What makes a Project "Pencil Out"?
Making a housing development project “pencil out” requires an understanding how multifamily investments are financed. This is especially true of affordable housing projects, which typically draw resources from multiple sources to facilitate a deal.
The decision to invest in a particular community is complex, incorporating numerous factors and calculations. However, to simplify, investors seek returns that exceed those from safe vehicles, such as US Treasuries, given the increased risk associated with real estate investments. One of the most basic measures of this is yield on cost.
This simple measurement compares the project's potential revenue with the overall investment cost. A higher percentage yield on cost makes the investment more attractive, while a lower percentage makes it less attractive.
Prior to the pandemic, investors sought a yield on cost of around 5-6%. As interest rates have risen, the threshold has been raised to around 7% to make a deal “pencil out” with a sufficient return on investment and sufficient surety for financiers.
Harkening back to our evaluation in Part IV of regional competitiveness and the impact of the policy environment on investment decisions, D.C. and Suburban Maryland score well on the top part of the equation. Both are incredibly attractive markets, characterized by strong demand, high income levels, and solid rental rates. But ever-increasing operating costs mitigate the potential yield on cost.
A plethora of governmental mandates and policies have driven up the cost side of the investment equation, rendering DC, Montgomery, and Prince George’s Counties less attractive. These include Building Energy Performance Standards (BEPS), frequent radon testing and security camera requirements, mandatory fire and life safety system upgrades, lengthy eviction timelines, and various administrative and registration requirements. Add rent control to the mix, effectively restricting the potential NOI that can offset these costs, and it becomes very difficult, if not impossible, to meet the 7% yield-on-cost threshold.
Virginia has far fewer of these mandates and policies. The result: New investment in housing supply has continued in Virginia, whereas in DC and Maryland, it has slowed to a virtual standstill.
As Virginia undergoes a political shift, we should take care to avoid pursuing policies proven to drive away investment, or else suffer the same fate as our neighbors across the river.