Written Jointly by Phil Macey – National Director Collaborative Project Delivery
JE Dunn,
and
James (Jim) McGibney-Development Services Consulting and Support
Commercial and Industrial Facilities
Introduction
In a very recent discussion with a friend (and competitor) in project development, we were discussing a project that had failed. The permit was in hand, the contractor selected, the contractor’s legal work was done, but the project did not get their construction loan funded. It was a project that seemed to make good sense so I asked why it had failed. My friend said simply, “they had secured the wrong kind of money”. That meant, any one of a number of variables weren’t going to be acceptable.
“Money” is a defining parameter in a project and is also a basic resource that needs to be in place well before work on your project commences. A banker I have worked with over several years, Dan Sheehan of Commerce Bank, sets the basic philosophy the project team members should bring to each project and their view of the project costs as follows:
“From my banker’s perspective, a financially successful project will depend largely on the type of owner — ie. whether it be an REIT, corporate/owner-user, individual investor, equity fund, government-owned, etc. Each has their own separate criteria for return on and return of investment. I know of some corporations who want to make a statement by designing buildings that may be architectural wonders and testaments to big egos but very inefficient and with a limited universe of potential buyers if the property were to be sold. I think both of us could point to some buildings here in the Denver area where costs didn’t seem to matter. For the vast majority of owners though, costs do matter because of the impact they have on the return on capital, and cost-conscious design teams and GCs need to have this cost-consciousness at the forefront of their minds.”
We are approaching this topic in two separate posts. This initial post looks at the basics of money and the kind of attributes and constraints that differentiate the type of money being used on each project, and that the owner and team must understand as they proceed from design thru occupancy and operation. In the second post we will explore the distinctly different attitudes towards money that each team member brings to their portion of the development process from owner to the design team to the contractor and, of course, to the financing entities.
Changing Technology
What is not addressed in this post is the impact of changing technology on all the listed items. The introduction and extensive use of prefabricated systems change the way the building is built, the way it operates and the way that cash flows throughout construction and operation.
Changing Technology will also impact the way the building is used. Can the retail space be changed over a day so there are two tenants that share a single space with different uses during the day, and during the evening?- as one example.
Changing Technology will also impact how the emerging work force uses the building. The 9 to 5 office environment is rapidly becoming a relic, and that impacts utility usage, security, life cycle costs, etc. These impacts will continue to be addressed in future Posts.
All Money Does Not Have the Same Value
In the following we address many (but not all) of the different capital/ money requirements that should be addressed by the owner and that can be imposed by the financing entity and others on a project. Many of these will seem simple, and some will seem complex. In aggregate they define the “type of money” that is being used on your project and its value.
– First, has the owner/ developer/ manager completed a pro-forma description of the project? That is a complete description of all the sources and uses of capital on the project and is typically not shared with all team members. It is important to understand if the owner has developed that financial plan and if the plan has been reviewed and approved by the financing entity. The pro forma provides all project cost assumptions and can easily grow to be hundreds of line items that are projected (and tracked) over the multiple years a capital project takes to start and complete. All of the items outlined below will include or be derived from that pro-forma. Many owners have a standard form of pro-forma they use, and it might be useful to have a copy of the standard as the project begins.
– A very basic definition is how much equity does the owner need to provide for the project and what form does that equity have? Essentially this defines the amount of investment the owner must make and can be defined as a combination of cash (preferred) or land or other assets. The equity requirement also defines the risk the financing entity sees in a project plan where a higher equity requirement would imply a higher perceived financial risk. A lower equity might define a lower perceived risk for the owner.
– Who are the team members and what is their experience. This is rarely a “valued” part of the pro-forma description, but the team’s experience will influence the perception of risk and likelihood of an on time completion and project quality. In the current market, that even includes individual team members and their specific track record — and actual commitment to the project.
– How complete and detailed is the Construction Cost Estimate and what type of contract does the General Contractor have with the owner? The financing entity will often do a complete analysis of construction costs based on current market conditions and may require that the owners’ pro-forma carry an additional contingency amount if they believe the construction costs are not adequate. The pro-forma can be adjusted as the project construction is completed and if that contingency is not used or partially used. Often the lender will require that the Contractor provide some form of “completion guarantee” which puts the contractor in the position of guaranteeing the team’s performance and is a difficult risk to assume.
– How are the basic returns to the ownership being calculated and are they realistic? Specifically, what is the Debt Coverage Ratio projected to be? What is the project Net Operating Income (NOI)? What is the calculated Debt Yield ( NOI/ Total Debt)? Each lender will have a specific set of projected and calculated parameters they will use to assess their risk and then establish the required interest rates for the debt.
– How is the Construction loan being “taken out”? This is, essentially, the long term financing of the project and what are the terms of that “take out”. Typically the take out must be a committed loan based on very specific benchmarks of percentage leased, completion of building and interior construction, receipt of a Certificate of Occupancy and completion of a very wide range of closing requirements. The bank we used in our current project brought a very definitive list of “closing requirements” to the project management team very early in the process, so we had a clear understanding of what had to be 100% complete before that permanent loan could be put in place.
– What is the interest rate and how is it determined? Many times the construction loan has a variable interest rate that is keyed to LIBOR or the London Interbank Offer Rate (http://en.wikipedia.org/wiki/Libor ). The permanent financing will typically carry a fixed rate, with potential adjustments based on certain benchmarks in leasing and meeting the pro-forma objectives. It may also be possible for the lender to provide a mini-perm, or combined construction loan and short term (5 to 7 year) permanent loan.
– Are there any unusual or extraordinary risks that the owner may encounter during construction that are not accounted for? For example, are there any environmental risks on the site or around the site? How is ground water being managed for excavations? Are there market risks — specifically, construction labor costs have risen dramatically in just the past 2 years. Is that accounted for? Is the project located in an area that has lease rate volatility? Are there site-specific security concerns?
– The leasing (income) projections for the facility. For a single user building, that is relatively easy to establish, but for multiple users in a building, the leasing or income projections can vary quite widely. How many years does the lease stay in force? What are the “bumps” or annual increases in the lease rates? Is there any free rent? Who pays the expenses, the owner or tenant – or both? How much is the tenant finish allowance for the space and how is that paid? What are the penalties if the building or space is not completed on schedule?
– How are the expenses for the operation of the facility being projected? Many times this expense projection is a simple lump sum projection based on the “market expense rates” for competitive properties. Typically a tenant will not sign a lease until the owner provides a complete projection of all building expenses, developed by a professional building manager. That in itself can be a several hundred line item projection that includes utilities, janitorial, shared communication systems, taxes and so forth. The expenses that are not paid by the tenant are part of the operating pro-forma costs for the building operations.
– There may be other areas that the project financing must address, but it is important to remember that the lending institutions also operate in a competitive environment so their assessments will need to be well thought out. Otherwise they risk not being selected as project lender.
In short – on capital/ development projects — money carries with it a wide range of attributes, and these attributes all have to work to the owner, the lender, and the team’s benefit (and acceptance) for the project to proceed and for it to be successful.
There is also a corollary that for each of the four key team members — Owner, Design Team, Construction Team, and Financing Team, money has a distinctly different value and carries completely different meanings. This fact is not widely appreciated and can lead to considerable contention throughout the lifecycle of a building project. The next Posting of GordianViews.com will address these differences in detail.
Summary
Money truly carries a wide range of definitions and uses across a typical project and those definitions are established in the project pro-forma which is constructed very early in the development process. These uses are changing very fast as new technologies are being adopted by all members of the project team.
The single most difficult variable to deal with is time. Market cycles are shortening, and what may have been a 10 year real estate cycle in the 1990’s may now be a 5 year cycle, which make projections for market conditions, cost of capital, lease rates, operating costs, property valuation etc. all the more difficult to project with any accuracy.
There are a number of Means and Methods that can be used to compress the development cycle which are being made possible because of the rapidly changing technologies of design and construction. Those will also be addressed in a Post that will be on the Gordian views site shortly, and hold the answer to reducing the risk of time to a building’s success. The concept of Lean Thinking in development ties directly to shortened delivery cycles and increased quality throughout the project.
Thanks for visiting Gordianviews.com and your comments and thoughts are always greatly appreciated!
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