Back of the envelope (BOTE) modeling is a great way to quickly screen potential development sites in and out of your pipeline. The benefit of back of the envelope modeling is we can initially only spend a handful of minutes to see if a site has attractive economics, i.e., if we perceive it as potentially profitable enough to justify pursuit.
One of the tricky parts of BOTE modeling for development transactions, though, is estimating the construction interest costs that we must include as part of our overall project budget.
The simplest way to crack this nut and end up with a reasonable ballpark figure is to take the total number of years that the loan is anticipated to be outstanding, multiply by the annual assumed interest rate, and then divide by 2.
So the formula for construction loan interest is: Years outstanding * Interest rate / 2
Why do we divide by 2?
The reason is that the loan is taken down piecemeal in monthly draws, and as such, for the majority of the loan’s life, only a portion of the full loan size is outstanding. See the chart below, which illustrates the monthly loan ending balance for a condominium development transaction.
As you can see, the average outstanding balance is approximately one half of the overall loan size. Put another way, at any one time, on average, only half of the loan is outstanding.
You can find free BOTE models for developments in the links below: