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Real estate investors are yield obsessed. Our core valuation metric, Cap Rate, is literally unlevered yield on purchase price.
I have gotten a few questions on the difference between cap rate and Unlevered Yield to Cost (UYtC).
A thread on the differences
I have gotten a few questions on the difference between cap rate and Unlevered Yield to Cost (UYtC).
A thread on the differences
Cap rate = Profit / Purchase Price. For public market equity investors think of it as similar to EV/EBITDA, or, more accurately, EBITDA/EV.
It is a pretax, unlevered measure of valuation, a multiple. All multiples have intrinsic “bets” on growth and risk.
It is a pretax, unlevered measure of valuation, a multiple. All multiples have intrinsic “bets” on growth and risk.
You are taking current year, or TTM or NTM, profit and applying a multiple (or 1/multiple) to determine fair value and to inform your purchase decision.
In reality, you are forecasting future profit streams and discounting back to today, and using the multiple as shorthand.
In reality, you are forecasting future profit streams and discounting back to today, and using the multiple as shorthand.
What is the nature of that future profit stream? How fast will it grow? What risks does it face?
When you apply a cap rate to your stabilized NOI forecast, you are implicitly answering those questions and should make sure you have at least thought through them.
When you apply a cap rate to your stabilized NOI forecast, you are implicitly answering those questions and should make sure you have at least thought through them.
This is why LA MF trades at a 4% cap rate and Cleveland (no offense to Cleveland) might be at 7%. LA has better growth prospects.
Or why LA MF is at 4% and LA Hospitality is at 9% (making that number up). MF has a lot less risk than hotels right now (and probably always).
Or why LA MF is at 4% and LA Hospitality is at 9% (making that number up). MF has a lot less risk than hotels right now (and probably always).
If you are buying MF in an area where 50% of the jobs come from a coal plant, have you thought about what happens to your NOI/investment if the coal plant closes?
If you are buying a NNN Walgreens have you thought about what happens if Amazon gets into prescriptions?
If you are buying a NNN Walgreens have you thought about what happens if Amazon gets into prescriptions?
Ok, now that we have defined cap rate, how is UYtC different?
Basically one major way: it includes EVERYTHING you needed to spend to achieve your stabilized NOI in the denominator, not just purchase price.
Every dollar deployed needs to earn a return, not just the purchase.
Basically one major way: it includes EVERYTHING you needed to spend to achieve your stabilized NOI in the denominator, not just purchase price.
Every dollar deployed needs to earn a return, not just the purchase.
When I model out UYtC, there are three major components to the “cost” denominator: purchase price, closing costs and rehab budget.
Closing costs include title and escrow fees, legal, inspection costs, debt origination costs and the acquisition fee, if there is one.
Closing costs include title and escrow fees, legal, inspection costs, debt origination costs and the acquisition fee, if there is one.
The rehab budget includes labor, materials, contingencies, scope creep, price increases, etc.
Every dollar deployed needs to earn a return, not just the purchase price.
Every dollar deployed needs to earn a return, not just the purchase price.
If I had a nickel for every OM, I have seen with pro-forma cap rate and no cost to achieve those pro-forma rents …
Example: Buy a 10 unit property for $1.5mm with NOI of $68k, 4.5% in place cap rate.
Through better management and accretive rehabs, we think we can increase NOI to $115k.
Broker would say that is a “pro-forma” cap rate of 7.7% (115k/1.5mm).
Through better management and accretive rehabs, we think we can increase NOI to $115k.
Broker would say that is a “pro-forma” cap rate of 7.7% (115k/1.5mm).
In reality, it cost us $300k to do the rehab work and another $25k to close the deal. So our total capital outlay is $1.825mm ($1.5+300k+25k) and our Stabilized UYtC is 6.3%.
Still good, but not the slam dunk that 7.7% would be.
Still good, but not the slam dunk that 7.7% would be.
This lens (YtC) informs all of our management decisions, beyond the purchase.
Should we add a package concierge for $15k? On a 10 unit building, we would need to be confident we could raise rents by $12.50/mo to achieve a 10% return on our $20k outlay. Possibly.
Should we add a package concierge for $15k? On a 10 unit building, we would need to be confident we could raise rents by $12.50/mo to achieve a 10% return on our $20k outlay. Possibly.
For more of my thoughts on how we use UYtC in our underwriting. https://twitter.com/gabebodhi/status/1313207196222537728
Cap rate is the lingua franca of real estate, but I think UYtC is a positive improvement for investor/operators.
/fin
/fin
