This is the second in a series about stress-testing using financial models in the real estate industry. The first article was about Stress-Testing Real Estate Portfolios.
CREModels was founded shortly after the Global Financial Crisis and has spent the past decade working with a wide array of multifamily and commercial real estate developers. Our analysts are experts at evaluating and stress-testing real estate developments, from programmatic offices and strip centers, to vast mixed-use projects that involve many phases over years or decades. We understand how quickly developers need to move when disruptions arise. Our proprietary suite of collaborative tools facilitates speed by enabling our clients to work effectively—and make difficult decisions—as a distributed workforce.
Four broad areas to review when stress-testing real estate development deals, both multifamily and commercial, are supply chain; capital availability; stabilization effects; and changing scope or size. But first, some context.
Why Stress-Testing Matters
Real estate development is highly cyclical. When the market is improving, not only do development projects continue to break ground, but the rate at which they break ground also increases. Development pro forma models are based on reasonable market assumptions for the prevailing conditions. However, after the loan is funded market realities can and often do change.
As long as the market keeps getting better, these changes tend to present as upside surprises. It’s a perverse incentive in the sense that such uniformly good news can make it more likely for stakeholders to overlook the need to revisit and update the projections.
But major market disruptions—you would be hard-pressed to find a more fitting example than the Covid-19 pandemic—are another matter entirely. Developers tend to be inundated with phone calls and emails from investors, lenders and prospective tenants as expectations change and concerns intensify. Typically, the chorus is rife with requests to discuss “what-if” scenarios, and stakeholders may be inclined to pose sharp questions about assumptions made early in the process. Model inputs that seemed plausible at the outset—market rents at CofO, rent growth, refinance terms, exit cap rates and more—are now subjected to the “clarity” of 20/20 hindsight.
As market volatility continues, stress-testing real estate developments becomes imperative: Developers need to model potential scenarios and identify where cash flow is at risk. If capital calls will be necessary, they need to work quickly to evaluate alternatives and immediately communicate these options to investors and partners. Broadly speaking, the developer is the “CEO” of the project and needs to be prepared to take decisive action. Stress-testing provides clarity into the scenarios and levers that will make the biggest difference, not only for the project but also for individual stakeholders. Working through these scenarios can be the key to delivering a successful project in turbulent times. Stress-testing also gives lenders and investors the confidence to go along with the developer’s carefully considered recommendations.
Areas to Review: Supply Chain
Supply chain issues can affect any development project. There are many sources of supply chain disruption ranging widely in size and scope: a global pandemic, a local hurricane or even an extended period of heavy snow, rain or freezing temperatures. While developers cannot control such external factors, they can evaluate and model their potential effects. In this way, stress-testing can ensure that they have appropriate hard and soft cost contingencies to handle potential problems or manage these contingencies as a crisis evolves. Another uncontrollable factor: whether counterparties will seek relief under the force majeure clauses in their contracts.
There are two major variables that need to be considered when assessing the risk tolerance of a project due to supply chain disruptions: development timeline and construction cost. Developers are frequently faced with difficult decisions and those around timeline and cost are often two sides of a tradeoff. Spending more can reduce timelines. On the other hand, delaying the delivery can reduce overall expenses, but it tends to add to capital costs and also push the limits of your interest reserve.
Developers must carefully balance the timeline and cost levers. Timeline issues can be frustrating because developers end up sitting on their hands. Moreover, unforeseen timeline extensions can undermine the developer’s ability to recycle capital as loans come due. A key concern is whether the construction loan can be extended if it will come due before permanent financing is available. Marketing efforts could be interrupted or delayed depending on the type of project and stage of development, or the team may need to review executed leases to ensure they will remain in force during any expected delays.
When supply chain issues occur, material prices may go up, especially if the developer wants to maintain the expected timeline. One way to catch up on slipping timelines is to increase the headcount of the construction crew. However, this also raises costs, so modeling this is a key part of the analysis. Importantly, labor costs can rise in a nonlinear fashion due to overtime, especially in tight labor markets.
Any increased costs from supply chain issues will require a close eye on interest reserve requirements which may quickly eclipse agreed-upon reserve limits set forth in the construction loan. All development projects should also have hard and soft cost contingencies, and these should be reviewed to ensure they will cover new projections.
Valuation at stabilization is a crucial consideration when developers assess the likelihood of successfully attracting capital to a completed project. When capital markets are impaired, lenders will consider only the safest projects for financing as their supply of capital dwindles and lending requirements are increased.
Two of the most important factors when stress-testing real estate developments and assessing whether a project will be attractive to a lender are the defensible projected Debt Service Coverage Ratio (DSCR) and the Loan-To-Value (LTV) ratio. Keeping the projections of these ratios updated is crucial as construction loan maturities approach to ensure debt can be successfully refinanced. Construction loans may lack these criteria, but the permanent financing will almost certainly incorporate them. The total amount available will depend on DSCR and LTV, the trajectories of which can change magnitude or direction quickly.
Even if the available debt can cover construction loans, often developers include equity payback and preferred interest in these refinancing transactions. A reduction in permanent loan proceeds can hinder the ability to provide these expected cash payments. That, in turn, may hinder other projects with shared pools of investors or damage valuable relationships. Developers can prevent these types of negative, cascading effects by quickly and effectively communicating the emerging options to stakeholders.
When equity paybacks take a hit, this also increases the cost of the project to the developer: It may now be necessary to make higher payments to investors, and the hurdles in the investment structure may be harder to reach. This can also disrupt investors’ reinvestment plans, a most unwelcome development for them. And of course, the developer’s profitability is also at risk.
In better markets, developers compete ferociously to source land for projects. Late in the cycle, this aggressive competition can lead to skinny returns for both developers and investors. As such, there isn’t much room for capital shortfalls to be absorbed before returns erode entirely and invested capital is exposed to greater risk.
This also means that developers may need to approach new lenders they have no existing relationship with, as well as consider different types of financing options, such as bridge loans or mezzanine financing. Analyzing and understanding the increased deal complexity is the first step. But for these efforts to make a difference in the outcome of the project, it’s equally important to communicate the project’s vision using these new financial tools. Raising any type of capital in down markets can be extremely time-consuming, taking up valuable resources exactly when the developer’s focus needs to be on the project in question. Running accurate and complete financial models can greatly expedite the capital-raising process.
When demand for capital outstrips supply, one of the most important weapons a developer has is an airtight loan request package with all relevant information included and a business plan that shows significant forethought and understanding of the various risks involved, along with contingency plans to combat them.
The real estate market is cyclical, moving in concert with macroeconomic trends. When the economy slows, this can affect the developer’s ability to lease the property and can significantly extend the time it takes to stabilize the asset, forcing stakeholders to revisit their revenue projections at stabilization.
Developers rarely have perfect information, but they can use models designed specifically for stress-testing real estate developments to move the levers and get a clearer picture of the likeliest scenarios. In particular, it’s important to look at how new market rents could affect leasing, and to understand how different rental and lease-up rates will affect income. Previous models may underestimate the time it takes to reach stabilization; it’s a good idea to adjust these expectations and game-plan the potential effects of varying funding amounts and timetables.
Reducing rents may allow a faster lease-up that can allow the developer to save a deal that otherwise might be at risk, even if this alternate scenario is simply a breakeven exit. Avoiding future uncertainty in the market and covering costs can sometimes be the best option.
Changing Scope or Size
Altering the size or scope of the project is an often overlooked—but potentially game-changing—option. Scaling back the number of buildings or floors (or putting the entire development on hold) may be a way to move all the important variables in a positive direction. Doing so can allow the developer to finish the project faster, refinance sooner, and lease-up earlier. However, because the project was originally modeled with a larger construction budget and more income, new models need to allow developers to see how these changes can affect stakeholders throughout the capital stack. Elongated timelines can also require more creativity. For example, could a future refinancing in a better market actually pay for the rest of the development?
Marketing strategies can also be shifted to focus on parts of the economy that are performing better or are subject to less competition. For instance, it may be possible to invest more in fixtures to change a Class B property into a Class B+ thereby attracting a higher-paying, more affluent tenant base. Or perhaps there is an opportunity to cut costs and move to a Class B- asset and attract more lower-income tenants from the local workforce. It is generally difficult to move entire classes, such as turning a Class B property into a Class A property, without drastically changing the entire project. However, well-executed tweaks can make a meaningful difference in the success of the project.
Developers again need to be decisive and act quickly in these situations; otherwise, they run the risk of chasing the market down, which often leads to stabilizing property fundamentals at the bottom of the cycle instead of locking in rents before fundamentals bottom out.
Communicating Skillfully with Lenders & Investors
Developers always need to keep the concerns of their lenders and investors top-of-mind. Most traditional models will handle simple debt structures. However, advanced tools like bridge loans, mezzanine financing and other complex structures are difficult to model, especially with the variety of inputs needed in these cases. Models need to be adjusted to demonstrate the effects of potential decisions from each stakeholder’s perspective, not just the developer’s equity.
All the scenarios discussed above must be reviewed not only at the property-level but also at the investor level. Quite often, partnership agreements are modeled under rosy scenarios of continued rent growth, capital availability and cap rate compression. When these assumptions change dramatically, developers need to review their documents, update the models, and review the effects on the investor waterfall. Developers need to know early if they will need to issue capital calls or inform investors that expected distributions will be missed.
In many cases, a developer’s plan may have initially been to sell the asset at stabilization. In the new environment, that option may not be possible. In other cases, a developer may have planned to hold the deal as an investment but now wants to sell at stabilization due to the onset of market uncertainty. Either way, understanding how these decisions flow through the investor waterfall is crucial to being able to get buy-in and take action. Clear communication with stakeholders is crucial, not only to ease concerns, but also to limit the number of inquiries received by the developer.
Presenting Options to Key Stakeholders
At the end of the day, all the modeling for stress-testing real estate developments is done in the background by the developer/analysts. Evaluating the variety of actions that need to be taken, and what outcomes may result, requires significant iteration. Stakeholders who are not part of this involved process need to be informed clearly about what the developer intends to do and how these actions will affect them. As such, developers should prepare packages for each group with calculations that show exactly what actions are being taken and how their investments or returns will change. This is an excellent opportunity for developers to manage the expectations of stakeholders throughout the capital stack.
It’s not a time to cut corners and send a poorly formatted email or leave a quick voicemail. Difficult times require diligent efforts by developers to ensure that their decisions are based on sound financial models. The goal should be to demonstrate that all reasonable options have been evaluated, both independently and together, to arrive at an optimal solution.
Models for Development Stress-Testing
The bulletproof real estate development models included in the CRE Suite (supported by CREModels’ expert analysts) allow you to model these scenarios easily, without having to worry about faulty calculations or building uncertain calculations from the ground-up internally. Multiple intertwined inputs which are tied to each other can create exponential complexity, but the CRE Suite has the power and intelligence to simplify them into push-button comparisons that are essential when stress-testing real estate development projects. The software also includes a real estate Development Budget Tracking tool that compares a projected construction budget with updated cash-flow forecasts. This allows developers to review a project’s status at any point and evaluate investor returns according to a variety of variables.