Cap Rates on Value Add vs. Core

Looking for some clarity/thoughts on differences in going-in cap rates between value-add and core deals (or anything in between). My initial thinking is this: For a core product, a lower cap rate is justified given higher quality asset, stabilized cash flows, less risk etc. On the value-add side, a higher going-in cap rate would be needed given risk of doing renovations/repositioning in order to push NOI. However, it does seem that value-add has been really hot lately, with investors willing to buy at lower going-in cap rates. Is this largely due to investors fighting for additional yield? Also, I have heard the terminology regarding "growing into the cap rate". For example, buy a building at a 4% cap rate, but you have ability to push NOI over the hold and get it to a higher cap rate.

I guess I am just looking to see if I am thinking about this correctly and if anyone has any thoughts or additional feedback.

Thanks!

 
Most Helpful

Define 'deal.'

Generally, the nomenclature 'core', 'value-add' and 'opportunistic' are used to describe the risk and return profile of an investment opportunity. Even then, there's not exactly agreed upon definitions of these terms across the industry. Attempting to extrapolate further by prescribing capitalization rates is that much more futile.

For example, let's say I can either - 1. Purchase a Class A office building in downtown Los Angeles at a 5.25% capitalization rate and secure IO debt at 75% LTV / 3.50% interest, or 2. Purchase a Class B office building in suburban Inland Empire at a 8.75% capitalization rate and secure IO debt at 25% LTV / 3.50% interest.

Both of these deals would probably be described as value-add, even though they may sound extremely different at a glance. However, at the end of the day you're still clipping a 10.50% dividend, but you're trading leverage risk for asset risk.

I find it best to think of these things in return parameters, or at least discount rates if you have to frame from a valuation perspective.

To more explicitly answer your question, the capitalization rate on in-place NOI for a 'value-add' deal (as your describe it) is most likely lower then a 'core' deal (as you describe it), because there's a value proposition to the deal. However, the capitalization rate on the market NOI will be higher, because of the risk (whatever risk that may be) for said deal.

 

To answer your question, yes everything you’ve outlined above is correct and you’re looking at it the right way.

Going in capitalization rates/development yields are a function of two elements: the project cost side and net operating income side (Development yield = NOI / Project Costs).

Theoretically in a balanced market, the yield on a “value add” versus “core” deal should be higher because it is typically riskier - to get that extra yield the project usually involves an element of lease up or construction. To maintain the higher return levels required that define a “value add” deal (say 15 to 20% IRR), the purchase price has to be adjusted downwards to make up for the additional lease up/construction costs (affecting the project cost side).

The current market environment we are in has been influenced heavily by the Federal Reserve policy. Borrowing rates (and bond returns to those investors) have been driven to historically low levels. Since a majority of investment funds/firms are driven off of relative return (ex. Our fund is value add and are looking for fund level returns over the 10 year Treasury + 6.00%) they are usually shooting to outperform a hurdle over the risk free rate. When “safe” investments such as US Treasuries are giving such low yield/return back to investors (2.50 to 3.00%) then investors start to “stretch” for yield to hit these return targets. This has led to the historic equities bull run we have seen over the past ten years.

What does that mean for real estate? It means higher asset prices because not only are investors chasing yield but also they can borrow cheaper than before. This means that same piece of land you may have been able to buy in your typical market might be 10% higher today so it makes deals hard to pencil (to achieve the same returns). Players have to stretch to get the same returns by switching into riskier value propositions (changing strategies from value add to more development), going into new markets or ideally holding tight and waiting it out until asking prices correct.

This is how firms get into trouble - a combination of investing outside their core competency, in regions they aren’t familiar with but most importantly combined with over leverage. As you can imagine, not knowing an area, the players or process needed to execute the deals lead to overpaying which is the death knell for investments.

Value add in particular has gotten returns squeezed (as a function of higher demand, leading to higher purchase prices) because mentally it fits in the “not too risky but there’s some upside” bucket. Usually these are deals that have some existing tenants or cash flow but have some space that is under market, available to develop, etc. This is perfect for new players as they feel protected in a downside scenario but have all that juicy return to point towards versus bonds giving them 3%.

Note: as the above user pointed out, unfortunately the “core”, “value add” and “opportunistic” definitions are a little arbitrary and even worse they are defined/categorized by return levels which change depending on market conditions and are viewed differently firm to firm.

 

Cap rates for value- add deals should always be lower than stabilized deals. Cap rates aren't a good metric for looking at value-add whereas they are for stabilized deals. The more relevant metric for value-add is unleveraged "return on cost" which is your stabilized NOI divided by total "cost basis" - purchase price + closing costs + TI/LCs/CapEx. A buyer is going to look at the delta between their projected return on cost and market "cap rate" as that represents their profit in the deal after they stabilize an asset. Another more relevant metric for value add is IRR.

e

 

I would replace 'should always' with 'is sometimes.' The generally accepted definition of a capitalization rate (in US nomenclature at least) is in-place NOI / gross acquisition price.

Therefore, let's assume you have the opportunity to acquire one of two 100 sq. ft. office buildings in Houston, TX where in-place and market rent is $1.00 / sq. ft. / year. Assume the physical and market characteristics of the buildings are identical. However, assume:

  1. Building A is 95% occupied, with a mixed tenant base.
  2. Building B is 50% occupied, but was previously heavily occupied by tenants in the energy sector - who have been disproportionately negatively impacted since 2015.

If the market capitalization rate for Building A is 5.50%, you'd most likely be willing to acquire Building B for sub-5.50% to have the opportunity to re-tenant the building. In number terms, if you are willing to purchase Building A for $1,727 (95 / 5.50%), perhaps you'd pay $1,250 (50 / 4.00%) for Building B, re-position it to 7.6% (95 / $1,250) and subsequently sell it for $1,727 (38.2% profit margin).

With leverage, that's a nice value-add bet on the broader energy sector and the Houston, TX market.

Hence, to my original point - it is best to think of these things in risk / return parameters and not boxed in by capitalization rates or other specific industry KPI terminology.

 

Ok, sure there are a few very specific examples where a value-add deal might trade for higher cap rate than stabilized deal of a similar profile (i.e. a single-tenant office building with a tenant paying way above market rent with short term roll and is a known vacate). The example you gave supports the concept that value-add deals will trade at a lower cap rate than stabilized deals.

Every type of real estate deal up and down the risk/return spectrum - whether it be "development", "opportunistic", "value-add", "stabilized" deals - has specific set of return metrics that investors use to measure if the returns are attractive relative to the risk profile of the deal. In the case of value-add deals, investors are less concerned with going-in cap rates and more so with IRR and the return-on-cost relative to market cap rates. Think we be talking around each other a bit here.

 

Necessitatibus qui vero aut. Repudiandae unde ut est aspernatur. Eum maxime dolorem non id quas ea dolorem impedit. Nihil suscipit rem ratione labore alias magnam. Aut ut laudantium dolorem asperiores. Quia et reiciendis rem molestiae nostrum et nulla corporis.

Illum voluptates mollitia corporis sapiente aut. Laborum omnis aliquid neque nihil odit reiciendis similique. Ea voluptatem tenetur sint voluptates qui. Laborum voluptatem maiores quibusdam error et. Et consequatur veniam praesentium laborum numquam quisquam ipsum ipsum. Laudantium ipsam quia nisi aut.

Aliquam temporibus vel sit qui deleniti. Non iusto voluptatibus facere aut.

Career Advancement Opportunities

March 2024 Investment Banking

  • Jefferies & Company 02 99.4%
  • Goldman Sachs 19 98.8%
  • Harris Williams & Co. (++) 98.3%
  • Lazard Freres 02 97.7%
  • JPMorgan Chase 03 97.1%

Overall Employee Satisfaction

March 2024 Investment Banking

  • Harris Williams & Co. 18 99.4%
  • JPMorgan Chase 10 98.8%
  • Lazard Freres 05 98.3%
  • Morgan Stanley 07 97.7%
  • William Blair 03 97.1%

Professional Growth Opportunities

March 2024 Investment Banking

  • Lazard Freres 01 99.4%
  • Jefferies & Company 02 98.8%
  • Goldman Sachs 17 98.3%
  • Moelis & Company 07 97.7%
  • JPMorgan Chase 05 97.1%

Total Avg Compensation

March 2024 Investment Banking

  • Director/MD (5) $648
  • Vice President (19) $385
  • Associates (86) $261
  • 3rd+ Year Analyst (13) $181
  • Intern/Summer Associate (33) $170
  • 2nd Year Analyst (66) $168
  • 1st Year Analyst (202) $159
  • Intern/Summer Analyst (144) $101
notes
16 IB Interviews Notes

“... there’s no excuse to not take advantage of the resources out there available to you. Best value for your $ are the...”

Leaderboard

1
redever's picture
redever
99.2
2
Secyh62's picture
Secyh62
99.0
3
BankonBanking's picture
BankonBanking
99.0
4
Betsy Massar's picture
Betsy Massar
99.0
5
kanon's picture
kanon
98.9
6
dosk17's picture
dosk17
98.9
7
GameTheory's picture
GameTheory
98.9
8
CompBanker's picture
CompBanker
98.9
9
DrApeman's picture
DrApeman
98.9
10
Jamoldo's picture
Jamoldo
98.8
success
From 10 rejections to 1 dream investment banking internship

“... I believe it was the single biggest reason why I ended up with an offer...”