RE Finance Question
I've searched the forum plenty but have not been able to find a comprehensive discussion on this.
How do you interpret development metrics such as Yield on Cost relative to other benchmark datapoints? For example, what would you take away from the below? Assume that the Development Project produces an investor's required IRR.
Projected Development YoC: 4.25%
10-Year Treasury: 3.65% Comparable Stabilized Cap Rate: 4.00% Debt Interest Rate: 5.75% Debt Constant: 6.25%
What I'm trying to get at is a way to quickly look at projected stabilized yields relative to other benchmarks and inform a path forward (or not). Maybe that's not the right way to think about this but would love to hear from you all.
Think of it as an acquisition deal and it becomes a lot easier. If you bought something at a 4.25% cap rate (dev YoC = purchase price cap rate in this scenario) and the interest rates are at 5.75% then you're going into a deal at negative leverage. Similarly, if your YoC is lower than your comparable cap rates of existing properties then you should probably just buy instead of develop.
Typically when people talk about development spreads they are looking at how big of a spread if the YoC over the stabilized cap rates and our general rule of thumb for our firm is we are looking for at least 150 bps spread. So MF in the SE is selling at like a 5% cap rate then we want to develop to a 6.5% YoC. You can also quantify development risk internally and add that premium onto a T-Bill, acquisition cap rate, etc. to figure out if it's worth developing and taking on the risk.
Got it. Thank you for your succinct response. This is really helpful.
How are you getting a Debt Constant of 6.25% with a 5.75% interest rate? 5.75% with a 30yr AM works out to a debt constant of about 7%, with a 40-yr AM it's about a 6.4%.
To piggyback off of other answers, development is much riskier than buying existing assets. There has to be a compensation for taking on the risk as well as compensation for giving up cashflows during development/stabilization and the amount of labor/brain-damage required to develop.
Comparing the YoC to stabilized cap rate is a quick way to figure out the profit margin and in some ways can be used as a measure to quantify the risk of development. For example if your YoC is 6% and the market cap rate is 5%, then the profit margin is 20%. From a risk perspective, as long as the income and cost assumptions are correct, cap rates could move as much as 1% higher and the project will still be profitable.
Thanks for this. The debt constant was made up as were the other numbers in my post.
To follow up - is it then fair to say that even if the project I described above meets IRR thresholds we should then use the YoC to risk adjust the project returns in a qualitative way? Meaning, sure the project is projected to achieve a 15% IRR but that IRR does not reflect the risk of a development project?
I can't imagine many circumstances where the project looks good on an IRR basis but doesn't look good on a YoC/Market-Cap basis. One example I could think of is by taking on a crazy amount of leverage at really attractive terms (since the YoC calculation does not account for leverage outside of financing costs). However if that's the case, that probably means that there are better projects out there that would perform much better with the financing available to you.
Est quia quibusdam et velit esse. In aut fugiat et non.
Corrupti eos consequuntur aperiam est. Architecto itaque ut sunt quos. Est eligendi qui iste voluptatum eveniet. Aut vel quia incidunt enim ut tenetur cumque autem. Hic consequatur magnam aut asperiores vero rerum.
Magni aut praesentium velit quas neque. Et cumque repellat incidunt ea. Aut voluptas eveniet est non. Optio debitis dolorem rerum repudiandae iusto aliquid qui.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...