Construction cost / deal penciling / YoC

To those in development, is anything penciling anymore?  Costs are up at least 20% YoY, rates are up 200 bps and rents are not catching up to cost despite rent growth.  Even then, rent growth has been BS!  It's been owners offering 1 to 2 months concession and pushing rents, so effective rent is still about ~5 to 10 percent despite folks saying rents are up 15 to 25% in most markets.  

Suburban podium costs are the same as core with $/sf rents being the only variance.  Deals still look "OK" on some core locations if the land seller isn't out of their mind on land valuation but podium product in the burbs isn't penciling if rents are sub $3 psf. If it does, you are have to assume crazy rent growth or cap rates at low 4s at exit.  Untrended YoC is at low to mid 4s and I can get the land for free and I still can't develop due to shit economics.

What are you guys doing?!!  Are we all doing drunk math if all in costs are $350 to 400K and sometimes $450K per door.  No margin for error unless you get developer terms on land and most groups today want you to buy right away.  I am seeing self performing groups with GCs and balance sheet execute but very challenging for groups that have to go raise equity from family office or private equity get beat out on land pursuits in the sun belt.  Also seeing groups who tie up land try and sell today because they realize they can't execute once they go to a reputable GC to build the actual product.

Comments (49)

Jun 22, 2022 - 9:41pm
The Duke of Wall Street, what's your opinion? Comment below:

Breaking ground on flex and big-box industrial projects in one of the stronger industrial markets. We are only staying alive because rent growth is 20-30% versus cost increases of 10-20%. Otherwise, our other product types we own land ford (e.g. multifamily and office) aren't penciling for shit. 

Jun 23, 2022 - 9:55am
CREnadian, what's your opinion? Comment below:

Not much, it's definitely a slow play of occasionally checking in and toying with numbers/strategy right now. Anything that was in the ground, about to be in the ground, or that is long-term mixed use is going forward (the latter because our institutional partners want it and don't care if one tower out of 12 has shitty returns). Everything else is on hold.

A couple markets we're in have not seen nearly as much cost inflation as most other markets, so we have had a few new projects there.

Jun 23, 2022 - 10:57am
FlashyKaptain, what's your opinion? Comment below:

Rookie question here, and understanding that it will vary from market to market / asset class to asset class, but in "normal" times, what's a threshold YoC that your firms would use for the go / no go decision?

Don't know if there is a "rule of thumb" like the 20% IRR in private equity (although that will vary from fund to fund, generally a good rule of thumb to use)

  • 1
Jun 23, 2022 - 11:39am
CRESF, what's your opinion? Comment below:

I try to hit an untrended return on cost (so today's rents and expenses) that is 150 bps above where I think market cap rates are today. Six months ago, before the big run up in rates, that basically meant anything north of a 6% ROC for me. I have no idea what the market cap rate is today, and I haven't seen many deals close to a 6% ROC, so it's been a challenge. 

  • 3
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  • Developer in RE - Comm
Jun 23, 2022 - 1:58pm

LOL - what markets are you seeing 6% untrended YoC?  That has not happened in any of the markets I am looking at in the past year or two.  Is your expense weight 20% of EGI or is your construction cost light as f**k?!!  Or you must be looking to tertiary markets.  Dallas, Austin, Phoenix, ATL were all 3 cap markets during covid due to those market ripping for class A product, those are a 4 today due to rates if you are being honest in your underwriting of the deal.  20% IRR LOL again, you must be raising money from crowd street.

Jun 23, 2022 - 2:04pm
CRESF, what's your opinion? Comment below:

Tertiary markets with large TIF subsidies. We're long-term holders, so hope is to build to a 6% and put on fixed rate debt at 4.5-5%. Again, haven't really seen a deal with that profile outside of one. SE markets are a different bag. 

  • Developer in RE - Comm
Jun 23, 2022 - 2:22pm

State those facts than just say 6% YoC.  Tertiary markets I looked at during covid all show 5% cap so your true spread is 100 bps still.  You gotta give good information my guy!!  You should go to brokerage with your talking points, you will do well.  TIF and tertiary markets are "key" in what you said, even more important than stating YoC.

Most Helpful
Jun 23, 2022 - 3:37pm
CRESF, what's your opinion? Comment below:

My guy - relax. This is a real estate message board. We're not curing cancer here. In my market, Class A multi was regularly trading in the low to mid 4%'s in 2021. My entire point was that, last year, I was trying to build to a 6% ROC. I didn't make any representations to how I got there or any of my inputs.

I'm not sure why my post was so triggering to you lol.  

  • 8
  • Developer in RE - Comm
Jun 23, 2022 - 4:34pm

My dude, I am relaxed.  I think I got excited but details do matter.  I literally would develop in any market with a 6% YoC but stating TIF or location is important to understand risk profile.  

It's like a broker who tells you he has an off market but you find out it's another brokers deal and you have to pay his commission. 

The next 6 months will be interesting!

Jun 23, 2022 - 4:44pm
CRESF, what's your opinion? Comment below:

I'm not selling you anything, nor am I asking you to invest in my deals. I was simply stating that I was trying to find deals that pencil to a 150 bps spread over a market cap rate. How I get there, whether by free land or TIF or grants or whatever really shouldn't matter because none of those materially impact the risk profile of the deal. If I had said "I find 6% ROC deals all the time, you guys are idiots" then maybe you have a point. 

I agree details matter, but not on a real estate message board where I was very simply talking about return thresholds. If I had to add every last detail to every comment I made on here, I just wouldn't post. It would take forever. 

  • 5
Jun 28, 2022 - 10:39am
CRESF, what's your opinion? Comment below:

It was the "you should go to brokerage" that really gave me a good laugh. 

  • 1
Jun 23, 2022 - 3:05pm
CREnadian, what's your opinion? Comment below:

Uh, not sure what markets you're in but my shop has done several billion dollars of new deals in the US over the last 2 years and the vast majority penciled to at least a 6.0% if not 6.5% untrended, with IRRs hitting 25-30% in a merchant build scenario. Getting tighter over the past few months, but those numbers have been very realistic in secondary/tertiary markets.

Note that the markets we're in were all trading around a 4 cap or sub-4 when we decided to move forward.

You guys must be doing something wrong or you're only in gateway markets.

Jun 23, 2022 - 11:51am
KingEsque, what's your opinion? Comment below:

I just had this conversation the other day.  In short, the answer is no.  Especially if you're measuring a deal on UYOC.

If you take today's construction costs, rents, cost of capital, and capitalization rates - deals don't pencil.  To add insult to injury, it seems cost of capital will continue to increase.  We need construction costs to decrease and rents to increase because as cost of capital increases the equity risk premium will result in capitalization rates to expand further.  It's a nasty combo right now in the short term and we really need some stability in the capital markets.  Or you have to be a cowboy and underwrite massive rent growth and stagnant or falling construction costs.

Either way, continuing to look for the needle in the haystack for the time being.

Jun 23, 2022 - 3:10pm
jarstar1, what's your opinion? Comment below:

We took a lot of land down at good prices over the last two years, so our pipeline is going to be fine for the next 4-6 years, but our CEO just told us that we are pencils down for the next six months. I'm sure if something juicy off market comes our way we'll take a look but he said he's not expecting to make any purchases for the next six months, and probably only value add deals over a 12 month horizon, and we exclusively do ground-up right now.

We normally try to get YOC at 1.25-1.5% spread to cap rates, and we can barely even get to 1.0% these days. Inflation is just shutting us down, though we've already seen steel/concrete prices normalize and wood pricing come down significantly, so if the rest of the market can settle down I'd see us getting back in after the six month horizon. Even just more stability at a higher price level will be helpful, so much of the issue right now is the crazy allowances for escalation we need to include because there is too much uncertainty. 

Jun 23, 2022 - 3:45pm
CRESF, what's your opinion? Comment below:

I'm finally starting to see these lower lumber prices trickle into bids, but I feel like we are in a race against interest rates. If I can lock in long-term 4.75-5% financing at these new lumber prices, suddenly some things start to work. But if rates are 5.5%+ two months from now, we are probably back to square one. 

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  • VP in RE - Comm
Jul 5, 2022 - 4:10pm

^^^This. Its all relative. Sure lumber is coming down, but it wont matter if rates go up 150-200 bps. Either way the deal gets killed. Not to mention the big thing everyone forgets is that if you look at a 5 year timeline from development to sale, lets say you build at a 6% ROC. You better hope, cap rates are still compressed in a rising rate environment.

Jun 23, 2022 - 4:51pm
yayaa, what's your opinion? Comment below:

very tough right now. My underwriting shows that I would probably have to put money into the deal on my term loan when exiting the construction loan to make up the difference. I am just happy to get construction financing right now....are lenders financing your projects?

Jun 24, 2022 - 8:08am
LIHTCLarry, what's your opinion? Comment below:

LIHTC developer here. Our latest construction bids were 15% above previous estimates and interest rates will definitely be going up before we close in a couple months. Times like this make it alright to be a fee-capped LIHTC developer…state and city will be closing the gap with additional soft financing.

Jun 28, 2022 - 9:28am
mIRRacle, what's your opinion? Comment below:

Not necessarily. We are about to close on a 130 unit 4% LIHTC ground up development in a major city. Construction costs 20% higher than our previous estimates, and we got lucky it wasn't more. The interest rate on our loan is getting bumped every month, we're probably eroding the 200 bps cushion we underwrote in January by the end of July. Our state LIHTC partner backed out of our deal because their cost of capital increased significantly, so we had to go back and get more subsidy from the city. We got an absurd amount of subsidy now that we won't be able to pay back most of it by the end of the compliance period. Sure it could be "forgiven" but still scary to think about. The back end of an affordable deal is non-existent nowadays. We still get our fee, but it is being paid over 13 years, we used to be able to easily pay in 7-8 years. 

Jun 28, 2022 - 9:45am
LIHTCLarry, what's your opinion? Comment below:

Good point. Some states have different fee/deferred fee requirements. I know the NH calculation results in a 50%+ deferred fee requirement, while other states have no requirements and simply like to see at least 10%.

Jul 5, 2022 - 6:26pm
TheDebtStar, what's your opinion? Comment below:

Just recently had to go back to the bank and ask for a 19% increase in loan size due to increase in construction costs for garden multifamily. Luckily rents have increased enough to bail us out that piece.

To further compound things, our equity backed out. Then we had a back up investor  who was a HNW individual who owns a tech business. He's no longer interested now that the tech market has gotten absolutely pounded the last few months. So now we're sitting twiddling our thumbs. 

  • Developer in RE - Comm
Jul 8, 2022 - 12:56pm

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