Fees are struck on the commitment but earned on a balance that averages barely half of it.
Measure a construction loan's yield on the money actually lent, not on the commitment. A 40,000,000 facility at 8.5 per cent, with a 1.5 per cent arrangement fee, a 1.0 per cent exit fee and a 1.0 per cent commitment fee, drawn on an S-curve over 24 months and repaid in month 30, averages only 23,333,333 outstanding. On that balance it earns 10.93 per cent a year, 11.18 per cent as an IRR. That IRR is 268 basis points over the coupon, not the 100 that spreading the fees over the commitment suggests.
Worked in full in The Real Estate Debt Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Fees on a construction loan are struck on the full commitment, but the lender's money goes out a draw at a time. For most of the first year very little is out, so every point of fee is earned on a fraction of the facility. That is why construction lending prices so differently from an investment loan funded on day one, and why a committee comparing the two on margin alone compares the wrong things.
| Term | Value |
|---|---|
| Commitment | 40,000,000 |
| Reference rate (held flat) + margin | 4.0% + 4.5% = 8.5% |
| Arrangement fee, on commitment, at closing | 1.5% (600,000) |
| Commitment fee, a year, on the undrawn amount | 1.0% |
| Exit fee, on commitment, at repayment | 1.0% (400,000) |
| Draw period / repayment month | 24 / 30 |
The draws follow an S-curve: slow during groundworks, fastest during the frame and envelope, slowing again through fit-out. 14.6 per cent of the facility is drawn by month 6, 50.0 per cent by month 12 and 85.4 per cent by month 18. The last six months are lease-up or sale, with the loan fully drawn.
Average balance = Σ opening balance each month ÷ months outstanding = 23,333,333, or 58.3 per cent of the commitment.
Interest = Σ opening balance × 8.5% ÷ 12 = 4,958,333
Commitment fee = Σ undrawn × 1.0% ÷ 12 = 416,667
Arrangement and exit fees = 600,000 + 400,000
Total income = 6,375,000, of which fees are 1,416,667, or 22.2 per cent.
Yield on average balance = income ÷ average balance ÷ years = 6,375,000 ÷ 23,333,333 ÷ 2.5 = 10.93%
IRR: lay out the monthly flows (fee in at closing, each draw out, interest and commitment fee in, principal and exit fee back in month 30) and solve. Monthly IRR × 12 = 11.18%.
Excel: =SUM(Income)/AVERAGE(OpeningBalances)/(Months/12) and =IRR(Flows)*12
Interest on its own yields exactly the 8.50 per cent coupon on the average balance. The fees add 2.43 per cent a year on top, because 1,416,667 is earned on a balance that averages 23,333,333 rather than 40,000,000. The IRR is higher still because the 600,000 arrangement fee is received at closing, months before most of the money goes out.
The shortcut that understates it. Spreading 2.5 points of arrangement and exit fees over a 2.5-year life gives 1.00 per cent a year, and an all-in yield of 9.50 per cent. That treats the loan as fully drawn from the first day. It misses more than a point of yield, and it ignores the commitment fee entirely.
The draw profile is the developer's programme, and the repayment date is the developer's exit. Both are estimates, and the lender's yield moves with each.
| Draw profile | Average balance | Of commitment | Income | Yield | IRR |
|---|---|---|---|---|---|
| Front-loaded (land and early works) | 28,657,407 | 71.6% | 7,373,264 | 10.29% | 10.43% |
| S-curve (base case) | 23,333,333 | 58.3% | 6,375,000 | 10.93% | 11.18% |
| Back-loaded | 18,009,259 | 45.0% | 5,376,736 | 11.94% | 12.39% |
A slower draw raises the yield and lowers the income. The lender earns more per unit of money lent but less money in total, which is why a debt fund with capital to deploy can prefer the front-loaded deal even at a lower yield.
| Repaid in month | Average balance | Income | Yield | IRR | Pickup, bp |
|---|---|---|---|---|---|
| 27 | 21,481,481 | 5,525,000 | 11.43% | 11.73% | 323 |
| 30 | 23,333,333 | 6,375,000 | 10.93% | 11.18% | 268 |
| 36 | 26,111,111 | 8,075,000 | 10.31% | 10.52% | 202 |
An early sale lifts the yield because the fixed fees are earned over a shorter life. A slow lease-up lowers it, and if it also triggers an extension, the extension fee is what restores it. The commitment fee alone is worth 82 basis points of IRR in the base case: drop it and the IRR falls to 10.36 per cent.
Build the draw schedule first, then measure income against the average balance it produces. On this facility the coupon is 8.50 per cent and the yield on the money actually lent is 10.93 per cent, 11.18 per cent as an IRR. How much of that survives the cost of funds, expected loss and capital is the question margin versus return on capital answers, and the free workbook for it is on the Real Estate Debt Investor companion page.
Because the money is advanced in draws as work is certified. On an S-curve over 24 months, only 14.6 per cent is drawn by month 6 and 50.0 per cent by month 12. Over a 30-month life the balance averages 23,333,333 on a 40,000,000 facility, 58.3 per cent, so fees on the commitment are earned on a much smaller sum.
It pays the lender for capital held ready but not yet lent. At 1.0 per cent a year on the undrawn amount it earns 416,667 over the draw period in the worked case, worth 82 basis points of IRR: without it the IRR falls from 11.18 to 10.36 per cent.
It usually raises the yield and lowers the income. Repaid in month 27 instead of 30, the illustrative loan yields 11.43 per cent on its average balance against 10.93 per cent, because the fixed fees are earned over a shorter life, but total income falls from 6,375,000 to 5,525,000.
This article is one calculation from The Real Estate Debt Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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