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// How “The Game” works in Institutional Real Estate Private Equity //
Many know that when cap rates go down RE investors make a lot of money. Most investors rely on a lucky market to do it
But what if you were able to “force” that cap rate compression?
Here’s how it works...
Many know that when cap rates go down RE investors make a lot of money. Most investors rely on a lucky market to do it
But what if you were able to “force” that cap rate compression?
Here’s how it works...
In institutional REPE, most of the game is “forcing” cap rate compression
Buy for market cap rate of 5%, increase the cap rate (stabilized yield) over the hold period to 7.5%, sell for a 5% cap rate
250 bps of “forced compression”, allows you to make serious money very quickly
Buy for market cap rate of 5%, increase the cap rate (stabilized yield) over the hold period to 7.5%, sell for a 5% cap rate
250 bps of “forced compression”, allows you to make serious money very quickly
This forced compression allows you to make money rapidly, even if the cashflow is minimal over the hold period
Instead of waiting for the cap rate to drop due to market forces, REPE funds force that decrease themselves
Its how REPE funds multiply capital in only 3-5 years
Instead of waiting for the cap rate to drop due to market forces, REPE funds force that decrease themselves
Its how REPE funds multiply capital in only 3-5 years
Diving into the numbers:
- buy for $50MM at a 5% cap rate (meaning that the NOI is $2.5MM)
- assume zero cashflow during the hold period
- increase NOI to $4.5MM (7.5% cap rate) with $10MM in improvements
- $4.5MM/5% cap = $90MM
- $90MM sale price - $50MM - $10MM = $30MM profit
- buy for $50MM at a 5% cap rate (meaning that the NOI is $2.5MM)
- assume zero cashflow during the hold period
- increase NOI to $4.5MM (7.5% cap rate) with $10MM in improvements
- $4.5MM/5% cap = $90MM
- $90MM sale price - $50MM - $10MM = $30MM profit
But what about leverage? If you levered the deal with 70% debt and only used 30% equity, that means you only put in $18MM ($60MM*30%=$18MM)
$18MM + $30MM profit = $48MM total proceeds
$48MM/$18MM = ~2.7x equity multiple
You just multiplied your equity ~3x in a very short time
$18MM + $30MM profit = $48MM total proceeds
$48MM/$18MM = ~2.7x equity multiple
You just multiplied your equity ~3x in a very short time
The higher you can move the stabilized yield, the more cap rate compression you force, and the more money you make
This is why the return on cost of any capital improvement project is so important
This is why the return on cost of any capital improvement project is so important
In the example above, the $10MM capital improvement yielded a $2MM increase in NOI
This means that the return on cost of that particular action was 20% ($2MM/$10MM)
This means that the return on cost of that particular action was 20% ($2MM/$10MM)
That $10MM gets added to the denominator of your cap rate calculation (now your “stabilized yield”) and that $2MM gets added to the numerator
$4.5MM/$60MM = 7.5% stabilized yield
This stabilized yield is then compressed down on your sale back down to the market cap rate of 5%
$4.5MM/$60MM = 7.5% stabilized yield
This stabilized yield is then compressed down on your sale back down to the market cap rate of 5%
So, if you were able to push the NOI increase even higher with capital improvements, your return on cost would be even higher, your stabilized yield would be even higher and your cap rate compression would be even bigger, meaning you’d make far more money
This is an extremely powerful process that you can use in your own deals as well
It’s also very simple. Establish market cap rate, increase stabilized yield, resell for market cap rate
Figure out a standardized process for this and you’ve created a license to print money
It’s also very simple. Establish market cap rate, increase stabilized yield, resell for market cap rate
Figure out a standardized process for this and you’ve created a license to print money
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