Ground up development- Return on Cost
I've got a question on the Return on Cost Ratio:
We've got an unusual cap stack for our ground up developments - 55% GP, 45% LP equity split with 75% construction loan.
Our GP equity is made up of cash, plans/entitlements, etc. and accounts for roughly $2.5M in our cap table. I'm looking for an accurate return on cost to provide to a PE group and am wondering if our GP equity should be fully included in the ratio as a function of the cost. Appreciate the help.
I'm not sure of the answer, but my guess would be that return on cost is the return on the total cost of the project and not the equity?
Return on cost = NOI divided by Total Project Cost. Say you expect a development to generate $7MM in NOI but it will cost $100MM to complete it, your return on cost would be 7%.
You are confusing concepts here because how you split up equity contributions will not influence this ratio - say you borrow $65MM from a bank, that leaves $35MM in equity. Whether you split this 90-10% or 45-55% between partners, this will not change the deal’s return on cost (since it doesn’t change NOI or Project Costs).
Now a slight nuance to this is that if you happen to start changing how much you can/do borrow as a loan it would have an effect on the return on cost (also known as development yield) since Total Project Costs includes financing costs and interest. More debt = more interest expense = higher project cost = lower development yield.
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