Real Estate Development Modeling
Hello Everyone,
I am curious to know how everyone underwrites and models a multi-family(mixed use with retail) development project. For example, if you or your firm is looking to acquire a current income producing project(future development site) and has plans on taking it down in the future, how would you value the property today and moving forward? When doing pro-formas for the development project you will be constructing in 2 years from when it is bought, there are many factors to look into such as construction costs, financing etc. I am aware of software such as Argus and Yardi which assist in the feasibility of the project. Is having software a must for development since it is the most specific and hands on project there is which involve many variables rather than an income producing property?
Bottom line, if you are acquiring a future development site, what steps do you think top development companies that are building large or even smaller scale multi-family projects take in achieving forecasting even though the future is not certain. What are the most important metrics in determining yield on the project. If anyone has any input or experience it would be highly appreciated. Also, any suggestions to what software or development model to use which is a good starting point to evaluate a development site. Thanks.
Generally speaking, developers traditionally look at NOI yields (stabilized NOI/total project costs) to determine if there is a sufficient spread between that return and exit cap rates. If spreads are sufficient to justify the risk profile (maybe 150-200 bps) a lot of developers will pull the trigger.
That picture is getting increasingly complex with interest rate volatility in the market and rising construction costs. Now, some developers may accept a lower NOI yield or spread over exit caps if they just like the market fundamentals. For example, in many West Coast markets, construction costs are rising quickly and projected to continue rising given the skilled labor shortage. That puts downward pressure on development pipelines, creating a potential supply problem, which paints a rosier picture for market rent growth. Even if a project misses the mark and the yields are tight, rising construction costs and lengthier entitlement periods are making it more and more likely that you will not lose money if you build sooner, since replacement cost is ticking up with no clear reversal in sight. You may not capture the risk adjusted return you are seeking, but you are not going to be underwater like a 2009 mortgagee in the Florida panhandle.
Going off of this. I built a dev model from scratch on excel and it is broken down into two "phases".
1) Development phase - this is a cash flow projection from the time you acquire site to the time you complete construction (delivery). During this phase, you are calculating your monthly costs, which then feeds into your monthly construction draws, which then feeds to your debt service (construction loan interest). Obviously there is no positive cash flow during this phase. Some people spread out there costs evenly during this phase. Some people believe hard costs occur in a "bell curve", there are a lot of soft costs to be drawn up front, etc. The distribution of your costs is very important because it dictates your construction interest.
2) Operation - This begins the day after delivery. You can begin receiving cash day one if you assume pre-leased units (I usually assume 15%), followed by your lease-up period which is derived from your leasing velocity (I usually plugged in 7.5% a month). Your expenses should kick in day one, and you are most likley still paying interest-only on your construction loan. It will be a while until you breakeven and start having positive cash flow. Depending on your mezz/equity, you - as the GP - will prob not receive a dime of operating cash distributions until you refinance or sell.
Exactly. Cost to build is known as replacement cost. If you can buy at a discount to the replacement cost, you probably wouldn't development new product unless you were in at an incredibly low land basis. This is why acquisitions heats up when the market turns--you can find properties at a discount to replacement cost and it's cheaper to buy than build. As supply and demand takes effect, asset valuations increase from buyers trying the same thing you are (acquiring) and development suddenly makes sense. When you see new buildings going up everywhere, it's usually indicative you're in an up cycle and potentially nearing the peak.
I've worked in both. To be honest, I think there's more room for error in Argus as there are a lot of toggles/functionality that one may or may not know about. If you understand the math and how to write formulas/self-audit and trace cell references, all you have to do is click through or hit F2 in an excel model to check the validity. Unless you are planning on holding the development for a long time (not as common as a merchant build model) and have to deal with a complex rollover schedule, you can usually do all product types in excel more easily. Just need to think out your planning /entitlement /construction /absorption(lease-up) phases and plug them into excel and it's not that hard. Depending on the hold period I use an equity multiple over an IRR as the primary metric. Even when DCF was viable (RIP) I would rely on excel and only plug everything into Argus as a sanity check on the returns to make sure everything was flowing correctly.
EDIT: This is for short term developments only in Argus Developer vs. Excel.... for an existing asset/deal I definitely use Argus Enterprise (since they forced me).
This really depends on your investment strategy as a company, and for a specific project. I can tell you what I personally look for, which is probably different from what the more institutional investors on this thread focus on.
We always like to have multiple exit strategies that give us optionality under different future market conditions. For most projects we are both a significant equity contributor and also the sponsor, so we underwrite conservatively (which means we do relatively few deals) and try to structure deals so we have the choice to invest more or divest at multiple milestones in development. Generally speaking we like to keep equity in a deal forever, regardless of scale, so we aren't purely fixated on exit caps. Cash flow is very much king for us, and on top of that we don't like deals where we aren't likely to realize our promote. Where does all this lead? We like difficult, unloved, non-competitive, high-barrier infill sites with a lot of potential for growth. We don't clip coupons. Our competitive advantage is in the quality of execution, so we can structure deals with non-market terms that give us some upside that wouldn't be available to merchant builders.
This generally sounds pretty scary to my institutional buddies, because it's ambiguous and driven by narrative. The deal structures are one-off, and the projects require a ton of active management. On the flip side, I don't control the market, so relying on cap rate spreads sounds pretty risky to me. It all depends on what kind of risk you are good at managing.