We expect a balance sheet to “balance” with total assets equaling total liabilities plus net worth. This same principle holds true with project economics. Total uses of funds must equal total sources of funds.
For example, say a construction project costs $1 million. The construction is a use of funds; therefore, total sources of funds through loans and capital must equal $1 million. If sources total less than $1 million, the sponsor needs either a bigger loan or more capital. If total sources exceed $1 million, then the project may be unnecessarily giving a cash surplus to the sponsor beyond what construction is funded.
There are a few key items that should be checked for on all sources and uses. In construction, the loan as a source of funds should not exceed 75% of total project cost for credit unions, or 80% of total project cost for banks. Also, when a sponsor lists cash equity as a source, you should verify if the sponsor has that cash or how and when the sponsor expects to provide that to the project. Ideally, the sponsor’s cash is the first resource consumed to assure they are fully invested in the risk of undertaking the project.
When examining the uses of funds, you should verify it includes common closing costs, such as origination fees, legal fees, appraisal costs, etc. When dealing with construction, the uses of funds should also include “carrying costs.” The most common example is an interest reserve to pay for interest until the project generates cash flow to pay debt service. Other carrying costs may include real estate taxes and condo fees.
Another item that should be identified in construction uses of funds is “contingency.” Contingency is surplus funds to deal with unforeseen costs or changes in costs. Ideally, uses of funds should comprise 10% contingency. Any contingency less than 5% suggests the project would have a difficult time dealing with unforeseen changes, and any contingency above 15% becomes notably ample, allowing for large deviations from the planned budget, which may be undesirable.
An additional use of funds you must come to understand is the developer fee. This is the fee a developer receives for seeing the project through to completion. Traditionally, a developer fee hovers around 10% of total project cost. Developer fees that exceed 10% should be questioned, and no matter the amount of developer fees, they should be funded last so they don’t compete with other project resources.
A project with no developer fees should also raise a red flag. With no developer incentivized to drive a project to completion, the project may twist in the wind without leadership, slowly driving transaction costs higher as time is needlessly consumed.
Deferred developer fees are an item that may be found in the source of funds. This suggests the developer is allowing for their fee to be used as capital, but this needs to be approached cautiously. The deferred developer fee is not hard equity, but it is really more akin to “sweat equity.” The extent to which this should be considered a valid form of equity investment is debatable. The closer the operating relationship between the developer and sponsor (perhaps they are the same entity), the better the argument holds water, but ideally there should not be an overly significant reliance on this source of equity.
When presented with a project budget, it is crucial to have it broken down into sources and uses. The project must “balance” with sources equaling uses. No matter the complexity of the project, there are common items to check for, such as loan-to-cost, carrying costs, contingency, and developer fees. Sources of equity should be well understood, especially in determining whether they provide hard cash or provide for proper risk sharing. Pursuing these simple checks will help you quickly identify problems that can occur with common project financing.