Understanding Cap Rates, Yield on Cost, Development Spread, and IRR

So you have these particular metrics for analysis, but also the return on the project overall, given what cap rates in the market are going for. And so help me understand if I'm a real estate investor and I'm trying to assess these projects that you guys have and trying to, to understand how you're thinking about the value of this project. Where do I start? Like, help me understand cap rates. Help me understand how you guys are thinking about yield on cost. How you guys are thinking about, IRR.

Just, just help me like walk through that a little bit to break this down because I, and then at the end of the episode, I hope we can kind of put this all back together and, and get a picture of, okay, this is how we're determining the value of this property.

of a property as a percentage of its cost. And it's how properties are valued in the marketplace. we focus on two other metrics in the analytic stage of a particular project that are predictors of IRR The first one is yield on cost. And we'll break that down maybe in a minute. And the second one is development spread.

And yield on cost and development spread basically give us the ability, once we have a pro forma built out on a project, and we've, we've done the cost estimates so we know what the project is going to cost, to predict what our profit will be, and therefore what our end terminal IRR to our investors will be. And so, our current funds at 8, 000. property portfolio fund to that will launch, in Q2 will probably be at least that if not 10 or 12 properties.

And those analytics are applied individually to each one of those projects. And they sort of have to meet certain hurdles, before we'll allow them to be a part of a fund portfolio because ultimately our objective is to drive a 19 to 20 percent IRR time value rate of return to our investors.

they are, first of all, the inverse of multiples, which is used in corporate finance for corporate acquisitions and corporate transactions. When people are buying companies, they use a multiple of cash flow or EBITDA. But one of the things that drive cap rates up and down in any market and in any property type is the likelihood of the continuance of that cash flow. So I'll give you a really broad example. In the hotel industry, where your tenant base turns over every night.

cap rates tend to be higher than they do in a grocery store. Grocery anchored shopping center where your grocery anchor has a 25 year lease and all of your other shop tenants have five to eight year leases. the likelihood of the continuance of the historical cash flow in the grocery Anchorage Shopping Center is a lot greater. in a hotel and that doesn't apply evenly and perfectly in all situations, but it's People wonder why cap rates go up and down, and that's one of the reasons why they vary.

Interest rates also move cap rates because they are essentially a yield. If I buy a piece of real estate and it's giving me a 6 percent yield, or cap rate, it's bought based on a 6 percent cap rate, and treasuries are providing a 10 percent yield. the real estate investment doesn't look very attractive at six. that kind of dynamic will move cap rates up, because you're always thinking in terms of a risk adjusted return with the treasury being basically a zero risk instrument.

Interest rates move cap rates, the dynamics of the property type, the likelihood of the continuance of the cash flow will move capitalization rates, and then also market supply and demand. We saw a phase in multifamily where both on the operating side and on the asset side, there was a real imbalance between supply and demand. There was a tremendous amount of demand for apartments from tenants.

and a lack of supply, so it made the development of apartments very attractive or the purchase of apartments very attractive and drove cap rates down, at the same time, because there was such a supply and demand imbalance, there were more people that wanted to buy apartments or develop apartments, and so all of that together drove cap rates, down, that in the multifamily space, that trend has really kind of reversed itself in the last 18 months where there was so much supply created that cap

rates have gone the other way. The seesaw swung the other direction, but that's just sort of an overview of cap rates, but they are essentially used every day. By every type of investor in real estate because The value of a piece of income producing real estate is expressed in the cap rate

Let's say both of them Produce a million dollars in net operating income or cash flow on an annualized basis the company with reoccurring cash with with the MRR model the Reoccurring cash flow model may trade at a ten times cash flow or ten million dollars while the transactional company May trade at a five or six multiple So five or six million the reason for that is the risk of the continuance of the cash flow when I've got long term contracts that are 80 percent of my revenue a Buyer can be

fairly certain that cash flow is going to continue for a period of time at least to allow him to recoup his original investment the transactional guy Is a whole different model.

He's very sales intensive and there's really no guarantee you'll have revenue tomorrow and that same dynamic applies to real estate long term leases but you have to combine those in the real estate world with the other dynamics supply and demand and Interest rates and other things that are driving cap rates, but it's one of the factors that really impacts how cap rates move in the marketplace

So I'll give you an example, and it's the example I think I gave in the other episode when we were talking about things related to this. If it's going to cost me 10 million to build a self storage facility. And our proforma net income at stabilization is 950, 000 annually. That property has a nine and a half percent yield on cost. But it's also one of the big reasons why we chose to really focus on self storage and office industrial flex real estate.

If you look at the market in general, across all property types, I would say the vast majority of developers are very comfortable with a yield on cost in the seven to seven and a half percent range. in self storage and in office industrial flex, the way we build it, and the way we manage it, Our portfolio yield on cost, we shoot for a target of nine and a half. and that's a pretty big difference between 77 and a half and 99 and a half. It's a 2 percent swing.

And I'll give you an example in a minute. We talk about development spread, what that means in terms of return or profit margin in the development of a project. But it's, it is, it is the first indicator. Of the premium return that can be earned in exchange for the incremental risk that comes with developing versus buying a stabilized asset.

the relationship between rent rates per square foot and cost to build storage and office industrial flex is simply a wider spread than it is in almost any other type of real estate and just by its nature. Let's be honest in a self-storage facility where we're renting a 10x10 box with nothing in it and we're getting 16 a square foot. that same, piece of real estate costs $100/ft to build.

so you take $16/ft take out your expenses and you're down at a net operating income level at, about $9.50/ft in terms of your net operating income, so, it's just, the product by its nature has a higher yield on cost than office, retail, multi family, all, all of those things, and in addition to that, we can build it a little bit less expensively than most people, if you think about, I don't know what apartment rents would be on a square foot today, on a per square foot basis, but, I'll give you

this example. everybody's familiar with a multi story sort of fancy big box self storage that's going up all over the country, mostly in more urban areas because land is so expensive. We build single story drive up self storage. Those big box, I call them big box locations, cost somewhere around 160, 180 a foot to build. Because they got elevators in them, they have to have sprinklers, it's a whole different product than the single story drive up self stores that we built.

That they have that I don't when you calculate yield on cost. So their yield on cost is coming in at eight, eight and a half, and I'm at nine and a quarter, nine and a half. And I, that's not exact math, but it's probably somewhere in that neighborhood.

Because the reality is everybody would really prefer drive up where they can back the truck up to the door, open the door and basically take two steps and put something down. I think the single story drive up is a better product at the end of the day. But what justifies the multi story buildings is if you're building in, more urban areas where land costs are extraordinarily high.

Then going vertical does make a ton of sense, but I think, in a lot of cases, single story drive ups a better product, but that's a conversation for another day.

the other thing you can do is grow net operating income. either by being able to raise rents, or reduce expenses. In most real estate, reducing expenses, most real estate isn't super expense intensive, so it really becomes about driving, you know, increase in top line revenue and therefore ultimately bottom line net operating income.

the thing that multifamily does have is lower yield on cost out of the gate, You'll see projections that are showing three, five, three, four, five percent annual increases in rents. And when expenses only increase at one or two, you drive some significant growth in NOI over a five, six, seven, eight year holding period. That translates into, you know, being able to sell that property for significantly more than you paid for it, down the road.

I want to get, I want to make sure that we've got two more of these, these, concepts is development spread. And then how all that leads to IRR and builds that fuller financial picture. So talk to me about development spread and how you think about it. Hmm.

An apartment project with a 7. 2 percent yield on cost. So that means the proforma net operating income of that property is going to equal 7. 2 percent of what it costs to build it on an annual basis and a market cap rate of five. That means they have a 2. 2 percent development spread. There's a simple formula.

If you divide the yield on cost by the market cap rate and subtract one, you get the projected gross profit or profit margin in the development of that property if you sell it at stabilization. And in that example, it's 44%. If you take 7. 2, divide it by 5, and subtract 1, you get 44%.

In storage, with a 9. 5 percent yield on cost, and market cap rates at 6, so we've got a higher yield on cost, but the cap rates that value that property at stabilization are higher too, which means lower relative to the net operating income. We have a 3. 5 percent or 350 basis point, development spread. If you divide 9. 5 by 6 and subtract 1, you get 58. 3%.

And at the end of the day, if we give our investors roughly back three times their money and we do it in 55 and a half years, that's a 20 percent hour.

what happens during a project when you're building or lease up that might throw off that projection, if that makes sense. is there something that you guys look for to mitigate against during the development of the project or during lease up that you need to mitigate when you're going through this process.

So, you know, if things are humming right at the right point, we may be super aggressive with race to try to lease it up faster to drive a little bit higher time valued return if we're off. point a little bit on cost, then we may be a little bit less aggressive, except a little bit longer lease up time. But there are things that are beyond our control. If you hit rock when you start grading the site and you got a blast rock and it's going to cost a quarter of a million dollars, I can't fix that.

Um, if you were only invested in that 2 percent deal, that, you know, that doesn't feel as great. Fortunately for us, most of our investors have invested. They created diversification. Not via a fund vehicle, because at that point in time, we were doing single property syndications. They created diversification by investing in multiple projects with us. So they might have been in the 2 percent deal, and they might have been in one that did 40.

Um, but we, we, and that's why we went to the fund store. One of the reasons was to create a little bit more consistent diversity for investors, by putting a portfolio together that spreads that risk of projections being off, you know, across more than one property, so.

But it wasn't a pleasant experience. And, I think that's another reason why I just that product doesn't attract me. Um, you know, fool me once. Shame on you. Fool me twice. Shame on me. So,

laying this out for us to understand how you guys calculate your, your, you know, the projects that you enter into and help investors understand what that looks like as well. and so I'm excited to keep going next time. We're going to talk about the capital stack as it relates to, different investments that, or, or, you know, capital allocation that you can have, regarding your investment. So Paul, uh, we're excited to meet next time and I'll see you then.