New Construction Due Diligence: What You Want to Check on Before Investing in a Deal

LP investments in existing multifamily had skyrocketed in popularity during the COVID boom of the asset class. For passive investors, investments in multifamily often came with some sense of security and typically a pretty good risk-adjusted return profile. However, just as I have personally shifted my focus more into the development space, I have noticed that there has been a growing hunger from some of my equity capital partners in chasing a more attractive return profile in the development realm.

Investing or operating in the development space can certainly be lucrative, but the risks are much higher than existing multifamily investments. Thus, I thought I would create a primer for retail investors who have considered diversifying their portfolios for potential higher returns to think through some key due diligence items about whether a particular deal makes sense to place capital in. Though by no means it encompasses every detail that you should consider, I think it’s a great place to start and really get a feel of whether the opportunity makes sense.

Let’s jump right in.

Business Strategy and Market:

o?? Business strategy of the project: At a high level, you should start by understanding the type of project this is, i.e. apartments vs condo projects. Now, you’ll need to dig deeper and think about what the positioning of the project as it relates to the local neighborhood

§? Is this going to be in line with other newer built properties in that area, where there is luxury product already built? ?

§? Is this going to be a new luxury product in a neighborhood that has not had it? For example, there is a developing area around where I live that has had some smaller townhome projects, but larger luxury apartments were an unproven product for many years. If this is the case, is the project you’re considering a trailblazer or is being built into a proven market?

o?? Hold period strategy: for something like apartments, is this a build and sell within a few years or is this truly a long-term hold (~5-10+ years)? Again, how does this fit into the market over a long-term period (i.e are there other similar projects right behind it, is this an anomaly in the marketplace)? ?

Layouts and Amenities:

o?? Layouts and unit mix: What kind of units is this project delivering? Smaller 1 beds/studios, or larger units like bigger 2 and 3 beds? ?

§? How does that fit into the market; is this more of a family driven market or more transient kind of population?

§? What kind of units do competitive buildings provide and how has their occupancy fared? ?

o?? Amenities:

§? Parking- how does this compare for the neighborhood? Does the project need it? Does it have it?

§? Amenities like outdoor space/common amenities: private outdoor space like decks vs common outdoor space

§? If dealing with smaller boutique projects, are there small differentiators (like common media rooms, work spaces etc.)

Zoning and permitting:

o?? What is the zoning with this parcel, and does it allow for the density/unit count that you need for the project

§? Is there additional relief that is needed from the city or is the project ready TO apply for a building permit?

§? If additional relief is needed, how far along in the process is the project in? What’s the risk that the project doesn’t get the relief (if investing prior to completion of entitlements)

o?? From a building permit perspective, how far along is this process?

§? Where are the construction docs in terms? of status? If they have not started, how long is needed to get all the docs in place?

§? Is the time and cost accounted for in the financial modeling (which we will take a deeper look into on another bullet point)

Debt:

o?? Has it been secured? If not, what is the status of it? Are banks looking for something in particular prior to commitment?

o?? If sourced, how does the debt look like for the project? Is it bank debt, bridge debt/hard money?

§? Is it a local lender? Does the lender understand the mechanics of the market?

§? What is the term of the loan? Is it purely a bridge and needs a refi to stabilization or is there some runway on the loan past completion?

§? LTV, interest rate, points

o?? Construction Loan: Does the developer/GP need to put the first amount of equity in the project early on before construction loan can be tapped?

Construction Logistics:

o?? At a high level, who is the GP/sponsor and what is their experience with this type of development?

§? ?If it’s a luxury play, do they have experience with this?

§? ?Have they operated or built in this market before?

o?? Is construction in-house or 3d party? Who is the GC and what does their book of experience look like in this market?

§? Have the built similar size/unit count and in that local town or area

o?? Will there be other project managers, or any other people involved with managing the construction?

Back-end Valuation:

o?? What kind of valuation analysis is done?

§? Look through critical assumptions in the underwriting to make sure no factors are artificially driving returns (high rent growth, low cap rate etc)

o?? What kind of cap rates are being used for the valuation? How do they compare vs not new construction in the area vs new construction in other pockets/neighborhoods?

o?? What kind of comps are being used to justify the projected rents?

§? Are they similar locations? Any differences like transportation, being closer to city center etc.

§? Are you comparing similar quality product? Ultra-high end luxury vs not?

§? Are you comparing condo rental comps (individual owners) that have nicer finishes vs apartment quality product?

§? Building amenities- parking, storage, common area amenities

§? Year built

Financial structure and analysis:

o?? GP/LP alignment: Is the developer taking fees upfront and during construction? Not? a bad thing, but you want to understand where fees are coming from

§? Is the developer less fee-heavy and taking a bigger upside stake in the project?

§? How much equity is the GP putting in? 90/10 split?

§? Is the GP putting in cash as equity or rolling in any fees as part of the funding?

§? How much equity has GP put in to date- if any entitlement cost, permitting cost (plans, surveys, legal fees etc.)

o?? Big metric to evaluate first is yield on cost: evaluate metric to see if it’s worth going through the risk/brain damage of doing a development vs purchasing an existing building

o?? As LPs, you can also look at standard metrics such as IRR, equity multiple, cash on cash—but some things to pay attention to:

§? Is there a preferred return? Confirm if it accrues during construction period? Do cash flows cover it post stabilization or does it continue to accrue after as well?

·??Not end of the world and not uncommon especially today with the higher rates, but if yield is truly important for you as an LP you want to understand the projected cash flow schedule

o?? What does the projected exit/recap look like? How much equity can be pulled out if refi?

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