(Practice Problems) Development

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University Of Georgia *

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5100

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Finance

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Apr 3, 2024

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1) What are the sources of risk associated with project development? Sources of risk associated with project development include market risks and project risks. Market risks are the result of unexpected changes in general market conditions affecting the supply and demand for space. Project risks are the result of choosing a specific location to develop a property and the design of the project. 2) What are some development strategies that many developers follow? Why do they follow such strategies? Business strategies used by developers can be categorized in three general ways: 1) owning and managing projects for many years, 2) selling projects after the lease-up phase, and 3) developing land and buildings for lease in a master-planned development or “build to suite” for single tenants. Following a particular strategy allows the developer to have a balance between use of external contractors, architects, real estate brokers, leasing agents, and property managers and having this expertise within the firm. 3) Describe the process of financing the construction and operation of a typical real estate development. Indicate the order in which lenders who fund project development financing are sought and why this pattern is followed. In general, developers must first line up permanent (long-term) financing that will be used once the project is complete and being operated with tenants before they can get a construction loan. It is necessary that the construction loan is repaid when the permanent loan takes over. 4) What contingencies are commonly found in permanent or take-out loan commitments? Why are they used? What happens if they are not met by the developer? Contingencies commonly found in permanent or take-out loan commitments include: 1) a maximum amount of time to obtain a construction loan commitment, 2) a date for completion of construction, 3) minimum rent-up (leasing) requirements and an approval of major leases, 4) an expiration date of the permanent loan commitment and any provisions for extensions, and 5) an approval by the permanent lender of design changes and substitution of any building materials. 5) What is a mini-perm loan ? When and why is this type of loan used?

A mini-perm or bullet loan is a construction loan that, in effect, becomes permanent financing when construction is complete. When construction is complete, the developer begins to make payments (principal and interest) similar to those made on permanent financing with the exception that the loan typically has a 3 to 5 year maturity with the balance (balloon payment) due at that time. 6) Why don’t permanent lenders usually provide construction loans to developers? Do construction lenders ever provide permanent loans to developers? Permanent lenders are often national companies, such as large insurance companies, that do not have the in-house capability of underwriting construction loans and monitoring a project during construction. Thus, construction loans are typically made by lenders, such as commercial banks with a local presence. Construction lenders, on the other hand, may be willing to make a permanent loan, although they may find it more profitable to focus on construction loans or mini-perms. 7) What is the major concern construction lenders express about the income approach to estimating value? Why do they prefer to use the cost approach when possible? In the latter case, if the developer has owned the land for five years prior to development, would the cost approach be more effective? Why or why not? The income approach usually provides a good indication of the expected value of an income- producing property once construction is complete and it has been leased-up. The projected value should exceed construction costs, if this is not the case, the project is not feasible and the loan should not be made. Assuming that the project is feasible, using the cost approach would provide a more conservative estimate of value, especially if the land has appreciated in value from its original cost to the developer. 8) You work for a lender and a developer has requested a loan such that they are able to draw $20,000 for construction expenses at the beginning of each month for 10 months. You have informed him the land where the property is being constructed will serve as the collateral and the loan will cost 0.75% per month with no payments being due until the end of 10 months. There is also a 3% origination fee based on the ending balance of the loan. What would be the amount due at the end of 14 months to the lender of this construction loan? FV of draws (calc in BGN mode) N = 10

I = 0.75 PV = 0 PMT = -20,000 CPT FV = 208,438 Origination Fee =208,438 * .03 = 6,253 FV of draws + Origination fee = Total Amount Due = 208,438 + 6,253 = $214,691 9) In the previous question, what is the lender’s (monthly) IRR? [hint: a timeline is very helpful here] CF0 = -20,000 C01 = -20,000 F01 = 9 C02 = 214,691 F02 = 1 IRR CPT = 1.28% (monthly)  annual 15.36% 10) What is an option contract? How is it used in land acquisition? What should developers be concerned with when using such options? What contingencies may be included in a land option? Option contracts are used to reserve a parcel of land so that it will not be sold to someone else, while the developer does preliminary analysis of the site. The developer should be concerned about the price of the option and the length of time until a decision is made. Contingencies might include passing an environmental inspection, being able to get the land rezoned, or receiving any necessary permits for development.

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11) What are the unique risks of land development projects from the developer’s and lender’s points of view? Land development can be quite risky for both the developer and the lender, especially when compared to existing projects. During the development period, a developer must be concerned about changing market conditions that subsequently affects the price and rate at which parcels are sold. The cost to develop the site can also be greater than anticipated. Ultimately, the same factors affect the lender’s risks because proceeds from the sale of parcels are used to repay the loan. Lenders get paid as lots are sold. As a result, the rate at which lots sell affects the lender’s as well as the developer’s rate of return. A higher release price might reduce this risk to the lender. However, if the release price is too high, the developer may not have sufficient funds to successfully develop the project. 12. An analysis of whether land can be purchased and developed profitably is known as: (A) Financial analysis (B) Feasibility study (C) Turnkey study (D) Project profitability 13. True or False: The release price is usually calculated to pay off the loan when the last lot is sold. False.