The Profit Ratio is only used in commercial construction loan underwriting. The Profit Ratio is designed to make sure that a developer stands to make a large enough profit so that he will not simply abandon a half-completed construction project the moment he incurs a few cost overruns. The Profit Ratio is defined as the Developer’s Projected Profit divided by the Total Construction Cost, expressed as a percentage; i.e., multiplied by 100%. The developer should expect to earn a profit of at least 20% of the projected cost of the project. If the developer’s Profit Ratio is less than 20%, the new building should not be built.
Profit Ratio = (Developer’s Projected Profit / Total Cost of the Construction Project) x 100%
The Profit Ratio is normally expressed as one digit to the right of the decimal point; e.g., 23.7% or 15.1%.
Billy Bad-Timing is a real estate developer. At the top of the market, he unwisely bought some land to serve as the site of his next apartment building. He overpaid for the land. By the time he got ready to develop the land, apartment rents had stopped climbing and construction costs had risen by 7%. When he applied to the bank for a $4 million construction loan, the bank looked at and used his actual cost of the land - $1 million in cash. In truth, the apartment building site was really only worth $600,000; but neither the bank nor the appraiser caught it. The appraiser did notice, however, that the apartment building was only going to be worth $5.1 million upon completion and had a total cost of $5 million. Loan Committee looked at the $1 million in cash that the developer had contributed to the project (the cost of the land) and figured that Billy would never walk away from a half-completed project when he had $1 million invested. Loan Committee approved the $4 million construction loan request, and construction got underway.
During construction Billy noticed his costs kept increasing over budget. Finally Billy took a step back and asked himself, “Why am I busting my chops every day to finish this apartment building? I am not going to make a penny of profit. With the recent cost overruns, my total cost is going to be $5.8 million, not the $5 million that I had projected. That means I am going to have to contribute another $800,000 of my own dough just to finish the project. The most I can get for the building upon completion is $5.1 million, and after selling costs of 6% and closing costs of 2%, the most I can walk away with is just $692,000 after paying off the bank. I have to work hard every day for another six months, contribute another $800,000 of my own dough in cash, and then walk away from my $1.8 million investment with just $692,000??? Forget this! I’m outa here. I’m going to take my last $800,000 down to Texas where the construction business is booming. If the bank wants to sue me, they’ll have to chase me there, where the bankruptcy laws are very favorable to debtors.” Now the bank really has a problem. The project is half-completed, and the developer has left the state hauling away much of the construction supplies. No one can find the latest copy of the plans, and the subcontractors are screaming to get paid. The rainy season is coming soon too. Looks like big trouble in River City.
The bank should have caught this dangerous situation in underwriting. Remember, the Profit Ratio is supposed to exceed 20%. What was Billy Bad-Timing’s Profit ratio? Remember, his Developer’s Projected Profit was only $100,000 - $5.1MM value upon completion minus his $5 million Projected Total Construction Cost.
Profit Ratio = ($100,000 / $5,000,000 ) x 100% = 2% (Just 2%!!!)
Oops. Somebody at the bank goofed up.