By Dan Mikes

While the economy has been lackluster at best for the past year, the housing market has been a point of relief. As a record number of new housing starts have bolstered the nation’s economy, it has in turn caused grief for churches and other organizations about to enter into new building programs. The rising cost of building materials, such as steel and lumber, have made a significant impact on church construction budgets, from small-scale renovations to multimillion-dollar worship facilities.

So, what does this mean to your growing church if it’s faced with the need to remodel or expand? Unfortunately, the reality is that things won’t change any time soon. Therefore, you’ll need to be more diligent in overseeing your budgets for expansion or renovation.

One way to do this is by carefully reviewing all costs and bids for construction materials to ensure estimates are based on current prices. Also, make certain the project contingency allowance is adequate; typically, this ranges from 5 percent to 8 percent of total hard costs, depending on the type of construction and construction contract.

If the proposed project is still months from being sent out to bid, a higher contingency is recommended. Many churches require several months, or even years, between conceptualizing a project and actually starting construction. Therefore, it’s very important to allow for cost increases at a rate in excess of the general cost of living and inflation rates.

It’s also understood that the majority of church leaders cannot fund construction projects independently and must rely instead on outside financing. As such, anticipating the basic elements of financing is key, as well as your church’s borrowing capacity.

For construction projects, there are two phases of borrowing. First, there’s the construction loan or line of credit, which is used to gradually fund the project costs during the construction phase. Following completion of construction, the construction loan is converted to a permanent (amortizing-term or “balloon”) loan. It is important that you fully understand these products, particularly their benefits and limitations. Do not sign your name to any agreement you can’t honor at the time of signing. In other words, don’t enter into a construction contract before you have your financing commitment in hand and in writing.

Also understand that construction loans are typically priced with a variable interest rate indexed to the Prime rate or one-month Libor. Usually, these loans require monthly interest-only payments. Over the past year or two, these short-term rates have been very stable and at historically low levels. A one-month Libor, for example, has been hovering around 1 percent — well below the averages of 1.7 percent in 2002, 3.7 percent in 2001, and in excess of 5 percent from 1995 to 2000. Budget for construction interest expenses for upcoming projects based on the assumption that rates are likely to move higher over the next year and beyond.

Of even greater significance is the potential for higher long-term borrowing costs. In the last year, long-term interest rates have risen more than 2 percent from their lows last June. As an example of the impact this can have on a church budget, if the interest rate on a $3 million loan amortized over 25 year rises from 5 percent to 7 percent, the monthly payment will increase by nearly $3,500!

Carefully evaluate how you plan to repay the permanent loan. Most financial institutions will review historic cash flow to assess your church’s ability to service the desired level of debt. When historic cash flow does not evidence the ability to support the contemplated debt, a three-year capital stewardship campaign is considered an appropriate means of bridging the time needed to transition the general budget. Capital campaigns also typically enable some level of debt prepayment.

Another means by which the lender will identify your church’s borrowing capacity is the income-to-debt ratio. A multiple of three times the prior year’s general contributions (excluding designated) is a common equation for estimating debt capacity. Capital campaign revenues also are included in this calculation if your church has demonstrated a history of, and an ongoing commitment to, concurrent capital campaigns. Other nonrecurring revenues or designated gifts generally are excluded from this ratio.

Developing a three-to four-year projected timeline for your project can be very helpful in illustrating the sources of funding and debt servicing of your project. It also provides an effective means of communicating your capital expansion plans to your lender.

The timeline should include a cash-flow model that relates exclusively to the project. This does not need to include general budget items, except to the extent that you anticipate making a revenue contribution from net operating funds. Other revenues and sources of funding include monthly inflows from the capital campaign, as well as draws against the construction loan during construction. Cash outflows should include the capital fundraiser’s charges, architectural and building costs and variable interest payments (debt service) through completion of the facility.

You might want to assume a few quarter-point increases in the variable interest rate for the duration of construction. After the building is complete, ongoing pledge receipts can supplement net operating funds to accommodate debt service, and excess pledge income can be applied to debt reduction. As a conservative measure, allow for 10 percent shrinkage when accounting for pledge receipts.

Before embarking on a project that will require financing, talk to a knowledgeable and experienced church lender about your options. It’s never too early to start planning for future construction projects. Experts in church lending can be of great value to you and your ministry as you enlarge your tent to accommodate the harvest.

Dan Mikes is the senior vice president of Bank of the West in Walnut Creek, Calif. For more information, call 800.405.2327 or visit www.bankofthewest.com.