What are the unique risks of land development projects from the developer’s and lender’s point of view

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Estimate the total loan amount including interest carry for TAG.

 

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1i. Refer to Concept Box 17.1. A revised market study indicates the following: pricing for standard interior lots will probably be $103,000 each, premium interior lots $118,000, and corner lots $125,000; the average development cost per lot has been revised up to $71,000; administrative costs, etc., remain at 12.5 percent of gross revenue.

a.Can the same 18 percent return on total cost continue to be maintained?

b.Suppose the developer wants a 21 percent return on cost. How much can be paid for the land?

(For Reference Concept Box 17.1)

5650-17-1pei1

 

 

1ii. How might land development activities be specialized?  Why is this activity different from project development discussed in the preceding chapter?

 

2i. Treetop Associated Group (TAG) is seeking financing for acquisition and development of 147 homesites. The land will cost $1.5 million, and TAG estimates direct development costs to be an additional $2.7 million. City Federal Bank will make a loan covering 40 percent of the land acquisition cost, 100 percent of direct improvement cost, and interest carry at 11 percent interest with a 3 percent loan origination fee.

TAG has decided to split the development into two parcel types, standard and deluxe, with the standard parcels comprising 87 of the 147 total homesites. Also, TAG thinks that the deluxe sites will be priced at a $2,000 premium over the standard parcel price of $36,000. Total project revenue will be $5,412,000. After making a 60 percent down payment for the land and incurring closing costs of $50,000, TAG believes that the remaining development costs will be drawn down at $600,000 a month for the first three months and $300,000 a month for the next three months. Parcel sales are expected to begin during the fourth month after closing. TAG estimates that they will sell three standard parcels and four deluxe parcels a month for the remainder of the first year, and five standard parcels and two deluxe parcels per month for the second year. The company and the bank have agreed to a repayment schedule calling for the loan to be repaid at a rate 20 percent faster than the receipt of sales revenues; that is, the loan plus interest carry per parcel will be repaid when approximately 83.33 percent of all revenues are realized. Other costs to consider include sales expense (paid quarterly at a rate of 5 percent on parcels sold during the quarter), administrative costs of $7,500 per quarter, and property taxes of $19,000 at the end of each year.

a.What will be the release price for each type of lot?

b.Estimate the total loan amount including interest carry for TAG.

c.Prepare a schedule based on (b) and the pattern of loan draws, showing when TAG will have the loan fully repaid. What will be the total cash payments on the project loan?

d.What will total project costs be? What percentage of total project costs are being financed?

e.What will be the NPV and IRR of this project if TAG’s before-tax required rate of return is 15 percent? (Hint: Prepare a cash flow analysis on a quarterly basis over the life of the project.)

 

2ii. 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?

 

3i.Lee Development Co. has found a site that it believes will support 75 homesites. The company also believes that the land can be purchased for $225,000 while direct development costs will run an additional $775,000. The Last National Bank of Texas will underwrite 100 percent of the improvements plus the interest carry. The loan would be made at 13 percent interest with a 3 percent loan origination fee. Lee believes that the development will sell faster with two types of parcels, standard and deluxe, with the standard parcel comprising 57 of the total parcels.

Lee’s marketing staff believes that the deluxe sites can be sold for $24,000 while the standard sites should bring $13,500. Lee estimates that the direct cost draws will be taken down in four equal amounts during months 1 to 4. Other up-front fees include closing costs of $10,000 and a 3 percent loan fee (not covered by the loan). Lee’s sales staff supervisor assures him that she can generate sales activity starting in the fourth month that will result in the sale of five standard parcels per month and four deluxe parcels per month for three months. For the next six months, activity should be seven standard parcels per month and only one deluxe parcel per month. The Last National Bank wants its money out of the project early and wants Lee to agree to a release price per parcel that will result in the loan being repaid at a rate 25 percent faster than sales revenue is expected to be earned. Other costs to consider include sales expense (paid quarterly on 5 percent of the sales price of parcels sold during the quarter), administrative costs of $11,000 per quarter, and property taxes of $7,000. None of these latter items are to be funded in the loan.

a.Develop a total monthly sales schedule for Lee. What will be Lee’s total revenue? How many months will it take Lee to fully repay the loan?

b.What will be the total interest carry funded in the loan amount? What will be the release price for each type of lot? Compute the loan repayment schedule. What will be Lee’s total cash payments to the Last National Bank?

c.What will Lee’s total equity requirement be? Should Lee undertake this project if its required return on equity is 18 percent? (Hint: Do a cash flow analysis on a quarterly basis for the life of the project.) What will be the IRR on the project?

 

3ii. What are some of the physical considerations that a developer should be concerned with when purchasing land?  How should such considerations be taken into account when determining the price that should be paid?

 

4i. Excel. Refer to problem 3. Refer to the “Ch 17 Land Dev” tab in the Excel Workbook provided on the Web site. Change the assumptions in the file to solve problem 3. Then answer the following questions.

a.Determine the release price based on a repayment schedule calling for the loan to be repaid at the following rates: 0 percent, 10 percent, and 30 percent faster than the receipt of sales revenues. (Note: the original problem assumes a rate 25 percent faster.)

b.Develop a loan schedule to demonstrate that with 0 percent acceleration the loan is paid off exactly when the last lot is sold.

c.Calculate the lender’s IRR (effective cost of the loan) for each of the rates in part (a).

e x cel www.mhhe.com/bf14e

(For Reference Problem 3)

Lee Development Co. has found a site that it believes will support 75 homesites. The company also believes that the land can be purchased for $225,000 while direct development costs will run an additional $775,000. The Last National Bank of Texas will underwrite 100 percent of the improvements plus the interest carry. The loan would be made at 13 percent interest with a 3 percent loan origination fee. Lee believes that the development will sell faster with two types of parcels, standard and deluxe, with the standard parcel comprising 57 of the total parcels.

Lee’s marketing staff believes that the deluxe sites can be sold for $24,000 while the standard sites should bring $13,500. Lee estimates that the direct cost draws will be taken down in four equal amounts during months 1 to 4. Other up-front fees include closing costs of $10,000 and a 3 percent loan fee (not covered by the loan). Lee’s sales staff supervisor assures him that she can generate sales activity starting in the fourth month that will result in the sale of five standard parcels per month and four deluxe parcels per month for three months. For the next six months, activity should be seven standard parcels per month and only one deluxe parcel per month. The Last National Bank wants its money out of the project early and wants Lee to agree to a release price per parcel that will result in the loan being repaid at a rate 25 percent faster than sales revenue is expected to be earned. Other costs to consider include sales expense (paid quarterly on 5 percent of the sales price of parcels sold during the quarter), administrative costs of $11,000 per quarter, and property taxes of $7,000. None of these latter items are to be funded in the loan.

a.Develop a total monthly sales schedule for Lee. What will be Lee’s total revenue? How many months will it take Lee to fully repay the loan?

b.What will be the total interest carry funded in the loan amount? What will be the release price for each type of lot? Compute the loan repayment schedule. What will be Lee’s total cash payments to the Last National Bank?

c.What will Lee’s total equity requirement be? Should Lee undertake this project if its required return on equity is 18 percent? (Hint: Do a cash flow analysis on a quarterly basis for the life of the project.) What will be the IRR on the project?

 

4ii.In land development projects, why do lenders insist on loan repayment rates in excess of sales revenue?  What is a release price?

 

5.What are the unique risks of land development projects from the developer’s and lender’s point of view?

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