Acquisition lens on Going-in cap / YOC / Exit Cap
Coming from the development side and trying to better understand how value-add investors look at deals.
I have read through previous forums and consensus I get is a) Going-in cap > YOC and b) Exit cap > going-in cap.
For a) - do you typically look at YOC on Y1 NOI / full acq basis inclusive of reno costs only or NOI when the renovations are fully complete if renovations take more than 1 year?
b) I would think your going-in cap would be high (assuming formula is cap rate = rfr + risk premium), given there is a higher risk involved with renovating/flipping units and or tenants, and then once renovated/stabilized, the exit cap would be lower, given there is not as much inherent risk involved. Is the exit cap typically higher just purely due to being conservative in UW?
Insight would be greatly appreciated on just how they all intertwine from a pure value-add acq. standpoint.
Thanks!
Your're looking at yields after the reno/value add program is complete. Same concept as a developer looking at returns after a project is leased up.
Your year 1 YOC will be lower than your going in cap rate because you're adding capital to your basis. Once you execute your value add/renovation program, your YOC should rise above your cap rate due to the resulting NOI growth. If your post stabilization YOC is lower than your cap rate, you've got problems.
You underwrite cap rate expansion for several reasons. 1) you don't want to hinge your returns off of something completely out of your control (market conditions). If the returns only work if the cap rate falls, it's a bad deal. 2) The next buyer will have to underwrite higher yields than you did since there's no more room to grow income. There's plenty more reasons covered in other threads as well.
It shouldn’t matter whether you’re coming from a development or value-add background. It shouldn’t even matter if you’re an equity or debt investor. All CRE investors should understand the math behind value creation.
In CRE, it’s all about making a profit on cost. The most simple math that I’m surprised so many young (and frankly seasoned) CRE investors don’t know is that simplistically, your profit margin or MOIC on a deal is just your stabilized ROC divided by your exit cap rate.
Since you’re from a developer background, that’s why you see developers typically use a rule of thumb of getting to a 200-300 bps spread over market cap rates. 8% ROC / 6% cap rate = 1.33x (excluding if you had current income which would further add to your multiple).
Going in cap rate and any other interim ROC is frankly irrelevant, imho, those metrics just tell you your starting point for return but you really care about your end point (cuz again, that’s where you are realizing on the value you’ve created by increasing cash flow).
That said, if you were a net lease investor treating core CRE as more of a fixed income instrument, then while the same math still applies, you would focus primarily on your going in cap rate (since in essence the going in cap rate is synonymous with your stabilized cap rate and you likely aren’t underwriting any value add that would allow you to increase your ROC above the market cap rate).
Ignore title, could you please elaborate how you get from 8% ROC / 6% cap rate to a 1.33x multiple?
Thank you
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