As the title says - at what point in the development process do you obtain quotes for construction? Trying to underwrite a project that would require consolidating two adjacent parcels and demoing the buildings, with the intent to build a 6-storey mixed use multifamily building. The current model uses average construction costs PSF as published by Altus Group for my city, but the levered IRR and equity multiple are too low to make it worthwhile (9% and 2.0x) - don’t think this is accurate as the area is seeing a lot of other similar projects in pre development stages. Is it typical to start talking to GCs this early in the process or would they view it as a waste of time/rub them the wrong way?
Thanks
50% of CD’s?
I think it’s best to have a pre-con estimator on the team starting during entitlements when you’re doing SD and DD. Their cost guidance will inform your design choices. And you’ll work with them all the time while the architects are working on construction documents.
If adding someone to the team wasn’t an option, what type of companies do pre-construction estimating? GCs or consultancy?
For context I work in brokerage and have limited experience on the development process. Would be looking to find an experienced developer to JV with, but before doing that I want to cover all the bases that I can to avoid being taken for a ride. One of the parcels is owned and the other has an owner open to selling.
I would think you would need to have an architect/land planner/site planner very early to help figure out what can fit on the site, etc. A basic massing plan and site layout is really needed to do basic feasibility. Generally a good architect and engineer should be able to give you a good assessment of construction costs. Still, if there are complex items or unique things to fix (like geo technical issues) then you may want those consultants on board early.
This is the fun part of development, you get to spend money before even landing a deal!
To me, if your model is spitting out returns that low (9% levered IRR; 2.0x property level equity multiple - that doesn’t seem too, too bad multiple at this stage), and you somewhat based your Hard Costs to an index (making sure you are not confusing $ per net rentable sf and gross sf), then your problem should be focused elsewhere. Dealing with a construction firm this early in the stage might be overkill (where are you on drawings? Conceptual?). When would I use Pre-con, that is a different subject.
Check your revenue assumption. Development is mainly all about the revenue. I wouldn’t be surprised if developments don’t pencil.
Your 2.0x equity multiple (I’m guessing you’re looking for a 2.5x property level, a 2.0x LP and 3.0x+ GP) but 9% lev IRR seems like you have a timing issue, maybe capital too front loaded and your debt LTV might be off.
9% IRR, what is the hold period? 10 years? Or merchant build like 4 years (should be higher IRR). If on property level you 2.0x equity that means you added 20-30% profit when you sell considering the leverage and divide that over say 4 years for a merchant build that should be around 18% lev IRR (use the Rule of 72 for mental math: 72 / 4 = 18%).
Something is off and I believe it is timing related. Check your predevelopement timing, your construction S curve and timing of when construction debt hits. You might have a calc error somewhere, most likely in your financing cost line item. There could also be an error in your absorption assumption and a conflict with your stabilized occupancy timing and exit.
Thanks for the help! When you say you wouldn't be surprised if developments don't pencil, why is this? Some of the clients we work with target a minimum 15% levered IRR for value-add deals so I imagine a 20% minimum would be a good target for opportunistic/development? They say they won't pull the trigger unless it pencils.
Revenue assumptions were based off of asking rents from a similar project a few blocks away so I can't really push those numbers. I can probably push the management fee but I'm not sure what the standard would be for the multifamily portion. 3.0% of EGI seems standard for commercial in my market. Hold period is 10 years and the returns are reduced for any shorter holding period. However, I haven't checked what a merchant build would look like - I'll try this shortly.
I haven't broken it down into a waterfall yet as I'm not sure what type of structure would be offered. I'm trying my best to do the work of a GP but expect to be offered the returns of an LP, maybe marginally better. For now I am only focusing on project level returns
I think you're right about timing being the cause. You say the capital may be too front loaded, but how do you overcome this? To my understanding, all equity has to be deployed before you can start drawing on your construction loan? My current model has all equity (LTC of 60%) deployed by month 5. Land acquisition occurs at month 0 and accounts for 15% of total costs or 37.5% of equity - does this seem high? Underground parkade construction starts immediately after rezoning in month 3 (2 months), followed by ground floor retail (2 months) and 5 floors of multifamily (1.5 months per floor). Construction is complete in Month 13 and lease-up period is from month 13 to 20 for a total of 7 months. Refinancing occurs at stabilization in month 20 at 70% LTV.
I do have S-Curve modeling built into the model and the chart looks like an M with the left vertical higher than the right. Standard deviation for hard costs is set at 2.5 and soft costs at 9999. I've checked the model multiple times for errors in calculations but can't seem to find anything - all of the checks are working correctly. If I were to put money on the cause it would be my lack of construction knowledge/timelines. Maybe its time to pick up some books...
9% 10-year lev IRR; I haven’t looked in a while but doesn’t seem all that bad (600 bps over the risk free rate???; 200 bps over S&P avg???). I know some REIT funds that target a 10%-11% lev IRR so might be in the ballpark on a longer hold.
I think that’s your answer for the lower IRR. The 10-year hold. The equity multiple seems low if it accounts for operating cash flow over 10-years. My merchant build gut check won’t apply then.
The timing of the equity disbursement seems ok (I spent about 2 mins thinking over it so caveat). How big is your project? 13 month construction period with subterranean garage seems really aggressive. Still that shouldn’t move the needle on a 10-year hold IRR very much.
You might be solving for a 10-year but need to sanity check a merchant build IRR. If you shorten the hold to 3 years (since you go vertical almost immediately); your IRR will pop.
Your refi at stabilization should juice your 10-year IRR unless you don’t count cash out equity distributions.
I say developments don’t pencil because the returns are too low. A lot of institutional investors look at Unlevered development yield (also called current yield, stabilized but untrended NOI / Current Dev Costs) because your timing, trending and debt assumptions can be all BS. I would look at the spread to spot caps (what is the cap rate of similar asset sales in your market).
As an analyst your job is to not only plug in Accurate assumptions to the best of your ability but to also visualize the asset on those two parcels as it would be magically built today. It takes time.
I say things don’t pencil because the development yield spread to spot caps don’t justify the development and lease up risk. Each market has its own. Now your investors might not be so institutional so different kinds of capital can still play (hence 10 year holders, focus on equity multiple). The merchant build hot money might not be there. Part of your job (or your boss’) is to identify which pot of money to seek given the market cycle.
There are a lot more nuances to consider with the modeling. Might as well DM me and talk on the phone. I’m more of a West Coast urban infill developer, for context, so what is achievable in other markets (like Texas) even that blows my mind.
We usually prep our GC's early in the process when we have Schematic Drawings, and they will typically give a shoot from the hip quote. Unless you have a relationship with a GC or can demonstrate that the deal will likely get built, they probably won't want to give you to much of their time on it. I've seen GMPs get signed at 50% CDs, close to the quotes that they gave at ~80% DDs. For preliminary purposes, I would call some GCs and ask them if they have any similar projects and what it cost to build. I find Altus and RSMeans are all over the board when trying to get prelim hard costs.
It's very typical to ask for GC's for concept pricing based on a rough site plan before you are in intensive design efforts. We do it on 100% of projects and new pursuits. You just need to establish a baseline relationship with a couple of solid local contractors and walk them through your process with the intent of explaining you are trying to build a longer term relationship with a builder who can help you with the project over time.
Getting GC attention for these types of exercises is much harder if you have an in house GC.
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