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I think either take out I/O debt and hopefully in a few years your NOI has grown enough to comfortably cover the principal payment or have a very low going in LTV and refi in a few years (which really depends on your targeted IRR and is risky if rates don't drop in the medium term).
For us at least, we are looking at construction loans in development at the current rates and seeing what the capitalized interest would be during construction and baking that into the proforma, then using our assumptions of refi at stabilization around year 3 or so where we think rates will go down. We would take that hit on capitalized interest for sure, but if we think a market has good enough fundamentals and get land at attractive enough costs we can get deals to pencil out. I've also seen an increase in interest for HUD construction loans for the attractive rates and higher leverage now. Granted there isn't a refi and its a slight hit to the IRR, but the equity multiple sees a nice bump.
We are pencils down on pure acquisitions though because there isn't enough value add to cover the spread between cap rate and interest rates.
Question for you relating to development financing - How are you estimating the capitalized interest considering rate environment? Most of what we're seeing is SOFR + 350-400 depending on the sponsor and if we're assuming at a 24-30 month build, are you letting it float and using yield curves to estimate total interest at completion or working in a cap and underwriting to max interest? If you're using a cap, is this lender required?
Sorry if this is a dumb question, but this type of volatility is new to me so I'm curious how other's may be looking at it.. We're seeing some good development opportunities come up in the middle market space but it seems the rate environment has most people on the sidelines
I would model out your construction costs based on your assumed draw schedule, and if you are floating, I'd model out a corresponding interest rate based on the SOFR curve. You'll also have some period of time after delivery where your NOI can't cover your debt, so have to consider that as well.
So like most things, it depends. We will run a sensitivity analysis based on the quoted rate and then at various bps spread from there. Since it is immaterial to the deal functionality itself (rent/op ex/ stabilized debt service/ etc.), it is easy enough to have the dev cost (where we put capitalized interest) vary by a certain amount that changes from the capitalized interest amount. Since this will affect predominantly the returns for the reasons above it is easy enough to have that sensitivity analysis dynamic when we input newly quoted development terms. No way to concretely know where rates will end up, so rather than try and predict based on yield curves and whatever "crystal ball" that people try to use, we see where we our returns would fall given the various scenarios. If the deal pencils out in the range of base case to 150 bps increase then we feel fairly confident in it, but if the deal only works for the first 50 bps increase then we get very cautious with it.
It also will depend on what type of deal you are doing. We are doing a lot of BFR right now, so we have delivery and lease up staggered and have seen first units delivered and pre-leased well before 15 months so stabilization can happen much sooner than 2-3 years and capitalized interest is much less variable when you have less time.
Should also emphasize the importance of the land cost right now for us. Based on everything I said above, we are able to talk with sellers and negotiate price to a more acceptable range in most cases since they know that they will likely be unable to sell for a higher price/current price and we can transact with them in cash vs financing the land take down like some other shops for large projects. So in that hypothetical I gave earlier about 150 bps vs 50 bps can then be expanded to say 200 bps vs 100bps increases of viability when land is re-traded then all of a sudden you feel much more comfortable.
Where are you seeing cap rates today? Hearing a lot of market chatter of in-place cap rates north of 5, but haven't actually seen those deals trade yet. For reference, these deals were 3.5%-4.25% cap rates in Q1 (mainly older vintage Value-Add deals).
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