What Makes Up Finance Costs?
In a previous post, we talked about indirect and soft costs related to construction. One of the more important cost categories is “Finance”, which primarily refers to the loan interest and fees related to construction financing. This cost is very much dependent on the timing of construction and sales, and generally is best calculated through a cash flow model.
With respect to a construction loan, the lender will typically charge some level of fixed fees or loan points, which is intended to cover the lender’s cost of originating the loan. The larger portion of construction loan costs will tend to be the interest expense, which is the product of interest rates and loan balances outstanding. Good estimates for these costs rely on good revenue and cost assumptions, which are essential elements within the cash flow. Once you have good assumptions, the interest cost calculations are fairly straight forward – again, dependent on rates and loan balances.
Finance costs may sometimes include what is referred to as the “preferred return” for an investor or equity partner. Similar to the construction loan, an investor may require a preferred return that is calculated on the outstanding balance of the investment. This preferred return acts like a time-oriented cost, with an investor usually earning this fee in addition to a share of the profits. Some builders and developers may prefer, though, to view this preferred return as part of the profit sharing and exclude from the finance costs.
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