Underwriting development spread and IRR
I've got a couple general questions related to underwriting. I know any answer ultimately depends on the specifics of any deal so I may risk asking for overgeneralizations.
- I've heard that developers require a minimum of about 125-150 bps spread between stabilized YOC and market cap rates. How does this spread requirement compare to value-add and core-plus deals? Would it be fair to say value-add deals usually have a spread of 75+ bps, while core-plus is closer to 25-75 bps?
- Additionally, are there any rules of thumbs when solving for a purchase price? I know it's nuanced and depends on the asset, market, etc., but I'm wondering if there's anything I could use if I'm asked to solve for a purchase price during a modeling test so that I don't completely miss the mark.
Following
Based on the most helpful WSO content, here’s a breakdown of your questions:
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.
Spread Comparisons for Value-Add and Core-Plus Deals:
Rules of Thumb for Solving Purchase Price:
While underwriting is highly nuanced, a general approach during a modeling test could involve:
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
its funny to read out loud the 'solve to purchase price' because when things were hot, we had to start with the highest number possible for purchase price otherwise there was no way we'd be competitive. Ass backwards it was
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