Quick primer on common real estate return measures...
----- Cap Rate -----
A property's NOI as a percentage of its value
----- Yield-on-Cost -----
A development's anticipated NOI as a percentage of development cost
If market cap rates are 5.5% and YOCs for similar assets are 6.5%, how much would it cost to get a property with $1M of NOI? Buying a stabilized property would cost about $18M ($1M/5.5%) or you could build a property with $1M of NOI for about $15M ($1M/6.5%).
----- Internal Rate of Return -----
The implied annual rate of growth that an investment's cash flows are expected to generate
Cap rates and YOCs are point-in-time measures, while IRR considers the timing and magnitude of all cash flows over the life of an investment.
----- Problems and pitfalls -----
1. Cap rates:
- Point-in-time. Changes in market rents, lease expirations, and operating expenses directly affect NOI, so reading a property's value simply as a function of a single year's NOI is very simplistic.
- Ignores CapEx: An office building with a 7% cap rate could easily have an inferior return vs. a self-storage property with a 5% cap rate because office properties come with a significant capital expense drag (i.e., "below the line" tenant capital and building capital), while storage typically has very little capital.
2. Yield-on-cost:
- Point-in-time. YOC simplistically reflects a single year's NOI, but this isn't the major pitfall associated with YOC since developers and operators focus on "stabilized" YOC.
- Speculative stabilization. The major pitfall associated with YOC relates to the fact that projected NOI is inherently a guess. Small misses in rents or expenses vs. projected levels can lead to a meaningfully lower YOC. And if it takes longer to lease up a property and/or requires more capital (via higher development costs, more loan interest, a renewed interest rate cap, higher tenant capital, etc.) the YOC denominator increases, pushing YOC down.
3. IRR
- In a low cap rate environment (i.e., when income relative to value is low), which has been the CRE reality over the last 10-20 years, IRR is heavily influenced by reversion assumptions. Conservatively underwritten income can easily be outsized by an aggressively underwritten exit cap rate assumption.
----- No silver bullet -----
When it comes to measuring real estate returns, there is no silver bullet. The key is to understand return measures and, more importantly, the cash flow assumptions that feed into the return measures.
Ps - These aren't the only real estate return measures, but they are likely the most commonly cited. Multiples and cash-on-cash come to mind.
Pps - IRR placeholders for future discussion: Unlev IRR (also called a "discount rate") vs. lev IRR (most commonly cited "IRR.") Share of IRR from income vs. reversion ("partitioning IRR.")
What measure do you rely on the most? What are the most important input assumptions?
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