This is in regards to a ground-up multifamily deal. Do investors (in this case, institutional equity partners) look for a healthy spread between these two metrics? I would imagine if the levered IRR and untrended yield-on-cost meet investment criteria, the unlevered IRR would not matter. The boss has asked me to investigate this as we begin to seek institutional equity.
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For any deal, construction or not, I'm primarily concerned about unlevered IRR to make sure our partner isn't juicing returns with excess leverage. Not looking at the spread between levered/unlevered so much as asking whether the deal makes sense, period. This is an oversimplification, but if there's basically no return without leverage, it's a bad deal.
I think you're generally on point though with respect to the rest. For a ground-up deal I'm primarily going to be concerned with untrended yield-on-cost using realistic rents, and your basis versus where new product has recently traded.
Feel free to PM me if you want to talk more. Pretty sure we're in the same market, so I'm probably going to end up on your list of people to call soon anyway...
The biggest driver for the company I was a summer associate at was yield, almost to the point that nothing else, including IRR, mattered. If the could hit their yield target, the deal would be financed (Carlyle, Goldman, AIG, etc.) .
This is legit, too. I know a guy who runs new development for a large builder and he said he doesn't care about IRR, etc. to the point where he doesn't even put a forward looking cash flow model together. He green lights a project if he can conservatively underwrite a yield-on-cost 200 bps above current cap rates. That's it. His opinion is that my forecast exit ~5 years down the road is BS. Kind of a hard thing to argue against...
Think of yield against cost for a development project as you would in-place cap rate of existing asset. Yield on cost is cap rate for stabilized (income producing yr 1 at expected occupancy) development project.
If multifamily assets trade at 6%, you only want to undertake a multifamily development project with a yield on cost of >=8%. Depending on situation I'll undertake at 150+bps to market.
Development Spread is also a function of the initial Yields to begin with.
Example 1
Location: Secondary
Yield-on-Cost: 7.50%
Exit Cap: 6.00%
Development Spread: 150 bps
Development Premium: 25%
Example 2
Location: Primary
Yield-on-Cost: 5.00%
Exit Cap: 4.00%
Development Spread: 100 bps
Development Premium: 25%
It's worth prefacing a development spread with the general cap rate environment. a 100bp deal in SF could yield the same profitability as a 200bp deal in Phoenix.