Model Question: Negative Cash Flow / DSCR in Year 1
Anyone with good experience in modeling?  My problem is essentially the following: evaluating an investment with a 10-year exit, that requires occupancy to ramp up over the first few years to a stable rate.  The problem is, for the first year after the build, the NOI is pretty much zero or slightly negative after subtracting operating costs from the lower rent income that year due to lower occupancy.  

To use some raw numbers, lets say the purchase was for 10 million, with a loan to cost of about 65% leaving a 6.5 million loan, amortizing in 36 months with an annual PMT of \~450k.  In year 1 my rental income is about 400k and operating expenses of 400k.  (I just pulled these numbers from thin air in case you're wondering why my PMT seems wrong)

Thus, I'm left with a shortfall of about 450k to pay off that debt in year 1.  Am I supposed to go back in year 0 and demand another 450k invested up front to credit an "equity reserve" account?  And then I assume I debit this account in the year 1's "before tax cash flow" to cancel that debt obligation and result in 0 before tax cash flow.  

I don't know how to treat this in a model so would appreciate any clarification.  Conceptually it seems like you can't have a negative "Before tax cash flow" in any year because that signifies you have not paid the debt obligation of that period, or is that wrong?
[{"id": "ffutd8f", "text": "This would be dealt with I think with carrying some type of loss reserve in your overall capital budget to cover the shortfall.", "replies": [{"id": "ffuusah", "text": "Agree with this and since this is a development deal, I would carry 18-24 months of a interest/prop tax/insurance reserve.  You can always distribute the excess funds after your occupancy levels are getting more comfortable but you don't want to fund the reserve short and then have to raise more money if your leasing assumptions are not met.  \n\nIn the model it should go toward the equity required and toward the total LTC.", "replies": [{"id": "ffuyv0s", "text": "This is kind of how I understood it too. Good point about leaving a cushion to not raise a second time.\n\nAm I correct to state that you can\u2019t have a negative pre tax cash flow for a year (after subtracting the debt that year)?  The lender will expect constant debt payments for the duration.  From an IRR standpoint it doesn\u2019t seem to change much, for the equity investors it just replaces a cash flow of -3.5M -450K ... ... ... with -4.0M 0 ... ... ... for year 0 and year 1, assuming I add a 450k reserve.", "replies": [{"id": "ffuzc80", "text": "If you can DSCR the stablized property, and you can show where you'll be carrying shortfalls from, and the plan to get it to where it needs to be, there are lenders that will buy it.  How many units?", "replies": [], "depth": 4}, {"id": "ffv201o", "text": "The lender is going to require the reserve, they only care about getting their money back.  In all development deals that I have done, the lender holds the funds in an account they control and do monthly sweeps for debt service until we either sell an asset after the entitlement process or development is completed.  Once you start your lease up period, you are going to want to refinance that costly development debt.", "replies": [], "depth": 4}, {"id": "ffv33b7", "text": "You should make the 450k part of committed capital, with the capital call coming as the debt comes due, usually one call/yr to frontload the negative CF obligation. Calling 1x/yr alleviates strain on the IRR (if you have multiple years / periods of neg CF)", "replies": [{"id": "ffv3tdx", "text": "Cool sounds good.  But that additional committed capital is basically bucketed differently than the equity portion of the purchase price, right?\n\ne.g. using my numbers above, 6.5 mil debt 3.5 mil equity to purchase all-in at 10 mil -&gt; then after that I tack on another 500k needed for the anticipated shortfall\n\nOpposed to saying I buy it for 6.5 mil debt 4 mil equity for a purchase of 10 mil", "replies": [{"id": "ffvc8tw", "text": "Correct, compensating for CF shortfall does not increase equity in the deal assuming pro rata capital contributions consistent with the total model. \n\nIe, these things are built into the initial capital call, versus someone reaching into their pocket to cover a shortfall.", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ffuu4vu", "text": "You should create an \"Operating Shortfall\" in your capital budget to capture whatever that shortfall is. You can definitely have negative cash flow as the asset stabilizes - this is why you plan for the shortfall and add it to your budget.", "replies": [{"id": "ffuz4bv", "text": "Thanks, you\u2019re right and I know I can have a negative cash flow but the debt needs to get paid regardless, so it seems like I can\u2019t just leave pre tax cash flow in year 1 at -450K in that sense because it\u2019s basically like not paying the debt obligation.  \n\nWould then need to account for rolling back that debt and late payments, etc. which seems dicier than planning for the equity reserve up front.", "replies": [], "depth": 2}], "depth": 1}, {"id": "ffuvx7l", "text": "Do you have a construction loan? Typically you would have a mezz piece to complete construction before the asset is stabilized then secure your standard loan. In regards to valuing the asset you would use the first year NOI of the asset being stabilized", "replies": [{"id": "ffuz8gr", "text": "Thanks for responding.  See initially I thought about doing two loans (one being incurring mezzanine debt) but the model just allows for one loan.  So I think an equity shortfall is necessary.", "replies": [], "depth": 2}], "depth": 1}, {"id": "ffvea12", "text": "You should model your operating cash reserve and keep a minimum balance in that account. You should call equity if you get below the minimum balance, but you should prefund the reserve with debt proceeds or equity and have your monthly cash flow flow through the reserve. \n\nYou can Make it iterative in your model so the prefunded balance is the exact amount you need to ensure no capital calls are needed or to suit whatever your needs are.", "replies": [], "depth": 1}, {"id": "ffvikfh", "text": "If you are modeling this with an investor waterfall you may want to consider not \u201cfunding\u201d the shortfall up front and calling investor capital when you need it (which reduces your cost of capital or preferred returns paid out)", "replies": [], "depth": 1}]