Underwriting Development Deals in Today's World

Someone sent me a development deal in LA for $1M. Here is how I looked at it for a market rate development:

It's a 7,250 SF lot zoned R3. No TOC but we can utilize the state density bonus program.

After setbacks, 1st floor buildable area = ~4,350. R3 allows for a base FAR of 3:1. As part of our entitlements, we would request an increased FAR to allow for a 4.05:1 in lieu of 3:1. This means we would have about 17,500 SQFT of gross buildable area.

I feel this particular area needs ample parking, so I figured we could get about 15 parking spots in a subterranean garage (15*475sqft per spot = 7,125 < 7,250).

Land costs: $1M ($60K/unit)

Hard costs: approx $315/foot or $5.5M ($323K/unit)

Soft costs(architect and engineering, permits, fees...etc): $650K ($38K/unit)

Carry costs (assuming prime + 1 or 9.5% rate and lower leverage bank debt of about 50% LTC): $550K ($32K/unit)

So we're all in for about $7.5M.

We could build ~17 units. 14 units + 3 ADUs. We will need 2 affordable units.

I figured the following unit mix: 3 studios (ADUs) and 14 two bedrooms.

The studios could probably rent for about $2K/monthly in this area. Two beds ~$3K/monthly.

Gross rent about $550K + another $45K of other income.

5% vacancy and 1% credit loss = $562K Effective Gross Revenue.

I got about 33% for operating expenses or $188K annually.

This leave us with an NOI of ~$374K

Some further assumptions:

1)I assumed stabilization will occur over 3 months post construction with roughly 6 units rented per month

2) Construction will take about 24 months

3) Entitlements will take about 16 months

4) 5% exit cap rate (which I think is a bit aggressive but valid for the area)

5) 7.5% selling costs because the deal meets the ULA threshold

6) Sale upon stabilization

Based on this, the deal will provide a 4.98% ($374K/$7.5M) yield on cost & a negative 11% IRR. Even at $0 for the land, you would still only achieve a 4% IRR, and 5.85% YOC.

As you would likely think, we passed on this deal. Development today is HARD. A lot of the deals we're seeing make 0 sense even at a very attractive land basis. It's a function of interest rates, high construction costs, stagnant rent, elevated vacancy, and slower absorption to just name a few of the issues we're seeing today.