Developing to a 6% Cap?
Sounds crazy doesn’t it?
It wasn’t that long ago when a 10% cap rate was the norm. If you couldn’t achieve a 10% unlevered NOI return on investment, it didn’t make sense to pursue an acquisition. But remember, that was for a cash-flowing stable income property asset. Not only are industry professionals today interested in acquisitions well below that old 10% threshold, there are veterans (even after having been through at least two real estate cycles) who are rolling-up their sleeves to make a development deal work at that low 6% level – without “blinking an eye” to the associated development, interest rate and market risks.
Well, as crazy as that sounds, the old principle of making sure a 2%+ spread exists between the cap rate and interest rate indeed holds true today under a 6% cap rate threshold. And, it doesn’t appear that commercial borrowing rates are positioned to sky-rocket (who would have thought that U.S. dollar LIBOR would reduce to 0.20%). But the more prudent way to underwrite these deals is by focusing on unlevered and levered IRR’s, using conservative assumptions. The latter measurement is down from the old 20%+ days, but something less than 15% today is still risky. If you can make it work at that level (ensuring a more reasonable return on cost margin), you would be well-advised to build and sell quickly so that you yield a reasonable developer’s profit – that is, before LIBOR starts moving north or your tenant leaves.
Start blinking your eyes.