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Hi
When modeling a REFI after the development of an office:
1. Is it best practice to assume the refi takes place after full stabilization? So if you assume 1.5 years after construction until stabilization, you have to pay the interest on that outstanding construction loan (which can be large for big developments).
2. In the above scenario, could you assume a bridge loan between end of construction and full stabilization? if yes, typically how would that be sized if your property is only 33%-70% occupied?
3. Would you need to add back any free rent to the NOI when sizing the REFI loan?Thanks!
I hate to answer it depends – but the answer to these particular questions really depends on the borrower, the capital markets at the time, the property type, the in-place capitalization, and a host of other factors. Nevertheless, allow me to offer some general rules of thumb to help provide color for when you’re modeling them.
1) It is best practice to assume refi (or sale) at stabilization, yes. However, you should generally only capitalize (i.e. add to the development budget) interest shortfall, not total interest. So even though you might have 1.5 years of construction interest, much of that interest is paid for by income during lease-up.
2) I wouldn’t. From a modeling perspective, it’s a lot of brain damage for a marginal level of increased precision. A bridge loan to get to stabilization usually occurs when the lease-up pace is slower than initially forecast and the developer needs extra time. But to model that scenario initially seems overkill, especially when the rate and loan amount of the bridge loan is likely to be similar to the construction loan.
2.5) In terms of how to size a loan before stabilization. This is actually quite common. While we generally model refi at stabilization, in the real world the takeout loan is usually underwritten before stabilization and closed when the property is close to stabilized. This is because it takes months to get a loan closed, and so the developer can’t wait until the property is fully stabilized to start the process. All loans, whether the property is stabilized or not, are underwritten to a stabilized pro forma. Then structure , as it’s called, is added to the loan to protect the lender. Structure may take the form of specific conditions to close (e.g. closing once the property has been greater than 92% for 90 consecutive days), or it might take the form of a staged funding (e.g. initial funding with fewer dollars, followed by subsequent fundings as leasing targets are hit. Those subsequent fundings are sometimes called earn-outs or good news money.
3) Whether to underwrite free rent on a stabilized pro forma is always a point of discussion. It really just depends on the property type, market conditions, and lender. For instance, if a soon-to-be-stabilized property with 1st gen concessions is located in a market with zero concessions at other fully stabilized properties in the market, than the lender can make the argument to its IC that concessions at the subject property are likely to burn off. And thus, the free rent won’t likely be underwritten. However, if the property is in a market where concessions are common at fully stabilized properties, the lender will certainly underwrite some long-term concessions into its pro forma.
Great questions!
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