What is PROPER underwriting process like for development projects

Recently joined a boutique developer in Toronto focused on the purpose built multifamily rental space. I'm from a corp banking background so CRE is new field for me with good amount of learning. The firm has some good projects/lands ongoing in the pre-approval entitlement phase.

I work with a small team responsible for the underwriting, financial analysis and capital raising aspect of the business and projects. So far have mostly been dealing with HNW type of lenders/investors who aren't as sophisticated based on the various diligence sessions I've sit through.

Ultimately, the firm/project portfolio will hopefully scale to a point where we raise capital from institutional guys incl. REPEs and REITs. By that point, I want myself to be able to answer any questions from these folks across the table in an intelligent manner. Short/near-term question is, how do I get there, in particular in an environment where no structured training is present?

Hence would like to leverage fellow monkey's knowledge, experience and guidance on the following as a start:
1. How do you properly underwrite a dev project (focus on multifamily rental)? A full explanation or documentation of the u/w process, e.g. what metrics, comps, etc would be analyzed, is most helpful
2. What are the key considerations when analyzing a multifamily rental project, from the perspective of a developer or acquirer (for either a development proj or stabilized property)?
3. For those in REPE and similar buyside, what goes into your investment memo?
4. Any other relevant guidance would be very much welcome.

Lastly, any Toronto-based monkeys, look forward to connect offline.

Appreciate all the feedback in advance!


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Comments (24)

Jul 20, 2020 - 4:36pm

Perhaps I'm not understanding the question entirely, but it's really just a matter of modeling the deal and seeing if the yield and investor IRR match or exceed the thresholds you and/or your investors are looking for.

There are tons of metrics that go into this, such as rent, unit mix, expenses, development budget, etc. as well as tons of assumptions like rent growth, absorption rate, etc. but that's all part of the deal modeling process.

If you need help learning how to model a deal, Adventures in CRE has some great templates and I believe WSO is launching one soon. If you need help on how to interpret modeled results, that's a bit more complicated because it changes from firm to firm, market to market, etc.

Commercial Real Estate Developer

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Jul 20, 2020 - 5:22pm

Appreciate this. I've gone through all the materials on A.CRE over the past couple weeks - useful resource for sure, but majority are on the mechanics rather than the underlying assumptions. I myself came from a corporate finance background, so I know the modeling aspect cold.

If I were to give you an example on what I meant by "proper u/w process" - at the time I joined the firm, for rent roll, the analyst on the team simply browsed MLS on recent leases for 2-bed units, and added, say $100 premium to account for the new-built/amenity aspect of our project. Rent growth - 5.0% p.a., because rents across Toronto have been growing at, say 3.5% p.a., and we believe the 1.5% p.a. premium is justified because our projects are major transit oriented and sit in neighborhoods with above average population growth. Then, these numbers go straight into investor pitch and other docs, and rarely get questioned.

Just compare this to how things are done in a corporate finance/M&A/financing setting where you benefit from multiple commercial DD (e.g. GLG calls, ER calls, consultant reports, etc.) and overall a robust diligence process to substantiate your assumptions, I've found it a bit challenging to match the word "professional" with how things are done at the lower end of the capital/tick size spectrum.

Most Helpful
Jul 20, 2020 - 7:26pm

Ah ok. This is a good question. You're probably looking at a combination of market norms, the realization that real estate isn't rocket science, and the exact level of unsophistication you suspect.

I can't really help you with market norms, particularly in another country. For example, if I saw market rent growth at 3.5% annually, and thought my site/project justified higher rent growth, I'd probably underwrite it at 4%, not 5%. (And a lender would probably stress it to 3%, or at least 3.5%) A 1.5% spread seems absurd to me, but perhaps it's not absurd in Toronto. Here in America, where rent growth is projected to be negative the rest of the year, flat next year, and then spike the year after, my company is no longer underwriting set percentage increases through lease up either in order to be conservative.

The "not rocket science" aspect is very real though. Real estate modeling is in large part a guessing game. Good real estate people make educated guesses. Great real estate people get lucky and beat their guesses. Getting the unit mix, rents, expenses, taxes, absorption, etc. right in the model is important to getting the deal financed, and you have to be able to justify your assumptions to debt & equity, but so much of real estate is in the execution.

You can make the most scientific model imaginable, but if your lease up is poor, or your delivery a few months late, or your budget gets blown, or you don't grow rents like you underwrote, it doesn't really matter how you modeled it. Even at the biggest shops, execution is far more important than underwriting. Underwriting is more like a floor or a bare minimum - getting it wrong is dangerous, but getting it right is far from a guarantee of success.

What you have to remember is that real estate has only become "institutionalized" very recently. For years (and really - decades, centuries, etc.) people made money in real estate because of information asymmetry. Even with a bare minimum of information, you were probably still more informed than the smuck across the table, and if you had a lot of information for the time, you capitalized on it - you certainly didn't share it. Depending on who owns your company, chances are it was like that when he was coming up - literally underwriting deals on the backs of napkins and being able to ballpark returns via mental math with the help of rounding some numbers.

It was like that for my bosses and they aren't even in their 60s yet. When I first started, there was a math error in the model we used because it was a Frankenstein creation that merged three different models together. Did it matter? Not really. I'd estimate that my bosses made $30 million+ each over the last decade. Maybe more.

You should always do your best to get the best information for underwriting. Get professional market studies. Tour comps. Talk to brokers, lenders, and equity partners. Read as much as you can and put all of the knowledge into the process. But at the end of the day? Put a lot more time and energy into getting fantastic drawings from your architect, having your GC price almost completed drawings so you don't get slaughtered with change orders, keeping your GC on schedule, being maniacal about budget tracking, and taking an active interest in lease up strategies.

The real numbers being good matters way more than the underwritten numbers being good.

Commercial Real Estate Developer

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Jul 20, 2020 - 6:29pm

I was hired a few months before the pandemic to be exact, so was lucky in retrospect. Obviously very different fortunes because of COVID for developers depending on the sector of focus. As far as CRE, multifamily and certain industrials have demonstrated strong resilience, and I've seen some postings (may have been converted into hiring as well) accordingly. But overall it's tough market, and majority of firms are on hiring freeze, if not layoffs already.

Aug 7, 2020 - 1:11pm

That's really lucky, I was hired by boutique residential developer before the pandemic too, but for an August start since I was finishing up my MBA and once the shit hit the fan my position has been put on "indefinite hold".

Jul 20, 2020 - 7:27pm
Are developers looking to hire now in Toronto?

Every real estate student in America right now:

perk up

Commercial Real Estate Developer

  • 3
Jul 22, 2020 - 12:15pm

1. How do you properly underwrite a dev project (focus on multifamily rental)? A full explanation or documentation of the u/w process, e.g. what metrics, comps, etc would be analyzed, is most helpful
2. What are the key considerations when analyzing a multifamily rental project, from the perspective of a developer or acquirer (for either a development proj or stabilized property)?
3. For those in REPE and similar buyside, what goes into your investment memo?
4. Any other relevant guidance would be very much welcome.

1. There is no way to really "properly" underwrite a dev project because it isn't a mathematical formula. Most of the underwriting relies on heavy assumptions (read: straight-up guess work), particularly because everything is so far into the future. As CRE said above, it isn't even necessary to be exact because execution will be more important.
  1. On a dev project level: Rents, supply/demand, new construction, construction costs (concrete v frame), confidence in ability to fully lease, etc. For an acquirer: rents, op ex/mgmt, quality of build, unit mix, location, revenue opportunities, etc. (It really depends on the acquirer and their intentions. Is it a pension fund looking for 3.0% yield, or a group of doctors looking to maximize leverage?). On a company level: where do we want to build/buy in the city? What's the long-term vision?

  2. Not in REPE or buyside, but IRR is a big one, typically on 5, 7, and 10 year horizons. A memo would have typical sections like: executive summary, location, asset description, acquisition terms, returns, assumptions, key risks & mitigations, and summary, then appendix that holds all of their market information / stats / primary analysis / etc.

  3. Ton of cranes in Toronto these days. Might be tough to find dirt at a price that makes sense, but as a boutique developer (+ what you said about +5% rent growth), I'm guessing you pay top dollar and promise to build bougie buildings with above market rents. Lastly, if your lenders and investors don't seem that sophisticated, it's because they probably aren't. They believe in Toronto as a city above and beyond believing in your individual proformas/underwritings. With that in mind, always have pretty pictures! Drones are a godsend these days to make nice packages.

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