With construction costs where they are and the SOFR Curve smoking my interest reserves daily, is anyone getting deals to underwrite?
We typically like to underwrite 150bps of spread 50bps above the market cap rate. Try to hit a 20%+- IRR. Are people getting more aggressive on trending rents or how are deals getting there?
We are having deals pencil out about the same spread and IRR you mentioned, but it all comes down to land costs for us. Our pipeline is full of deals we got off market land at great discounts to market value, but when we find land through a broker or at market rate it gets much harder to underwrite. Typically we trend rents 3% years 2-10 and 0% in year 1 with expenses trending at 2% so nothing super aggressive in our assumptions.
I'm seeing most firms only struggling with the availability of debt rather than the underwriting not penciling out. Lenders are pulling back hard and it's no longer just higher rates and lower leverage, it's just less lenders in the market in general.
What markets and product type?
BFR MF and in the Southeast US.
I'm doing MF in the northeast and we've had three deals fall through from lack of equity/debt partners, that's definitely what's been killing us the most. A few deals have been killed because of interest, but getting capital is just too hard right now, no one is moving.
Have definitely had to get more creative with where we source the land for our multi developments - as stated above. More off-market deals, and going for more OZ and LITHC plays. Conservative underwriting still, with 0% rent growths at Year 1 and 3% rent growth 2% expense growth Years 2-5.
We've had a couple opportunities where we were lucky enough to have seller financing on bridge loans, with the assumption that agency debt rates will be lower in two years when we go to refi
As others have said, we're able to make up for it on land costs right now by taking a hit on the potential lift on land we got off market at a discount over the past few years. Generally speaking, we'd rather move forward with a deal and only see a small lift on the land rather than waiting a couple more years.
Yeah when I assume they're gonna pay me to take the land off their hands
I'm pretty much pencils down, personally. Getting quoted close to 7% interest rates and fighting like hell to get to a 6% ROC - just not a risk that makes much sense to me. We have legacy projects where we have to either find a way to tread water for the next 12-18 months or walk away from a lot of pre-dev spend which hurts. Demand feels like its starting to soften, so I just really can't justify taking the plunge on new projects. Interestingly enough, however, I got my first call from a GC saying they are starting to see real softening with subs. I think some guys woke up and realized 2023 was going to be a blood bath for them.
So for 6% YoC, isn't that generally looked at from stabilized cap rate and a 1.5 to 2% spread there? How do you think about a 6%YoC compared to general interest rates say 4% and today at 7%?
You're right that it's compared against cap rates. I think the issue you'll have with that approach right now is there is a lot of "discovery" in market cap rates, and that's only going to get worse as interest rates continue to climb. If I'm building to a 6% YOC and financing with 7% debt, I know that my cash yield is going to be significantly below 6% (depending on leverage). I think merchant builders are talking themselves into the fact that we haven't seen cap rates significantly gap out and that they are still building to a spread, but we are long-term owners so cash yields are important to us. So unless you want to make a $40-80M bet that interest rates are going to go down here w/o a significant economic downturn causing it, I'm just not a fan of greenlighting a project right now.
Question for the people who worked during 2008-2012 - when did deals start to stack again following the GFC? I haven't seen any good deals pop up in the past 3 months that we have got remotely close to. I thought given 7% interest rates that would be the case by now (re getting good deals).
You’re assuming that seller pricing and expectations will match what the debt markets do. They won’t. Never will. Unless you’re a forced seller, you’re not going to sell. You hold the asset and hope values come back and don’t admit to yourself your asset is worth less than last year.
In terms of when deals popped back up after the GFC-it’s a very broad question and probably asset class specific. I would say to go do some research via costar and look at volumes. IMHO it’s going to take 1-3 years for pricing to reset, if it does, and volume to pick back up.
I'm very curious how banks (are forced?) to react. If they are more aggressive than during COVID, you are going to have some forced sellers who bought or developed in 2021/2022 with floating rate loans in certain markets. Office as an asset class will almost certainly be oversold.
I'm a bit too young to have been around for the meat of the GFC, but people a few years older said that 2009-2011 was pretty slow. 2011-2012 the market started to pick back up. The overwhelming majority of foreclosures are mortgage defaults, and most bridge/construction debt is three years.
That was a generationally bad recession, so hopefully this one isn't quite as bleak.
Nope and 99% of people saying they can are lying to themselves. Spot caps for multifamily are 5%-5.25%. Show me a deal that underwrites to a legit (RETAX and reserve adjusted) 6.00%-6.25% RoC untrended and 6.50%-6.75% at exit and I will eat my shoe. Couple of high-rise deals in my market right now can't sell. The bids they get are less than the HARD COSTS today.
what type of market are you in? Spot 5 sounds high for high rise but I'm not active in multi.
Southeast
Sellers are still living in early 2022, expecting 3.75-4.5 caps depending on product type. A good gauge for actual multi values is to look at public REIT book values. Public REIT’s have to rebench themselves every 6ish months and current valuations are coming back at 5-5.5 caps. Almost no one is transacting at these values unless they’re forced sellers pushing up against loan maturities or expensive floating debt.
Distressed deals with aggressive senior notes and deals with near term loan maturities will be the only opps in the short term.. nature of the business fellas
This is a differentiated way of thinking about where cap rates stand and I just want to make sure I am following correctly.
Essentially, you would take consolidated NOI of all properties, for example off of a 10-Q or latest filing of an AVB or EQR and divide that by the Total Enterprise Value (TEV) of the company to derive of a cap rate?
Its a clear problem and we don't know how long it will last. Simply put. You had record low cap rates due to record low interest rates. If I had to guess, probably 75-80% of all CRE assets transacted in the last 10 years at some point. This means you have a massive amount of owners in at record low cap rates. Plenty got out through further cap rate compression, but firms were still buying well past 2020. Now you have this massive interest rate bump. These owners are effectively stuck in these deals unless they can raise rents heavily. As someone said above, this is all a discovery period for every seller/buyer right now. Humans inherently have a tough time accepting a loss. Its a lot easier to accept a profit, but its just human nature to not sell for a loss unless you have to. This discovery period will last longer. Deal activity will be dead to limited for the foreseeable future.
Do you have a SOFR forward curve projection in your model? Like does it flow alongside the CF months affecting the interest pmt amt?
Yeah I'm pretty sure that is standard. Can't imagine someone not using a forward curve
Hmmm funny you mention that. I just realized my firms development model just applies a 365/360 with set interest rate from yr 1. Cant believe I never realized this. All of our debt is floating too.
Super easy to make deals pencil in this market. Underwrite land owners giving away there land for free after you murder their heirs. Underwrite 30% rent bumps for the next 5 years by handcuffing tenants to their units. Marry the GC's daughter, therefore you dont have to pay a GC fee. Divorce GC's daughter and then marry JPow, yes, JPow specifically. Marry him and convince him to lower rates back to zero so you can underwrite cap rate compression. Easy peezy.
Land values and construction costs will both need to drop for more deals to pencil. The high interest rate environment has substantially increased everyone's cost of capital over the past year. What's stopping our group from doing many deals is the cash equity required for the amount of risk involved. If a ground up development deal hits our ROC threshold in this current environment, we're buying land in a B-/C+ submarket and modeling at A/A- submarket rents with aggressive expenses. Even if this pencils as modeled, it's risky- nothing can go wrong. As someone mentioned earlier, most of us our lying to ourselves.
The one deal we may put under contract is an off-market Class B vacant office building that is a residential conversion opportunity. Conversions CAN be a good way to save 25%+ on hard costs, but you really need the right office building to incur real savings and be able to lay out a good unit floorplate. Most office buildings just don't have the right characteristics for conversion. Anyway- we found one located in a prime submarket in major metro ($5/ft. rents). We plan on obtaining some tax incentives as well which will increase NOI. The sellers asking price was initially too high, but their debt is due by EOY so the owner decided they are willing to take a loss on the current debt they owe. Will still be expensive to acquire even at the reduced sale price, and the deal is more of a double than a home run.
As more owners start to face reality, more of these opportunities will come along. But for now, it seems a lot of the challenges for development opportunities in todays environment are not being priced into land values.
I would say it's moreso that construction costs have to drop before things really start to pencil.
Land prices can drop 20% and it only equates to a 2% project cost reduction, which is huge ask of landowners that by and large own their land outright and are quite sticky sellers. On top of that, 2% alone simply doesn't get it done. We will need to see meaningful (5-10%) reductions in construction costs before deals start penciling again. We've begun hearing about costs dropping in our market as many of the frenzy projects (small devs expanding too fast/office devs dipping into multi) are being killed, and even big-time traditional devs are dropping projects. When the biggest apartment developers in the country are dropping projects because they can't get financed, it will have a material impact on construction pricing. Fundamentally, my market is sound (provable housing shortage, diverse economy, incomes staying high and growing, desirable weather), but pricing needs to adjust.
GCs and the entire construction industry have been giving "go away" prices for the past 10 years, so I'm not too concerned about their ability to adjust pricing 5-10% and still run a modestly profitable project. Materials prices have been dropping steadily over the past few months and should continue with projects being dropped and global manufacturing slowing down. Labor pricing should also get under control with fewer projects and more competitive bidding from GCs and subs.
As a bonus, workmanship quality should rebound a bit as well. It should also help modelling by taking the punch out of expected contingencies and escalation costs. It will hopefully bring down the costs and timeline for permitting/entitlements with less projects being squeezed through a tight municipal planning hole. In the most extreme circumstances of municipal budget shortfalls and declining tax bases, municipalities will begin reducing onerous planning/affordable/environmental requirements with help spur new development (but that typically only occurs after many years of decline and municipal decay).
It will take some time to adjust, but I'd expect that to happen sooner than notoriously sticky landowners to suddenly take >50% price reductions because GCs can't figure out how to reduce costs 5%. It will be a concerted effort, but land can only contribute so much to the project penciling, construction will have to carry some of this burden.
Ran the traps on this late last week - 100% correct. The problem (except for some dumb land numbers paid in Rocky Mtn and Sun Belt markets) is that hard costs are up 45%-50% since pre-COVID. A 4-story interior corridor surface parked project used to be $140K/door, now it is $205K-$210K/door. I think hard costs need to come down even a bit more than you are saying. My guestimate is more like 15%-20%.
Agreed, except that I would emphasize the subcontractor pricing more than the GC pricing. The projects I'm seeing are getting squeezed the hardest by electrical, plumbing, HVAC, etc.
Most insightful thing I’ve read on WSO in months. Superb
This man hit the nail on the head. Agree with all the above. The hard costs are the biggest hurdle right now, and I can't make sense of any development right now on multi. Only works on lux hotel right now on stuff I'm looking at because that use can generate enough $/sf to offset the insanity of the current construction pricing.
Want to make sure I understand your initial statement correctly:
are you underwriting essentially a 200BP cap expansion from your going in Cap? Or did you mean a 150bp spread over SOFR, and a 50BP explanation in cap?
Anyone in student housing development have an abridged version of current state of market?
Whoever claims on this thread that multi dev (not talking about incentivized like OZ or LIHTC) pencils right now is high on the good good.
Let me ask a very blunt question as I see this mentioned multiple times on this thread - how do y'all convince yourselves that 2% annual expense inflation is a conservative assumption in this wild inflationary environment? I'm genuinely curious. You really think we're gonna see 2% inflation at any point within the next several years?
Expense inflation (and underwriting) is such a collective hallucination. Very few places in the country where taxes aren't increasing by at least a 3%+ CAGR, multifamily payroll costs are getting silly, utility costs are going to be up significantly this year, and insurance costs have basically doubled in the past five years. No one is underwriting NOI margin erosion and yet if rents are flatlining or going negative people are going to get walloped.
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