There are a number of people on this forum associated with real estate development. Some are real estate developers. Some are involved tangentially. Others want to get more involved. It would be interesting to hear your stories on getting started, or what you've learned along the way, or if you prefer to stay involved tangentially and if so why. But let's start with the basics.....

 

Underwriting 101 for non-finance folks

 

If you know how to design or build a building, but don’t how to judge whether a project is a good financial investment or a waste of time, read on!

 

1.The Proforma

 

2.Underwriting

a. Market Study

b. Yield Study

c. Profitability Metrics

d. Sources and Uses

 

3.Fundraising

a. Debt – Local/regional banks vs private lenders

b. Equity - Self Funding vs taking on investors

 

Section 1 – The Proforma

 

Below is a simplified proforma for a small development project. Don’t let the numbers scare you – we will break it down section by section, using simple examples.

 

To start, let’s pause and understand the mechanism for value creation in real estate development:

Yield on Cost - Cap Rate = the Development Spread

(Net Operating Income aka NOI / Cap Rate) - (NOI / Yield on Cost) = Value Created

 

Here’s a simplified example showing the development spread in action–

1.You build a $600k project all cash, lease it up, and clear $60k per year (10% yield)

2.You find a buyer who is willing to pay $1mm for a leased building that clears $60k per year (6% cap)

3.Congratulations, you created $400k of value.

(60k NOI / 6% cap rate) - (60k NOI / 10% Yield on Cost) = 1,000,000 - 600,000 = $400,000

 

For those who haven’t seen these terms before, they are defined below:

 

Stabilized Net Operating Income is the annual net income received from your rentals after deducting vacancy costs and operating expenses.

 

Stabilized Net Operating Income = Rent at full occupancy (aka Gross Potential) – Stabilized Vacancy - Expenses

 

Yield on Cost measures the investment yield of the asset to the developer, or how much annual profit the stabilized project will generate relative to its Total Cost.

 

Yield on Cost = Stabilized Net Operating Income / Total Project Cost

 

Cap Rate measures the investment yield of the asset for the end buyer, or how much annual profit the buyer is receiving relative to their Purchase Price.

 

Cap Rate = Net Operating Income / Purchase Price

 

Was this worth the headache? That ultimately depends on what you and your investors are looking for. But here are a few metrics we use to determine that:

 

Section 2 - Underwriting

 

Underwriting is the process of running the numbers to gauge the profitability of a potential investment and see if it's worth the brain damage and the risk

 

Your goal in underwriting is to identify all of the assumptions necessary to make a profitable project that is worth the brain damage and risk it takes to do it.

 

The first step in underwriting a development project is to calculate the yield on cost and compare it to the cap rate.

 

Calculating Yield on Cost

The first step for calculating the yield is defining your rent and occupancy assumptions by commissioning a market study. This report should define the boundaries of your market and assess the rents and occupancy within it. If the market study shows there’s a ton of vacancy, then you may want to skip that project.

 

Once you’ve confirmed the rents and determined you have a reasonable chance at leasing up, the next step is to define how much square footage you can build by commissioning a massing study. This study should determine how much rentable square footage (rsf) you can squeeze out of the site. Generally speaking for infill markets - the more density you can build, the more your property will be worth.

 

Next, get out in the market and talk to people. The fun part about real estate is that it’s a people business – you have to talk to people to learn the market. Here are some things you’ll need to find out to complete your underwriting:

 

1.Vacancy and expense assumptions for your asset type in your market.

2.Total cost to build (including fees).

3.Cap rates for similar projects

 

With this info in hand, you can finish your underwriting. Multiply rent by total rsf to get gross potential rent, then subtract vacancy and op ex to calculate NOI (Net Operating Income).

 

Divide NOI by Cap Rate to get your projected sales price, and compare to your all in cost. This is your total projected profit. Is it worth your time? That depends – to learn how to answer this question, please read on below.

 

Determining if a project is worth pursuing

 

To determine if a project pencils, you need to consider the following things

1.Who will the investors be (if any) and how long are they comfortable holding the asset for?

2.How long is the holding period?

3.What are the returns?

4.What is the risk?

 

Defining your Hold Period

 

Your business plan can vary dramatically depending on you and your investors goals. Here are the two primary plans:

1.Long term hold – Hold the property for cashflow, enjoy the tax benefits, and ride out long term rent growth. This is best for HNW folks who don’t need their equity back anytime soon. This maximizes total proceeds.

2.Merchant build – Sell the property as soon as it’s leased up (or sooner). You will be selling for a lower price / ft than if you hold it a long time, but you will get your money sooner.

 

Calculating the returns

 

Once you know your goals, here are 3 metrics you can use to gauge the profitability of your project.

1. Cash on Cash: Net Cashflow / Total Investment. This is your actual cash yield from the asset. You can compare this to owning a bond – it’s the actual % return you are earning on your money while it’s tied up in the asset. Depending on your situation, you may be able to include tax benefits in the numerator, further driving cash on cash for your investment.

2. IRR: total cashflows annualized over the hold period. The shorter your hold, the higher your IRR. Shortening hold period drives IRR more than increasing sales proceeds does. Most Real Estate Private Equity Firms derive their compensation from how well they perform on this metric. Most investors want to see 16%+ IRR for development projects, but some huge developers find investors willing to accept as low as 12% for trophy assets.

 

3. Equity Multiple: Total Distributions (net cashflow + proceeds from sale) / Total Investment. Generally speaking, the longer you hold the larger your multiple will be. Fully leased and seasoned properties generally command a higher price per square foot than newly delivered product because they have less lease up risk. Rents also tend to go up over the hold period, and each $1 of net rent can add $10 or more in sales value. (Remember, NOI / Cap Rate = Sales Price)

 

Most investors want a 1.4 minimum multiple, or else it’s just not worth the brain damage and the risk.

You can compare this figure to 10 year treasuries. Most investors want to earn a spread over the treasury (T+ 1% at least) to make development worth the risk.

For long term holds, you are focused on maximizing cash on cash return and total multiple.

For merchant builds, you are focused on IRR subject to a minimum multiple.

 

Risk analysis

 

Here are some questions I like to ask in order to determine if the returns are worth the risk

1.How much is my total investment?

2.How conservative are my underwriting assumptions?

3.How long will the project take to reach profitability?

4.In a worst case scenario, how bad can the deal get?

 

Be careful when you are underwriting high IRR projects with big budgets and short holds. The total multiple might be low, meaning there’s a risk of asset value being lower than your total cost to build should the market turn on you.

 

Section 3 – Fundraising

 

Once you’ve underwritten a project that appears to meet your team’s goals, the next step is putting together the Sources and Uses. This table summarizes the total project budget as well as the total sources of capital for funding the budget.

 

Sources, AKA total budget:

You can put a bracket on these figures by asking for data points from architects, loan brokers, and GCs.

Uses, AKA capital stack used to fund the total budget:

Generally, development projects are funded using a combination of both debt and equity. A loan broker can provide data points on how much you will be able to borrow to fund your deal.

 

Sources of Debt

1. Local bank / Credit Union – lowest rates but will require you to personally guarantee repayment of the loan (aka recourse). This is typically the best execution available for loans of under $5 million, but they aren’t always open to funding construction costs.

2. Private lenders – high rates and high fees. This is sometimes the only group willing to make small construction loans.

 

Sources of Equity - the example attached proforma assumes you are self-funding. Many sponsors raise Other Peoples Money (OPM) through syndications or joint ventures (JV), which greatly reduces the sponsor’s total capital investment. Structures using OPM could be the topic of their own post, but I will provide a simple comparison of OPM vs self funding below

 

1. OPM: spread the risk, spread the reward. This requires complicated legal documents and a higher admin/accounting workload than if you fund the deal yourself.

2. Self-Funding: all your money, all your risk, all your reward. Simplest execution, least amount of legal and admin headache.

 

 

Source: Mason Equity Partners

 

2 hours ago, KJP said:

Sources of Debt

1. Local bank / Credit Union – lowest rates but will require you to personally guarantee repayment of the loan (aka recourse). This is typically the best execution available for loans of under $5 million, but they aren’t always open to funding construction costs.

2. Private lenders – high rates and high fees. This is sometimes the only group willing to make small construction loans.

you typically are not going to get non-recourse for the construction part of the project. Most of the time, this developer is going to put a traditional bank loan/credit union loan or use a hard money non-traditional investor or bridge loan to finance that part of the project. Only after the project is complete and stabilized will you typically put non-recourse debt on the deal.

 

The one other key thing that I think the your post does not adequately address well is the working with government entities and the time factor to being able to build. This is the biggest challenge with any development and can take years from the time a project is proposed to get the shovels in the ground depending on its scope.  Certainly, building a single family home in an existing subdivision is pretty cut and dry and can a permit can be issued in within a couple of weeks (if the paperwork is filed correctly and people do not ask for any strange zoning variances). Commercial properties will take much longer and have to go through a city/township approval plus get county approval and EPA approval for storm water runoff. Some states have state level approval as well (Indiana) which complicate things even more.  

 

 

Or dealing with NIMBYs, which you may be referring to in working with government. 

On 7/23/2023 at 7:30 AM, KJP said:

Or dealing with NIMBYs, which you may be referring to in working with government. 

Not just that. Mostly just having to navigate the development process. You have to get city/township approvals, county level approvals, EPA and state agency approvals, you have storm water approvals, etc. This is even without NIMBYs. If you know what you are doing it is mostly form driven but it takes time.  NIMBY's certainly play a role as do the egos of the politicians and economic directors. Throw those in and it is even more involved. Much of it is very relationship driven. Get to know the development directors in each town. There is a lot of horse trading that goes on too, and sometimes the developer who is not experienced may give away too much on the project to make it economical but be stuck developing it in a certain way to satisfy the politicians (and I do not mean that to sound negative but if you do not know what you are doing, you may compromise on certain things the NIMBY's may want to get the project going but then it drives the cost up so much that you can no longer make the development profitable). 

 

Again, not as big of a deal on an apartment rehab or single family but more significant for larger developments

The curriculum in the OP looks good; but, in my limited attempt at development in Cleveland, my biggest problem (never solved) was finding a builder willing to participate in the deal. I wanted to use an innovative material and was willing to fully finance the deal - all I wanted was a builder willing to take a part of his compensation out of the final proceeds. 

 

Never found one.  Was it an unreasonable expectation?

From Sean Sweeney, Minneapolis real estate developer....

 

Everyone wants to be a real estate developer.

 

It’s sexy. 

 

The financial upside can be enormous.

 

Famous developers are treated like gods. 

 

Even modestly successful ones get treated way too well and get way too much credit. 😉

 

It’s the dream for a lot of real estate people.

 

But the day to day reality is quite different.

 

Can you stomach going years without getting paid?

 

Can you sign a recourse loan knowing if the project isn’t successful you might go bankrupt?

 

Can you do that over and over and over again?

 

Can you spend hundreds of thousands of dollars pursuing a project, only to see it not get off the ground? 

 

What if that happens twice in the same year?

 

Can you face the wrath of your neighbors in meetings? 

 

Where they yell and curse at you? 

 

Where they call you the devil?

 

Can you manage every single detail of a multiple year process, knowing that one slip up can derail the entire thing?

 

My advice to most is not to become a developer.

 

Buy existing assets with non recourse loans.

 

Build a portfolio over time.

 

Get wealthy.

 

Sleep well.

 

Only become a developer if you’ve tried everything else and know in your bones it is what you want to do.

 

Then do it!

_____________

 

More.....

 

If you are one of the crazy people who want to give this a go, the world needs you.

 

We are short roughly 6.5 million housing units in our country.

 

Developers are going to be the ones to build those units.

 

That's the only choice as it stands now.

So get educated.  Learn the ropes.

 

Go work for a developer.  Understand everything they do.  

 

Then go do it yourself.

 

In the meantime, there are resources for you.

 

Join a peer group at joincohorts.com

And/or sign up for my free newsletter at thebrightbuild.com

 

Go change the world!

Wondering what could be ongoing in the Chillicothe OH area as for rehabbing older fixeruppers or remodeling/ subdividing bigger dwellings. Would prefer to join some of those and to work for their improvements. Me mid 40s, good team participant, well with supportive and preparatory tasks for internal structures. Might get in touch at rebersa798 ataol...

Albert.