So in an interview I was asked whether or not I should carry out the capital expenditure for this hypothetical scenario:
- Property purchase price : £5B
- Yearly Rental Income £200m
- Analyst said we had a 'cap rate' of 4% (which by defintion isn't strictly true but I got his drift)
He then asked if the following proposal should be carried out
- Capital expenditure of £1B that yields an additional £70m of rental income every year
- This takes the yearly rental income to £270m
The way I thought about this was that the annual return on capital expenditure is 7% and seeing as this exceeds our current cap rate (4%) then this should be beneficial.
The interviewer seemed to agree with me but I would be curious to know how would you all go about thinking about this?
If the market cap rate is below a 7 then yes. Pretty much the same concept as development spread in this context.
You’re trying to over complicate, we don’t do that in real estate. If you have a spread that gets you to your return threshold then you do it.
For the interview question, it would be safe to assume the 4% in place cap rate can be treated as your "exit" cap (really you just need the market cap rate) - you could confirm this with your interviewer if you wanted to be thorough.
The project has a 7% yield on cost ($70M NOI/$1B costs) while the property was purchased at a cap rate of 4%, assumed to be the market cap rate. This represents a 300bps spread. You can use these numbers to quickly figure out unlevered multiple and expected profit of the project:
- 7%/4% = 1.75X unlevered multiple, in other words a 75% profit on your costs.
- $70M/4% Cap Rate = $1.75B; $1.75B Value - $1B Costs = $750M Profit (+75%, as above). The CAPEX will take the property to a $6.75B value at a $6B cost basis.
Those back of the envelope numbers can be used to quickly determine whether a project is feasible in terms of risk/reward, depending on the metric the company is looking at. This level of analysis should be enough for an interview. Keep in mind that the spread of 300bps on its own is a useless metric, because the actual profit it correlates to varies depending on what the spread is between (i.e. a 7% yield over 4% cap rate will have a higher profit margin than a 15% yield on a 12% cap rate). What is an "acceptable" spread will vary based on the actual yield/cap rate as well as the type of project being considered - a higher risk project will demand a higher spread.
Beyond this, if you want to dive into it deeper you can start considering what this translates to in levered returns and how much these returns would be improved by going forward with the project. If you know the debt service, you can get your cash-on-cash or return on equity (depending on what your investors care about) after calculating net cash flow (NOI less debt service and any other reserves/fees). This is explained in more detail further down in the thread by Ozymandia. Whether these metrics matter is entirely firm dependent.