Just curious to see what metrics most shops are using and how they define those performance measures. Annually, we look at development yield and cash-on-cash, as well as an average of each over the time period in the pro-forma (typically ten years). Interestingly, I've seen cash-on-cash calculated three different ways within my company.
Development Yield: NOI / Total Costs
Cash-on-Cash: (NOI - DS) / Total Equity Contributions
Cash-on-Cash: (NOI - DS) / Net Equity Position
Cash-on-Cash: (NOI - DS - Capital Costs) / Initial Equity
At its most basic, cash-on-cash is just your annual CF divided by your equity investment. How do most of you account for TI's/Leasing Costs/Capital Costs and/or development costs in future years that will cause you to come out of pocket because operating CF can't cover the improvements?
I'm confused with your question. What do you mean by how would someone account for TI's/LC's/Capex in future years? At different points in time some metrics won't be as telling as others, which is why we like to look at multiple metrics.
For example, let’s say you bought a building for $1,000,0000 and put $1,000,000 of hard / soft costs in the 1st year. Year 1 your total basis is $2,000,000. The repositioned building is now attractive from a leasing standpoint, which leads you to sign a lease for $200k per year, starting in year 2. You are going to have to build out the tenants space and pay their commissions, so lets say TI’s/LC’s are $250k.
So, for Year 2 metrics we have the following: Total basis of $2,250,000. Your cash on cash is -2.2% (-$50,000 / 2,250,000). This doesn't tell you much. However, your Return on Cost (what you call Development Yield) is 8.9% ($200,000 / $2,250,000).
Does that help?
Are you not double counting? You are subtracting the $250k in TI's/LC's from NOI and also adding the $250k to your basis. As a side note, we use development yield and return on cost interchangeably.
I guess I was asking if most people add TI/LC costs to the basis so it's in the denominator or if most people subtract it from NOI so it's in the numerator. It sounds like you're doing both in your calculation.
No its not doubel counting. You adjust both the numerator and denominator.
Year 1 - Numerator is reduced becasue cash goes out, denominator is flat b/c equity basis doesnt adjust until the beginning of year 2
Year 2 - The numerator isn't adjusted (assuming no new leases/TI) b/c no cash goes out. The denomitor is adjusted to reflect Year 1's TI/leasing expenses b/c they increased your equity basis
Cash-on-Cash: (NOI - DS) / Total Equity Contributions - This is for project level Cash-on-Cash: (NOI - DS) / Net Equity Position - I'm assuming the Net equity position is refering to one of the specific entities equity committment (i.e. 40%)? In which case you would split out their portion of the CF (40% if pari passu). Cash-on-Cash: (NOI - DS - Capital Costs) / Initial Equity - We don't do this b/c it makes our yields look worse. I would assume that this is mathematically correct way.
I work in debt - so take this for what that's worth - but I'd include leasing/improvement costs for commercial space in your basis.
I would assume you look at these on a levered and unlevered basis. Also, I'd imagine that everyone looks at an IRR on an unlevered and levered basis at varying reversion cap rates, inflation assumptions, etc..
I quoted 2 different performance measures. Cash on Cash is essentially your NET cash you receive over your equity basis. Net cash flow is your NOI less below the line capital expenses, or $200k - $250k = -$50k over Equity Basis, which is $1m purchase + $1m renovation + $250k TI/LCs, or $2.25m. Cash on Cash is -$50k / $2.250m, or -2.2%.
Return on Cost is your NOI over your Equity Basis. or 200k / 2.25m = 8.9%. It's a different performance measure. The following year, analysis year 3, assuming NOI is flat at $200k and you do not have any additional TI/LC/capex/cap reserves, your Cash on Cash AND return on cost would be 200k / 2.25m = 8.9% (coincidentally for this simplistic example)
As a side note, TI/LCs are included in your equity basis, regardless if your building's cash flow can cover the cost or not.
Thanks for the comments. I know every place does it differently, so I was curious to see the most common way. I think Argus calculates cash-on-cash as Annual CF (either equity contribution or equity distribution on the S&U report) divided by the initial equity.
@"REValuation" NOI / Net Equity position - Net Equity Position is project level. Sorry I didn't explain it well. By net equity position, I mean initial equity plus any equity contributions and less any distributions. So your net equity position should be decreasing every year unless there's major capital expenditures that need equity contributions.
I think I am understanding why it's not double counting. The way @"GentlemanAndScholar" described it, I thought he was reducing NOI by TIs/LCs and also adding those TIs/LCs to the basis in the same year. I think what you are saying, and what makes sense to me, is that TIs/LCs incurred in Year 1 are subtracted from NOI in year one, but not added to the basis until year 2. Is that correct?
"Cash-on-Cash: (NOI - DS - Capital Costs) / Initial Equity - We don't do this b/c it makes our yields look worse. I would assume that this is mathematically correct way."
Which part don't you do? What does your cash-on-cash equation look like?
Lastly, we do not currently run IRR's. Management doesn't believe in them/like them for some reason (mostly due to unpredictability of exit caps/valuation), but there's a few of us that are working on them to add it to our return metrics. Given we don't have investors, we don't need to calculate it for waterfalls or anything. We basically just look at unlevered & levered returns through return on cost and cash-on-cash.
Thanks everyone, appreciate the constructive discussion with other RE professionals.
No, that's incorrect. Your total basis is how much total capital you are putting to work in the project, it has absolutely nothing to do with your cash flow from operations. Examples of things that make up your total basis are as follows:
Your purchase price, acquisition / sourcing fees, due diligence, closing costs, hard costs like core & shell and capital repairs, soft costs like financing fees, architecture fees, development fees, permits and fees, any other fees. Total basis also includes your leasing costs such as tenant improvements and leasing commissions. It's essentially your complete project budget.
Regarding Sources and Uses, these are your "uses" of capital. Your "sources" of capital are debt & equity (and occasionally cash flow from operations. but typically its just debt and equity.) Total basis is also a rolling measure, so in the example stated above, year 1 total basis is your purchase + renovations, or $2m. Year 2 basis, we end up paying TIs&LCs and increase our basis by $250k, so year 2 total basis is $2.250m. If, in year 3, we put more money into the building, say a new roof or HVAC unit, and spend $500k, year 3 total basis is now $2.750m.
Let me walk through a proforma with you:
Revenues - Expenses = Net Operating Income - Tenant Improvements & Leasing Commissions -Capital Expenditures =NET (unlevered) cash flow
Your performance measures you are mentioning are looking at 2 different points in the proforma. In the Cash on Cash measure, it's taking year 2 NET cash flow over your Total basis. In the Return on Cost measure, it's taking year 2 NOI over your total basis.
Are you in Asset Management, and your department doesn't look at IRRs? Or does your company as a whole not look at IRR & multiple metrics? Lastly, does your firm focus on Core products?
I agree with you on total basis including everything, which is how we calculate return on cost. On a levered basis for cash-on-cash though, I was curious how most handled the cash invested (denominator). In a simple stabilized property, it's easy because it's basically just the initial equity. In redevelopments, for example, there will be large capital costs in future years. Assuming all the debt is drawn by then, I was assuming it'd be all considered equity funding it, so it'd be added to the cash in the deal.
And at this point, I think I'm just confusing myself. I get what you're saying. We'd still be getting the same NOI, but then we'd have to put in cash for TIs/Leasing, so our net cash flow is less, plus that cash we put in for TIs/Leasing is added to our equity in the deal. I guess it just seems like double counting on the surface since you deduct the capital costs from NOI and also add that same amount to the basis.
I work in acquisitions/development/Asset Management. The company as a whole doesn't look at IRRs or multiples. We buy some stabilized properties, but focus mostly on value-add and opportunistic (redevelopments and ground-up spec and/or build to suit).
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