Establishing a budget for expansion for Grace Church

Jan 22

Here comes the future!

It’s really exciting to stand behind the pulpit and see a packed auditorium where literally every seat is filled by someone who is eager to hear that day’s message and be part of the local church family. It’s equally thrilling to take a walk through the children’s area and see (and hear!) dozens of elementary-school-aged children learning the stories of the Bible and discovering just how much Jesus loves them. And it puts a jump in your step to visit the youth department and watch middle- and high-school aged students as they sing and raise their hands in worship in a packed room shoulder to shoulder.

What isn’t so wonderful is worrying about how the church is going to expand its physical premises to accommodate this growth.

“How big of a space do we really need? We don’t want to over-build, but we don’t want to under-build either.”
“What should the space look like? If it’s too trendy it might go out of style too soon, but if it’s not trendy enough it may not attract newcomers.”
“Can we continue to operate worship services during construction and renovation, or will we have to meet offsite? This would assuredly cause a loss of momentum.”
And above all else, “What is this going to cost, and can we afford it?”

The questions are endless, and the entire process seems overwhelming.

Aspiring pastors sit through courses on hermeneutics, biblical cultures, theology, eschatology, and the truths found in the writings of the Apostle Paul, but not one would-be pastor has ever sat through a course entitled, “What to do when you’ve outgrown your space.”

To be sure, an important question to address is the money question. Nothing happens without it. It’s such an uncomfortable topic—the love of it is the root of all evil—yet it can’t be ignored. In reality, it’s the first issue that must be addressed when faced with significant capacity constraints.

Fortunately, one of our clients—whom we will call Grace Church, led by Pastor Rhodes—decided to engage outside expert advice to help him navigate this issue.

A relatable background

Pastor Rhodes joined the Grace Church staff 22 years ago as its Youth Pastor. It had just completed construction on a brand new 68,000 square foot building situated on a plentiful 68 acres of land. Excitement was high and new members were joining the congregation on a weekly basis. The building was large enough to accommodate its attendees, and large enough to accommodate future growth.

The auditorium sat 825 and had a flat floor (as opposed to a sloped floor) that allowed the space to be used for dinners and gatherings of all types. A team of volunteers were constantly transforming the auditorium to meet the demands of a wide range of events.

The children’s area was comprised of a large open room, a stage, and smaller classrooms around its perimeter. The youth room had a stage as well, and boasted of an area reserved for video games, a pool table, and a ping pong table. Both spaces were appealing places to gather and appropriately sized for the needs of the church.

Approximately 13 years into Pastor Rhodes’ tenure as Youth Pastor, the Senior Pastor of Grace Church retired. Pastor Rhodes, who had been a regular speaker on Sunday mornings and had earned the respect and admiration of the congregation, was unanimously selected to succeed the retiring Senior Pastor. Pastor Rhodes jumped into this new role with excitement and welcomed the opportunity to build upon the rich legacy that had already been established at Grace Church.

Since that time, the church has experienced steady growth. Total Sunday morning attendance is now regularly 1,400 or above. The auditorium is packed during its 11:00 a.m. service, and the 9:00 a.m. service has continued to fill up.

The lack of space in the auditorium is certainly a challenge, but the more pressing issue is the lack of space in both the children’s and youth areas. Typical attendance in the children’s department is over 150, in a room initially designed to accommodate 100 at most. The youth area is even more crowded. Weekly attendance has averaged 100 teenagers (and at times 125) who cram into a room designed for 60 at most. Because the room has an external door to a small outside courtyard, many students congregate outside before and after service. This is great in the summer months, but Grace Church is located in the north where freezing temperatures and seasonal snowfall prevent the use of the outdoor courtyard in the winter months.

Pastor Rhodes knows that the current situation is untenable. The church needs a larger auditorium and significantly more space to accommodate children and youth groups—not only those that are currently attending, but those that would join in the future.

Pastor Rhodes asked ChurchWay Advisors to help him and the leadership team navigate these issues. This case study focuses on how we helped answer the first critical question: “What can we afford to spend on a construction project?” All other decisions flowed from the answer to this question.

We tackled this assignment in three phases: (1) Discovery; (2) Creating a Financial Model; and (3) Validation.

Phase 1: Discovery

Over a day and a half, we conducted initial face-to-face meetings with Pastor Rhodes and the Treasurer of the Church (who is also a board member). Our goal was to understand the church’s history, current state of affairs, and specific challenges. Our due diligence focused on four key elements of Grace Church: (1) its financial health; (2) its human resources (i.e., people capabilities); (3) its physical property; and (4) its governance model.

Financial Health

We reviewed the church’s financial statements (Statements of Activities and Statements of Financial Position) for the past three years plus the current year-to-date period. We asked questions about the church’s cash position and the investment vehicles it used. We reviewed documents related to the church’s separate food pantry operations and its partnership interest in a senior assisted living facility. We also reviewed the church’s existing loan agreements and asked questions about interest rate reset dates and the formulas for calculating the reset rates. We evaluated the various sources of giving (missions, building fund, general tithes and offerings, rental income, ticket sales to events, etc.) and looked at the giving trends of the top 20 givers.

We concluded that the church’s financial situation was healthy. Giving trends were steady and favorable, the church was generating positive cash flow every year, the principal and interest payments on its existing debt were well within its ability to pay, and the church was not over-reliant on just a few substantial givers.

Human Resources

To evaluate the feasibility of a construction project as a way to solve the church’s space constraints, we needed to consider the entire church organization, including human resources aspects. We wanted to know if the church had existing staff members and/or volunteers that could play a role in the building project. Some level of outside support would be required, but to what extent and at what cost? We also wanted to understand the financial acumen of the existing staff, including the board members.

We concluded that the church’s existing staff lacked the capacity and experience to oversee a building project on their own. Grace Church did not have an executive pastor or business administrator. And while one board member had a financial background, he was not experienced enough in financial matters to lead the board in sophisticated financial discussions on his own. This was not unexpected. We were pleasantly surprised, however, to learn that Pastor Rhodes had an architectural background which would be helpful later in the project.

Real Property

With respect to the church’s real property, we wanted to ascertain what portion, if any, could be sold (or leased) with the proceeds from the sale (or the income from the lease) being contributed to a building project.

With a 68-acre parcel, the church had excess land that would not be needed for a building project. We noted the possibility of liquidating or leasing some of this land as a way to fund a building project, which would be a decision for the board to make at a later date.

We learned that the church operated a food pantry at a separate location and owned two additional stand-alone properties that were being used as halfway houses. The food pantry was making a significant difference in its community and volunteer participation in this ministry was high.

The halfway houses, however, while yielding some positive results for its few occupants, were not generating the desired results. Volunteer participation was low, and from a missional standpoint this ministry was not a priority. Pastor Rhodes and the board decided that in the absence of the ministry’s leader making significant changes that resulted in a much greater impact, these properties would be sold and the proceeds contributed to the building project.

Governance

Finally, we wanted to understand the chain of command at the church: who had the authority to sell property, execute loan agreements, hire an architectural firm or building contractor, make decisions regarding significant financial transactions, etc.? These decision makers needed to be part of the process.

We also wanted to ascertain if the church’s governance model was working effectively, or if it was going to be difficult to make decisions and execute plans. Based on a review of the church’s by-laws and minutes from its most recent meetings, we were pleased to see that the church’s governance model was working effectively, and the church was operating with a high degree of adherence to its by-laws, with most of the key decisions falling to the Board of Trustees and Pastor Rhodes.

During our due diligence we uncovered that a couple of the longest tenured board members had been involved in the first building project and its related capital campaign and had had an unpleasant experience with both. Knowing this background was important—we wanted to make sure that our process would not repeat the same mistakes made earlier by others.

Phase II: Creating a model

Once we had a solid understanding of these issues, we created a financial model that would derive an answer to the question, “What can we afford to spend on a construction project?”

Our financial model is summarized below:

Borrowing Capacity
Less: Existing Debt
Plus: Excess Cash
Plus: Cash Flow from Operations
Subtotal

Plus: Capital Campaign Proceeds
Subtotal

Plus: Proceeds from the Sale of Noncore Assets
Plus: Proceeds from the Sale of Excess Land
Total Budget

The first section (borrowing capacity through the first subtotal) provided an indication of what Grace Church could afford right now without taking any further action. We expected this amount to be insufficient to fund the anticipated construction project, and were prepared to recommend a capital campaign as a way to bridge the gap. The sale of noncore assets and/or excess land would provide additional funds if necessary. This framework allowed the church the ability to make successive decisions based on the total dollar amount needed.

Borrowing Capacity

A detailed description of how we determined the church’s borrowing capacity is beyond the scope of this case study. To summarize, we analyzed the church’s debt service coverage ratio (DSCR). The DSCR is a measure of the church’s available cash flow that could be used to pay its current debt obligations. Specifically, it is the church’s cash flow before debt service divided by its principal and interest payments.

A DSCR of 1.0 would mean that the church is generating cash flow (before debt service) that exactly equals its debt service payments (i.e., principal and interest). A lender would not look favorably on a DSCR of 1.0 because it means that all of the church’s cash flow is required to pay its principal and interest obligations. Nothing would be left over; there would be no cushion.

A DSCR of less than 1.0 would mean that the church’s cash flow is insufficient to cover its principal and interest payments. This situation of course is untenable and indicates that the church is over-leveraged.

The higher the DSCR, the greater the church’s ability to make its debt payments and the less risky the loan is from a lender’s perspective. Generally, lenders have a minimum required DSCR of 1.05 to 1.10. Our preference is to see a DSCR of 1.15 or greater.

In order to determine Grace Church’s borrowing capacity, we calculated the loan amounts that yielded debt service coverage ratios of 1.05 (the minimum expected by a lender) and 1.20 (which would represent a very comfortable loan payment). In deriving the loan amounts, we used a conservate interest rate and a conservative amortization period (25 years). This model built in excess capacity for the church to qualify for a higher loan amount should it need it. We believe a church should be careful in taking on debt and be well positioned to make its payments without aggressive income assumptions.

Our analysis estimated Grace Church’s borrowing capacity to comfortably be $6.75 to $7.0 million.

Existing Debt

The church’s existing debt was approximately $4.5 million at the time of our analysis. This amount was subtracted from the total borrowing capacity to yield the church’s remaining borrowing capacity of $2.25 to $2.5 million.

Excess Cash

Grace Church had a strong balance sheet and managed its financial resources well, spending less each month than it brought in. Lenders often require readily available funds to pay the church’s ongoing expenses as well as costs that may arise unexpectedly. Setting aside three months’ worth of expenses is a wise decision. Accordingly, we calculated the church’s monthly cash outflows and multiplied this amount by three. Cash balances over and above this amount could be used for the building project. In the case of Grace Church, we deemed there to be $1.35 million of excess cash.

Cash Flow from Operations

Because Grace Church generated a surplus of cash every year, we added an estimate of this annual surplus to our calculations—recognizing that a building project would not commence for at least one year. We calculated this amount to be $250 to $400 thousand.

Preliminary Conclusion

Adding these amounts together yielded the total amount that Grace Church could afford to spend on a new building project without a capital campaign or selling off any of its assets. In this case, we determined the range to be $3.8 to $4.25 million.

This would not be sufficient to fund the expansion that Grace Church so desperately needed. So we added estimated proceeds that could be raised from a capital campaign. The primary factor in making this determination was the church’s historical giving. Adding the proceeds from a capital campaign to the first subtotal gave us an indication of what Grace Church could spend without selling any other assets.

Finally, we added in the estimated value of the two halfway houses and an estimate of the value of excess land that could be sold. This resulted in the final construction budget as presented below.

Phase III: Validation

It was time to validate the estimates in our framework. We contacted a well-known person in the church lending space to get their view on our estimate of borrowing capacity. We provided historical financial statements, a summary of nonrecurring expenses included therein, the church’s by-laws, and various other documents and information to the lender. The lender determined Grace Chruch’s borrowing capacity to be “in the low $7 millions.” This gave us greater certainty about our borrowing capacity estimate.

We also engaged three capital campaign consultants for an estimate of the proceeds Grace Church might receive from a capital campaign. Their individual estimates were $3.6 to $4.8 million, $5 million, and $6.25 million, with much of the variability being dependent on the length of the capital campaign. We determined that our estimates were realistic given our preference for a capital campaign that would last just over two years (but would include three Decembers).

Finally, we engaged a commercial real estate broker to provide an opinion of value for the two halfway houses and the excess land on a per-acre basis.

Having thoroughly validated our estimates, we provided the Board of Trustees with the budget amounts (low to high) and showed them how they could afford to undertake a larger project by making certain decisions such as conducting a capital campaign or selling off non-core assets. Having a high degree of certainty in the amount the church could afford to spend enabled Grace Church to confidently move forward with vetting potential building contractors.

Conclusion

Pastor Rhodes and the Board of Trustees of Grace Church were grateful for the clarity this exercise delivered. The board had confidence in the feasibility of expanding the auditorium and adding additional space to the children and youth areas. The contractor the church hired had a solid budget with which to work—a key factor in ensuring that the construction project moved forward efficiently. Due to the conservative nature of our analysis, there was room in the budget to address unexpected changes in costs, and the church was confident that the principal and interest payments associated with a construction loan would be well within the church’s ability to pay so as to not place undue financial stress on the church.

Key takeaways

Money drives the project. The first step in any construction project is to ascertain what the church can afford to pay. Nothing else should be done until this analysis has been completed.
Do not take on more debt than can be reasonably serviced. A church should be careful to not over-extend itself in the lending process. Just because a lender is willing to make a large loan to a church does not mean that it is prudent for the church to assume this level of indebtedness.
A strong balance sheet provides flexibility. Ensure there are sufficient funds available to cover operating expenses and “rainy day” expenses. This enables the church to withstand unexpected negative financial events.
There is no one-size-fits-all when it comes to capital campaigns. When estimating the proceeds that may result from a capital campaign, it is important to look at the specific giving trends of the church and the composition of the church’s individual members. Engaging expert help is often the best course of action.
Noncore assets can be a source of funds. Prioritizing the ministry areas of the church is crucial. Resources used by ministries that don’t generate sufficient results can be repurposed to fund a construction project.
An ounce of prevention is worth a pound of cure. Financial planning is crucial to a successful construction project. Disaster occurs when building plans are drawn and vision is cast before the church is assured of its ability to complete the project from a financial point of view.

Get in touch

If you would like a free consultation on how ChurchWay Advisors can assist you in developing a construction budget for your church’s building project, and then assist in engaging the required experts throughout the duration of your project (e.g., fundraising consultants, builders, lenders, etc.), please contact Mike Kern by clicking the button below or calling 586.212.4749. Helping you make good decisions is our specialty.

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Mike Kern