I do heavy value add multifamily deals and talk about "Stabilized Unlevered Yield on Cost" as the most important underwriting metric. It is super simple and often misunderstood.
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Like many things in business...part of the confusion comes from different people calling it different things.
In school my professor just called it ROC. As in: "What's the ROC?"
I've heard “yield on cost”, “unlevered return on cost”, and several other variations.
In school my professor just called it ROC. As in: "What's the ROC?"
I've heard “yield on cost”, “unlevered return on cost”, and several other variations.
Bottom line...it is simple "back of the envelope" math.
Numerator: NOI after you have done all of the required rehab and gotten the project leased up at market rents
Denominator: Purchase Price + Rehab Costs + Closing/Deal Costs
Numerator: NOI after you have done all of the required rehab and gotten the project leased up at market rents
Denominator: Purchase Price + Rehab Costs + Closing/Deal Costs
Notice a few things about the above calculation:
No rent growth calculation into eternity
No projection of exit cap rates
Doesn't even look at interest rates
This truly allows you to compare apples-to-apples without getting distracted
No rent growth calculation into eternity
No projection of exit cap rates
Doesn't even look at interest rates
This truly allows you to compare apples-to-apples without getting distracted
Even though it's simple math, the output can be WAY off or easily manipulated by over stating the stabilized rents or under-budgeting CapEx.
As a GP, you have to be honest with yourself or trust very experienced mgmt partners. As an LP, you have to really trust the GP
As a GP, you have to be honest with yourself or trust very experienced mgmt partners. As an LP, you have to really trust the GP
Since my first building in 2012, this has been my first screening method.
I want the ROC to be 150-200+ bps above the market cap rate for the asset I will own once I am done.
I want the ROC to be 150-200+ bps above the market cap rate for the asset I will own once I am done.
Others have suggested that they want the ROC to be materially above the debt constant for the refinance loan that they will be seeking after stabilization.
Makes sense to me.
Makes sense to me.
You could also divide ROC by Exit Cap Rate rather than subtracting. 6% ROC with 4% market cap rate would be significantly better than 7% ROC with 5% market cap rates. Even though both have 200 bps of spread.
It is a basic check for “am I appropriately pricing in the risk?”.
In today’s market you may not win deals underwriting appropriately. That’s ok. The one that you do win will either be a homerun or have a nice cushion should something change in the market’s trajectory.
In today’s market you may not win deals underwriting appropriately. That’s ok. The one that you do win will either be a homerun or have a nice cushion should something change in the market’s trajectory.
I got a DM on this and wanted to add:
I do not care about going in cap rate. I would prefer to buy every deal 100% vacant. There are carry costs and they should be capitalized as part of the construction budget.
I do not care about going in cap rate. I would prefer to buy every deal 100% vacant. There are carry costs and they should be capitalized as part of the construction budget.
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