Return on Cost/Investment seems to be one of the more contentious metrics out there, and I'm wondering how everyone here's firms look at the metric as it relates to buying an existing property (i.e. not development yield).
I've seen it done two ways...
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NOI divided by acquisition costs, with any budgeted capital projects and required capital calls from operating deficits in future years added to the denominator as they are incurred. This would not include things like regular maintenance CAPEX and leasing costs (with the exception of major leasing costs that you've budgeted for specifically in your business plan such as leasing up a vacant anchor space).
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NOI divided by all capital costs to date inclusive of any maintenance capex, leasing costs, and structural reserve.
My shop uses option #1, but the argument I've heard for the latter is that maintenance capex and some leasing costs could be deferred to boost distributions so it is truly a cost to the owners.
Wondering what everyone else out there does/has seen!
I would say whatever gets you to that NOI numerator.
I’ve always believed #2 is the right way to go. But that’s just me. I’ve been at firms that do it both ways. #2 is what makes more sense to me as it is the true costs you are actually spending. If you don’t end up spending your reserves, then it won’t get added to the denominator. Either way, you end up in the same spot whether your formula tells you so or not. The real trick is knowing what formula you are using and than based on that formula, knowing which deals are deals you want to pursue.
We use something closer to #2. We tend to budget to cover 10 year capital needs upfront, so we tend not to have a CapEx reserve (we fund a small one every year but it rarely gets raided). Leasing costs get included in OpEx, so they're being captured in the NOI calculation anyway.
I'm sure its a function of being in the MF space, where leasing costs are part of the annual budget, but I don't see how anyone could possibly exclude that as an operating cost with a straight face. I guess if you're in retail or office or industrial, where leasing costs are very high but very lumpy (e.g. leases roll over every 10 years and then there's a ton of TI) I can see the justification. Just very foreign
We buy office and MF, how you described is how we do it. Our MF leasing is built into NOI, while office is below due to the inconsistency and cost. Also, we typically look at single tenant or low tenant numbers, so if you have a 250k sqft office building with 1 tenant, we'd sell after a renewal and so it just makes it easier to show with the leasing costs below the NOI for sales purposes. You also have reserves for TI/LC lender requires anyways that either cover all or most of what you'd spend similar to capex you described.
When you build leasing costs into the Op costs, what are you using? Is it like $500 / lease?
Also, I'm assuming the standard is that property managers charge extra for new leases, correct? Say a building pays 8% management fees, thats not including any lease ups?
When I underwrite I never include leasing costs in my NOI (but most of my clients are sell-side :D, so motivation is different) but I 100% see why you would.
For MF, there are a couple different avenues that we can get a leased signed, all with different price points. An inbound call with our internal leasing team brought in by the PM team will be the cheapest, with site driven traffic slightly higher. Most of underwriting is trend driven. If over the last T-12, on average we had X number of leases from each channel with the average cost be X. we underwrite that trend for our budget. Our PM costs are generally 2-2.5% of EGR, but then you also have payroll costs for onsite personnel which includes leasing commissions as additional cost.
On new acquisitions there are many factors, whether we would use the PM group we always use if applicable, if it's in a new location we'd need to gather the data from whatever PM group is going to run the property.
We also bounce it off our properties in our portfolio to make sure we aren't spending way more than our average, so we might see a range of $X - $Y/lease and use that as our first run in underwriting through like you had mentioned $500/lease, but we'd want to drill down a bit once we get further into the deal since there may be something different with this asset than what we currently hold.
Like Ozy said, MF is different than Office or commercial RE, where we would underwrite leasing below the NOI.
Both, but depending on how capital is funded one matters more than the other, it might be through debt one number matters a little bit less because it isn't and actual cash investment from equity...
Plenty of great comments here.
The Return on Cost is the NOI increase of a specific action (like a renovation) divided by the cost of the renovation, while the Stabilized Yield on Cost is the NOI at stabilization divided by Total Project Costs.
Based on the details behind your firm’s approach to the calculation it sounds more like you’re talking about Stabilized Yield on Cost — am I off the mark?
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