Development Debt Impact on IRR
I am about a year into the job at a large London based developer. My role is focused on modelling acquisitions and JV's on land we already own. I am posting here to learn more about how borrowing tends to work at other developers, as I feel that my firm might be a bit conservative/not borrowing optimally. We typically develop on unserviced land, meaning that we build and install all required infrastructure, grading and piling. We do have an existing portfolio of assets that generate income, but these are highly levered so cannot act as collateral for additional borrowing.
We borrow at 65% LTC with fairly standard borrowing terms from large banks. However, we are always required to put our 35% equity into the project before we are allowed to draw down on any debt. We pay commitment fees throughout the entire project period, so our levered IRRs are often lower than our unlevered IRRs.
Are other developers out there (in the US as well) typically subject to the same conditions? I have seen a model from one of our JV partners and it looked like they managed to take out an acquisition loan on the same project (perhaps from a non-traditional lender) and they ended up with much better levered returns. Our treasury department sources all our loans so I have no transparency as to how this process works.
Either your margins are too tight already or that is some very expensive high street bank debt.
This is relatively standard.
From what I've seen in London acquisition finance for smaller projects will generally come in the form of non traditional lenders but some of the larger shops may be able to get it from the bigger banks. Given that the project is making decent margins from the beginning and the mixed rate is not too expensive, you are guaranteed to see higher IRRs.
In the case of the above, with the bank having first charge, you would typically have to pay them back first before you can pay back the non traditional lender.
That's pretty standard structuring for a land development deal.
yeah ill echo here as well -- you're pretty standard.
the LTC % can be pushed as high as tolerable by the banks and obviously also restrained by your firms appetite for capital risk.
RE the commitment fee, I usually fee it fully paid at the beginning of the project...not straight lined out during the entire development period
on the debt draw side...mostly all banks will make you draw down 100% of your equity before you start touching debt. I've worked on a few deals where the bank would let you draw debt while you concurrently drew equity. Meaning the lender would let you draw on specific line items, and equity on the others. So during that month the equity contribution was just based on what costs were actually drawn that month. but again that was a large master development, NOT your basic mf dev deal.
you made a comment about the IRR and debt. It's worth nothing that putting your equity up first is better for the returns on the project from a capitalized interest perspective. Meaning, the longer it takes to draw the debt means the less your Outstanding Balance is which translates to a lower interest/capitalized interest expense.
The break-even of this effect on how it translates to a better or worse IRR of course depends on the significance that piece.
> you made a comment about the IRR and debt. It's worth nothing that putting your equity up first is better for the returns on the project from a capitalized interest perspective. Meaning, the longer it takes to draw the debt means the less your Outstanding Balance is which translates to a lower interest/capitalized interest expense.
This is pretty much a moot point because your debt is always going to be cheaper than your equity, otherwise you wouldn't be using debt.
agreed -- I'm referring to how the timing of your debt draw effects the O/B which effects your capitalized interest...thus your returns/IRR.
Thanks everyone on the responses.
Appreciate knowing that the equity before debt contribution is normal.
Also good to have the feedback on the levered vs. unlevered debt. I need to properly go through our debt modelling with this in mind to figure out why we are showing lower Levered IRR's in some cases. One thing to note is that this only occurs for developments that have already started but that have been delayed slightly in the infrastructure/early construction stages. I think it might have to do with this delay. In all the models underwriting new deals the levered IRR is higher.
In terms of the commitment fees, we do model them as a quarterly expense... definitely questioning whether this is right after reading the above. Will try to sit down with our treasury department and get them to explain to me logically why they have told us to model it like this. They are all from an accounting background so sometimes tough to get them on the same page as us for cash flow modelling.
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