PowerPoint Presentation Upper Floor Pro Forma

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The Bottom Line on Upstairs Development National
Main Streets Conference New Orleans, LA June 6,
2005
Dan Carmody President Downtown Improvement
District Fort Wayne, IN
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Economic development rules have changed
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Its all about attracting, retaining, and
cultivating talented people. . .
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. . . by developing compelling places.
Inverness, Scotland
Colorado Springs, CO
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Diversity
Compelling
Density
Details
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Upstairs development is key to a more dense and
diverse Main Street.
Housing has been the biggest driver of new
upstairs use.
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Demographics Drives Urban Housing The most common
household type in the United States according to
the 2000 Census
Couples with no kids
Second most common household type in the United
States according to the 2000 Census
The Single Person
Nationally, only 23 of households have
school-age children
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Changes in consumer preferences
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Oh my. . .
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Its all about cool space whether its where we
live or where we work.
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Suburbs dominated residential housing markets
when the paradigm was about safety and schools
for children.
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Cities are much more competitive in markets
driven by a greater emphasis on aesthetics,
access to cultural amenities, and proximity to
adult learning.
Pittsburgh
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Its happening in cities of all sizes and in all
regions across America
Marshalltown, IA
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Calumet, MI
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Memphis, TN
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Downtown is everybodys neighborhood!
Limited success in building successful
mixed-income neighborhoods.
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Downtown Neighborhood
Four types of housing
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Real estate development is really three different
businesses.
I build em
I do the financing.
I manage em
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Upstairs development starts with a good business
plan.

• Development Costs
• Develop a well thought out plan
• that adds value to your building
• by taking full advantage of the
• great details available.
• Carefully estimate construction
• costs and provide a minimum of
• 10 contingency.
• Dont forget about soft costs as
• they can be substantial. (i.e.
• architectural / engineering fees,
• legal, construction interest)

• Operating Income/Expense
• On the income side make a
• conservative assessment of what
• rents you can expect and how
• long it will take to re-lease the
• property when tenants move out.
• On the expense side carefully
• research various costs of rental
• property management

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Error on the side of Quality
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Which of you wishing to construct a tower does
not first sit down and calculate the cost to see
if there is enough for its completion? Otherwise,
after laying the foundation and finding himself
unable to finish the work the onlookers should
laugh at him and say, This one began to build
but did not have the resources to finish. Luke
14 27-30
Invest time and money on the front end to develop
a realistic budget and include a generous
contingency!
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Rental Project Case Study Assumptions

• No acquisition cost you already own or are
  buying the building
• You are a pioneer theres little upper floor
  housing nearby
• You will be undertaking the project without
  additional investors
• You want to improve your financial situation
  from the project but are
• willing to accept lower returns on investment
  than real estate developers.
• You may need bank financing and/or financial
  assistance from a public or
• quasi-public source to complete the project.
• You will manage the property yourself upon
  completion

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Annual Operating Pro Forma
Income Gross Rent Rent Collected at 100
Occupancy Tenant Contributions Tenant
Contributions towards operating expenses Gross
Income Total Income at 100 Occupancy (Vacancy
Rate) Adjustment for Vacancy and Collections
Loss Effective Gross Income Anticipated Cash
Actually Collected Expenses Taxes Research and
negotiate with assessor Insurance Discuss your
project with your provider Maintenance Snow
removal, window washing, common area
Utilities Are utility expenses paid as part
of rent? Management Are you going to manage the
project or pay someone? Reserves Appliances
need to be replaced, Units need repainting Net
Operating Income Cash generated by the
project Debt Service Interest, principal
payments to lender Cash Flow Return to owner
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What bankers want. . .

• Acceptable level of risk
• Reducing risk of default and/or foreclosure
• Lenders want to limit their risk rather than
  maximize their profits.
• Lenders are in a high volume low margin
  business. The spread
• between interest paid to entice deposits and
  interest earned from
• loans ranges from 1.5 to 3.5 percent.
• There is no upside for traditional lenders

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Upstairs projects may be difficult for banks to
finance because

• Lending to pioneers is difficult
• There may be past failures
• Housing market is unproven
• Spaces may be slower to absorb and take longer
  to fill once they
• become vacant than more traditional housing
  types
• Types of locations unfamiliar to many lenders
• New mixed-use projects in second/third tier
  markets are rare

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How Much Will a Lender Lend?

• The primary method to repay the loan is
• come from the project. Lenders really
• lend to a projects cash flow rather than
• to bricks and mortar.
• The analytical tool used by bankers to
• assess a projects ability to repay the
• loan from project cash flow is the debt
• coverage ratio (DCR).

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Debt Coverage Ratio
Case Study Tom Case owns a bakery in downtown
Biggsville and decides to build out two gourmet
residences in the dormant upper floors of his
building which he owns free and clear of
debt. The cost to complete the project is
150,000
Debt Coverage Ratio (DCR) is the net operating
income of a project divided by the annual
payments to pay back the loans needed to build
the project. DCR Net Operating Income (NOI)
Debt Service (D/S)
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Net Operating Income (NOI)

• Tom projects that each loft will
• generate a monthly rent of 800.
• Tom evaluated the costs to separate
• utilities and has decided to meter
• each unit for gas and electric.
• Tom will provide water for the
• tenants.
• Parking will be on-street at no cost
• to either Tom or the tenants.
• Tom discussed with his local
• assessor what impact his loft
• improvements will have on his
• property tax bill and has budgeted
• accordingly.

• Is the single most important
• number in a real estate
• project. Net Operating
• Income is the projects
• income reduced by a vacancy
• factor and the operating
• expenses of a project such as
• taxes, insurance,
• maintenance, and utilities.
• Gross Rent
• - Vacancy Rate
• - Operating Expenses
• Net Operating Income

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Case Study Net Operating Income (NOI)
Gross Rent 800 X 2 X 12 19,200 Less Vacancy
Rate 10 (1,920) Less Expenses Utilities
1,200 Taxes 2,400 Insurance
1,200 Maintenance 1,000 Total
Expenses (5,800) Net Operating Income
11,480
In this example vacancy and operating expenses
are 30 of income.
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Debt Service
Tom has 20,000 to invest in the project and
would like to borrow 130,000 from his local
bank. The bank is offering loans at 7 and is
willing to make a loan with a 25 year
amortization. How much will the bank loan Tom
based upon net operating income of 11,480?

• Is the total of annual interest and
• principal payments needed to retire
• the debt.
• A constant table provides different
• constants for each possible interest
• rate and loan term combination.
• Multiplying the constant times the
• amount borrowed provides the annual
• debt service.
• Interest Rate 7.0
• Term 25 Years
• Constant .0849

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Length of payback
Typical Constant Chart
Interest Rate
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Case Study Debt Service
The debt service for a loan of 130,000 with 7
interest and a 25 year amortization is 130,000
X .0849 11,037 The net operating income of
11,480 just barely covers the annual debt
service of 11,037. Will the bank make a loan to
the project of 130,000?
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Debt Coverage Ratio
Recalling our debt coverage ratio formula DCR
Net Operating Income (NOI)
Debt Service (D/S) For Toms project DCR
11,480 1.04 11,037
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How Much Will the Bank Lend?
This lender, typical of many, requires a DCR of
1.2 The largest loan this bank would make given
NOI of 11,480 can be determined in the following
manner D/S NOI 11,480
9,567 DCR
1.20 Loan D/S 9,567
112,685 c .0849
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Not So Fast

• The bank also considers what happens if the
  project fails and they
• foreclose on the project and force the sale
  of the project as a means
• to repay the loan.
• The amount of the loan compared to the value
  of the completed
• project is called the Loan to Value ratio.
• On commercial properties, banks typically look
  for loan to value
• ratios in the range of 60 to 80
• Banks will lend the amount that meets their
  minimum requirements
• for both debt service coverage and loan to
  value ratio.

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Loan to Value Ratio
In Toms case the fair market value is obtained
by diving the NOI of 11,480 by a cap rate of
.085 or 135,058. The banks policy is to loan to
80 of fair market value it agrees to make Tom a
loan of 108,000 which is the amount that meets
their minimum requirements for both DCR and
LTV. 135,058 X 80 108,000

• The appraisal establishes a
• cap rate reflecting the
• perceived risk of a project.
• Fair Market Value (FMV) is
• the cap rate divided by net
• operating income.

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Minding The Gap
Use of funds Acquisition 0 Arch / Engineer
10,000 Permits 500 Hard
Construction 119,500 Appliances
5,000 Contingency
15,000 Total 150,000 Sources of
funds Owner Equity 20,000 Bank
Financing 108,000 Total Sources
128,000 Gap 22,000
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• Ways to Fill the Gap
• Additional owner equity
• Historic or old building tax credit
• Subordinated loan or grant
• Reduce the scope of the project

Toms 20,000 cash and the banks 108,000 loan
leaves a shortfall of 22,000 in funding the
project. Toms city has a revolving loan fund
that provides up to 25,000 per project at 5
interest with 20 year amortization. Toms debt
service will be based on a first mortgage of
105,000 at 7 for 25 years and 25,000 at 5 for
20 years.
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Revised Debt Coverage Ratios
Revised Debt Service 105,000 X .0849
8,914 25,000 X .0792
1,980 Total Debt Service 10,895 Total DCR
11,480 1.05 10,895 Banks DCR
11,480 1.29 8,914
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Cash on Cash Rate of Return
In Toms case e 585 3
20,000 This is not a strong rate of return,
should Tom do the project?
One of the most widely used way to measure return
on investment e cash flow owner
equity
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More than Cash Flow

• There are other financial benefits to owning real
  estate than cash flow
• Tax Benefits
• Appreciation
• An upstairs project provides unique benefits
• Improving the value of
• the retail business
• Lowers first floor utility
• costs

Tom wants to improve his financial position but
project income just barely covers project
expenses. The other non-cash benefits to the
project encourage him to proceed.
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What is the Gap?
Expected income does not provide enough cash flow
to service debt and provide a return on
investment to the owner. The amount of
conventional debt a unit can service provides a
good measure of when and what level of public
intervention is needed to assist with upstairs
development.
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How Much Debt Can You Service At Different Rents?
Rule of Thumb
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Using Housing to build proper mass on in-fill
sites
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Three story massing and self contained parking
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Small scale condo projects
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Key issues of small scale condo projects
Market Issues Empty nester most important market
segment. Security and freedom is important to
this audience. Hard to jump past rental market
development to condos. Design Higher quality of
finishes expected. Higher levels of sound
insulation are needed in ownership units. Stairs
becomes an issue with the empty nesters. Parking
is more important that with rental projects. Most
buyers will require adjacent and secure parking.
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Key issues of small scale condo projects
Project Costs Legal and survey costs can be
substantial. Cannot use historic tax credits for
development of ownership units. Many rental
projects using historic tax credits are designed
to flip to ownership after the required five year
holding period.
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Key issues of small scale condo projects
Financing Ownership projects also typically have
gaps. The gap which needs to be addressed is
that between construction costs and anticipated
sale prices. All condo documents and surveys
should comply with secondary market
requirements. Appraisal gap issues can be
profound in an emerging market. Property tax
assessments can fluctuate greatly. Market
pioneers often need to feel like they are getting
a deal.
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Downtowns Upside economics
Starts with careful architectural assessment.