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...
Can you guys go into more detail about what untrended means as opposed of just looking at YTC
Untrended = Month 0 or Current Rent without factoring in any future rent growth during the construction period.
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...
Slothrop Can you explain this further? So he'll be looking for opportunities where he can value-add and grow NOI where he knows an asset that acquired at a 8% cap rate trades at a 6% cap rate?
Or i am wrong?
Makes sense. Any deal that you can realistically underwrite to a 200 bps spread should be a no brainer
Wholeheartedly agree with this.
Best to not overcomplicate. Less is more.
With a 0% LTV note, the spread would ideally be zero
200 bps spread seems high. I'd say more like 150 bps using realistic assumptions.
As Sloth posted, unlevered IRR could be good to use to make sure the deal isn't getting too juiced up by financing. Other than that, people generally use unlevered discount rates for internal valuations, Broker BOVs, sales processes, etc. It's important in the sales process as different buyers will have different sort of debt limitations.
In fairness, the guy I was referring to works for a large GC that occasionally develops with their own capital, so they may only go for deals that are no-brainers, as stated above, since it's not their primary business.
From the perspective of a globally active institutional such as a pension or endowment, there's no preset required spread between un-levered and levered. The un-levered number is critical and needs to be adequate for the deal to make sense. If the institutional uses standardized hurdles in different markets then they are often un-levered. If the spread between levered and unlevered is too low for any given LTV, the investor may suggest using less or no debt because you're adding risk without adding adequate return. Would I rather have an unlevered 8% or a 60% LTV 10%? Most likely the 8% looks better on a risk adjusted basis.
Ugh, wish this thread were a week older. I just underwrote a deal to a 100 bps spread last week and now wish I had done 150. :/
Not necessarily a bad deal though. Remember you're underwriting based on assumptions. If you underwrite at worst case scenario then you have a great chance for the upside and a smaller downside - because you already expect the worst.
Unless the market really is dictating that 100 bps spread I'd say you're alright. If comps are going for that 150 bps spread then you're golden.
Don't know enough of the detail but I wouldn't be too too worried. Maybe just concerned - not worried.
In today's market, I'd say 100 bps spread between the yield on cost and the cap rate is decent. All of the development deals I am seeing are getting tighter and tighter. Mostly a function of the recent increase in LIBOR and the increasing construction costs. It's very rare to see 200 bps spread these days
That's ok, man. 150 bps is about all you can get in this 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.
I'm doing Inland Empire jetski dealership development deals with 25 bps spread between YOC and exit cap so.... take that as you will
Would love to hear the quantity you're doing a year and if you're a preferred developer. I'm sure those two things would factor into a lower bps spread.
I can only imagine the case study.
"The returns are hella rad, brah"
The case study? Nerd! What about the site tour!?
1) The unleveraged IRR is important because funds can lever or unlever at any time with portfolio debt. 2) To measure yourself against other investments you need a baseline yield. 3) The unlevered return should be appropriate or something in the underwriting is f'd up so it's also a check the box thing
The 200 bps spread to me seems really generous.... How are you guys winning deals at those numbers? Industrial and Multifamily right now are trading in the low-to-mid 4's in almost all coastal (or adjacent) markets. So a 200 bps spread would be a 6-something YOC/ROC. I haven't seen a 6 in front of anything opportunistic in those 2 product types unless you cross a state border...... or unless extremely risky product... so where are you finding these?
This. If I underwrite a new development deal and can get a 100 bps spread over exit cap with my untrended yield, I feel special. It’s that tough right now. Project level IRR above 17% at 55% LTC is unheard of in our market right now for multi.
are you getting institutional equity at those yields?
we have 5 developments in major markets right now with a 6-7.5% YOC. We do ground up.
but we are long term developer with low land costs, although we mark to market, so the costs should be the same.
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