Underwriting development spread and IRR

Based on the most helpful WSO content, here’s a breakdown of your questions:

1. Development Spread Requirements:
   Developers typically aim for a spread of 125-150 bps between stabilized Yield-on-Cost (YOC) and market cap rates. This spread accounts for the additional risk and effort involved in development projects compared to stabilized assets.

2. Spread Comparisons for Value-Add and Core-Plus Deals:

   • Value-Add Deals: These generally target a spread of 75+ bps. The higher spread reflects the operational and renovation risks associated with repositioning or improving the asset.
   • Core-Plus Deals: These are less risky than value-add and typically aim for a spread closer to 25-75 bps, as they involve stabilized assets with minor enhancements or operational improvements.

3. Rules of Thumb for Solving Purchase Price:
   While underwriting is highly nuanced, a general approach during a modeling test could involve:

   • Backsolving from Target Returns: Use the required IRR or cash-on-cash return to determine the maximum purchase price.
   • Cap Rate Approach: Divide the projected stabilized Net Operating Income (NOI) by the market cap rate to estimate the purchase price. Adjust for any value-add or development costs if applicable.
   • Development Spread: For development deals, ensure the Yield-on-Cost exceeds the market cap rate by the required spread (e.g., 125-150 bps).

Remember, these are general guidelines, and the specifics of the asset, market, and deal structure will ultimately dictate the underwriting approach.

Sources: Is there an ideal spread between Unlevered and Levered IRRs?, REPE Interview Question: Evaluating whether to carry out CapEx?, https://www.wallstreetoasis.com/forum/real-estate/what-are-your-big-problems-right-now?customgpt=1, Alternative Lenders & the End of Risk Taking for Banks - Opportunity or Risk?, Spreads on New Multifamily Development