When constructing a waterfall and thinking about IRR hurdles, how do you account for pre-development costs? Construction may start 1/1/2020, but before that there could be land acquisition, architecture and legal fees, etc that go back months or years. How do you accurately account for these costs?
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You just accounted for it. Internal IRR calculation should start the moment you put real money out the door (e.g. maybe not the gas money you spent to get to a building to do a site tour). Most of the time, you're putting that metric together for an investor, who won't care about the "deal" IRR, but only the return their money is making, so it still makes sense to start the calculation at construction closing, or whenever your investors fund. Obviously if you ask LPs to fund pre-development expenses, that starts the ticker earlier. We generally pre-fund that stuff and ask LPs to pay us back pro rata (or bake it into the deal budget, obviously) at closing. Funding predevelopment expense is one of the risks of the business.
The waterfall is simply distributions less equity contributions Equity contributions should include the development costs you described.
This.
Your cash flows should span from the moment you start spending money. Most development/value add models will include a month-by-month pro forma that covers pre-construction, construction, lease-up, and then cash flows after stabilization/refi. All of these are considered in calculating your IRR.
If you were trying to bring in an early investor to fund these costs, how do you appropriately compensate them for this? You can give them a piece of your promote, but they are entering the deal earlier relative to the LP, giving them a longer investment horizon and reducing their IRR. What is the simplest way to model an investor funding pre development costs?
A common way would be for them to be a Co-GP and get similar returns to you.
Agree - Co-GP if they're willing to stick to end of deal. It would be unusual for a party to come in prior to other LPs and take more risk without getting better compensation either up front or back end.
Generally they get to come in at a lower land basis because those costs will increase your land value.
I 2nd Ozymandia - It's not uncommon for a developer to fund predevelopment expenses and get reimbursed for most of it at the equity/loan closing, not so much labor or overhead, but A&E, 3rd party reports, legal, etc. There is usually not a JV agreement in place until the deal is very real and you've already spent a lot of predevelopment dollars.
I would charge some carry rate to these costs until closing and include as line item at closing. A carry rate on costs of at minimum whatever the LPs preferred return is but ideally something more like a respectable IRR hurdle like 20-30% because these are higher risk dollars in the deal. If the deal is good enough, LPs will not put up a fuss if big picture predev costs are small % of total budget. Some lenders might not allow a carry charge in their budget just like some don't like funding development fees up front.
The pursuit cost you outlined get factored into the capital budget with becomes the uses in the sources and uses.
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