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The Profit Test

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The Developer Needs an Incentive to Complete the Project

Suppose a commercial property developer obtains an $850,000 commercial construction loan to build a small strip center. The project will cost $920,000 to build. Initially the developer expects to sell the strip center upon completion for $975,000.

Then the market for small strip centers tanks by 10%. The developer might say to himself, “Gee, even if I stick around to complete the project and sell   it $875,000, the realtor’s commission and closing costs will cost me another

$60,000. There won’t even be enough net proceeds to pay off the commercial construction loan. There is no profit incentive for me to stick around.”

So the developer calls the bank and says, “Good luck collecting on my per- sonal guarantee. I’m outa here. You can complete the project on your own.”

Okay, obviously the commercial construction lender made a mistake when underwriting the loan. What did the commercial construction lender do wrong?

The commercial construction lender should have computed the developer’s potential profit as a percentage of the total project cost; i.e., the Profit Test.

In this case the developer only stood to make a $55,000 profit if the deal went perfectly ($975K value minus $920K cost.) Expressed as a percentage of the total project cost, the developer only stood to make a profit of around 6% ($55K/$920K x 100%).

When underwriting commercial construction loans, the prudent commercial construction underwriter will require a profit percentage of at least 20%.

 

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