to significantly underestimate financing costs.
When you’re financing an acquisition, all the capital is deployed upfront. In real estate development, only the secondary debt is deployed upfront, while the much larger senior debt is drip-fed into the project month by month. That means the bulk of that loan may only be drawn for a few months before it starts to be repaid.
The higher-interest junior debt and equity will accrue interest from the first day until the real estate investments are redeemed through sales or leases (or, in some cases, refinancing). The result is that the WACC is at its lowest point when the senior debt is finally fully deployed and then shoots up when that debt is cleared.
This rise is sometimes inevitable, particularly for projects where sales happen gradually, such as a build-to-sell single-family home development; however, modeling different potential capital structures can help you identify the best way to minimize it.
Mistake 2: Overlooking Interest
When you’re considering senior debt options, the lenders you approach will have their own models and ways of structuring loans. Most will offer leverage as a percentage of costs and/or the end value. They will then break down the loan to cover construction costs and rolled-up interest, with the remainder being allocated to the site acquisition. However, even if two lenders present the same gross loan amount, the funding breakdown and assumptions might be different—and that will affect the bottom line.
Let’s revisit Project 5280 and focus on a scenario where two competing banks offer senior debt at the same leverage level: 60% of the GDV.
Both offer an interest rate of 7%, but let’s say Bank A is much more cautious on sales—perhaps it’s more pessimistic about the effect of a recession on the real estate market. It wants to model the numbers by pushing the sales out across 10 months, with only five units sold per month. Therefore, it offers the same gross loan but a longer term, which results in more rolled-up interest. This larger interest allowance has a significant impact on the structure of the funding.
Mistake 3: Failing to Model the Exit Strategy
When assessing a real estate project, funders want to know the developer’s exit strategy. The funding for construction is normally short term (one to four years) and intended to be repaid when the building work is complete. Even if a developer holds on to the completed project longer term, it will normally refinance the funding to a cheaper long-term loan once construction is complete.
Competing options for sale or refinance post-construction can be complicated to evaluate alongside different funding. However, not modeling the impact of the exit strategy can cause borrowers to miss key details that affect the optimal financing structure.
If the builder is not refinancing or selling the entire property at once, repayment of construction funding typically happens piecemeal through individual sales—as it might with a community of single-family homes.
It’s important to assess the effect of different exit strategies and compare multiple exit routes and funding options. One exit strategy—the immediate exit—is a bulk sale or refinance after construction is complete. Another exit strategy—the slow exit—would be drip-feeding sales into a slow market, with sales coming through in equal amounts over a certain time period.
Thorough Real Estate Financial Modeling Pays Off
As you can see, only by building a complete financial model can you identify the best blend of financing for a real estate development project.
Failing to do so can be costly in a number of ways: For larger projects, choosing a suboptimal funding structure can result in spending hundreds of thousands, or millions of dollars more in financing costs. It can also obscure the best exit strategy, leading developers to spend millions on developer loans instead of refinancing or pursuing a bulk sale.
It’s crucial to understand all the options before investing in real estate or starting a development project. At Realty Capital Analytics, our expertise spans across real estate financial modeling, fund modeling, asset management strategies, creative deal structuring, syndication consulting, and pitch book preparation. Our seasoned team is dedicated to offering tailored solutions that enhance value and optimize outcomes for our clients. We invite you to leverage our comprehensive services for your real estate investment needs. Contact us for a complimentary consultation, and let's discuss how we can support your objectives with precision and professional insight.