Today, we’re going to learn about real estate private equity models focused on development. Read each of these questions as if you were being interviewed, and practice our responses as if you were responding out loud. This is baseline real estate private equity for beginners, so make sure you understand this information cold before your first interview. After reading this, you will (i) understand the four main components of a real estate development model, (ii) know why construction is always considered opportunistic, and (iii) why time is such a critical assumption in a development model.
Walk me through a real estate development model
Development models have four main components: (i) cost to build, (ii) the construction and lease-up timelines, (iii) net cash flow during operations, and (iv) the terms of capitalizing the deal.
For the first item, cost to build, you must consider the land, entitlements, design, permitting, and construction, but the time involved in each is critical as well. The second item, the construction and lease-up timelines, determine exactly when you intend to spend your costs, and when your building will be complete enough to begin recruiting tenants. Merchant build models generally forecast a sale of the property at the immediate end of lease-up upon stabilization. Timing is crucial for your IRR.
The third item, net cash flow during operations, will need to take into account when leases are signed, the amount of TIs and lease commissions involved, and when rents begin. Developments will operate at a net loss until their occupancy breaks even, so it’s important your investors understand they will need to fund this operating loss until it is covered by rent. On the expense side, good estimates of operating costs such as insurance, maintenance, and property taxes are critical.
Finally, the terms of the full capital stack have to be incorporated, including construction and permanent financing, mezzanine debt, if any, and the equity. Many times, the equity will be complicated in development deals, with general partners and limited partners, promoted interests, preferred returns, and tiered waterfalls.
Why are projects that involve construction automatically considered opportunistic?
Construction brings a new set of risks to a project that must be mitigated. Cost overruns, entitlement and permitting, weather, material shortages or price swings can impact the budget or the timeline or both. Furthermore, there’s no definite way of knowing if your costs justify the future rents until you can actually start leasing out your space. Just imagine if you can’t hit your target rents, you could build an entirely new building, only to realize you’d be lucky to break even at the sale value implied by your stabilized NOI and market cap rates. These increased risks inherent in construction projects require higher compensation to the equity ownership in exchange for taking those risks. That risk profile is what pushes those deals into the opportunistic strategy.
Why is time such a critical assumption in a development model?
Development projects require a considerable amount of time where there is no revenue, and cash is being invested in construction of the property. In many projects, there can be years between the time that capital is first invested until the receipt of first rent. Additionally, the first dollars invested are usually the equity, and those dollars carry the highest return expectations of the entire capital stack. Thus project delays are very expensive, especially since most developer GPs are compensated on IRR hurdles, which are heavily influenced by timing. Yet limited partners are also greatly impacted by delays since their equity, too, is generally tied up in a fund structure with its own IRR hurdles.
Take it to the Next Level with Leveraged Breakdowns
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