Development Spread vs Cash on Cash Return
Is it possible to have a development project that doesn't pencil out with a development spread, but it produces such a high cash on cash return that it still makes sense to develop and hold versus develop and sell? How do you think about this?
Unless rent growth hockey sticks, your scenario is unlikely.
What if there is favorable financing for new construction projects. For example, suppose you could get a 90% LTV amortized over 40 years. That seems like it would product a high cash on cash return, even if there is a tiny development spread. Do developers look at both build to sell and build to rent scenarios in their calculations or just development spread?
ROC / development spread is a better gauge for the profitability and attractiveness of an investment. You can manufacture higher cash on cash yields through higher leverage for any investment, but this is just financial engineering created by taking on more risk (leverage). Trying to make a bad development pencil by underwriting HUD financing is not a best practice IMO.
If a deal pencils out with the development spread in either case, then what's the motivation behind shops that build to sell versus build to hold? Is there ever a difference?
Some people want to monetize investments quickly, other people want to rip tax advantaged cashflow over 20-30 years. People tend to fall in the first group more when they are younger and move to the latter later in their careers (obviously this is a generalization).
Can depend on what the LP's looking for. Investors who are happy to take development risk can develop to hold so they capture the development spread and a higher CoC as a result. Depending on length of hold period, developer can often put their equity to the LP once it's built and calculate a promote off a valuation. If the developer also operates assets, they may be retained as asset manager.
At what point do you do a multi year real estate financial model for a development deal? Do you just look at the development spread only and that's it? Or do development shops normally have an excel model with monthly cash flows, loan draws, etc?
You look at the investment monthly. Development spread is back of the envelope. And I may say that I can sell this for a 5% cap rate In 3 years from now, and my yield on cost is 6%. So my trended development spread is 1% (100 bps). I will do a monthly cash flow model so I can understand my profit, equity multiple, peak equity, and IRR.
Let's say the average development project is 4 years - who is to say that financing will still be available when its complete? You can't assume market conditions will be the same when its time to refi.
It's not wise to depend on holding returns for a project with stabilization 4-5 years away.
I mean, you are essentially describing a situation where you build the property for its final value, meaning no developer's profit. Could this happen? Of course, but you are, in theory all else equal, better off just buying an existing building with that yield then taking all the development risk. Like why build, just buy!
Only scenario where this can make sense is when NOI growth is expected to outpace cost growth significantly. Developer participates in NOI growth starting from when they control the site and is not fully invested Day 1 like a stabilized acquisition, growth would have to be enough to account for lost cash flow during construction.
Many developers use growth to make deals pencil given how tight margins are, this is especially relevant on longer term phased deals where current day ROC is unattractive but future rents are expected to be much higher once an area gentrifies. This is why Developers look at IRR in addition to ROC because it answers some questions that spread to spot cap doesn't.
I think that's what OP was getting at but this would be like using Stabilized or Exit ROC if Untrended ROC doesn't make sense.
In a straightforward sense this is unlikely. There are definitely ways to develop a building and make a lot of money, even if the final product has no terminal value (which is what I'm assuming when you say "doesn't pencil with a development spread"). Perhaps you are charging above market developer fees (e.g. the LIHTC business model). Maybe you have a fully integrated company and you're taking points on property management and asset management and GC fees, etc... fuck, maybe you have a construction business you need to feed, and earning those fee and overhead dollars are worth it.
I mean in theory yes but very unlikely. If you build at a 4.0% return on cost but borrow at a -5.0% rate / high LTC you're cash on cash returns would be decent. Spread between ROC and interest rate should give a rule of thumb answer given decent LTC%>
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