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?

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### Comments (21)

If the market cap rate is below a 7 then yes. Pretty much the same concept as development spread in this context.

Following on, if you can build it for a 7 yield but if market is say a 4 cap your selling 70 million of improvements for 175 million to the next guy

Also curious to understand how you arrived at the 175?

I mentioned something along the same lines as you, stating that in fact you're essentially getting an additional £70m for cheap, that is to say, you're getting more rent /£ spent through this investment, although this ties directly into the argument of 7% ROI exceeding 4% cap rate

OP here, is there any other way to think of this? I know we could consider the WACC and compare the IRR of the project etc etc but he did not give enough information to do this.

Ah I see, I was unaware of the development spread as a specific term but during the question I did think about cap rates pre and post capex, but he didn't explicitly provide a value for the property post CapEx. Any assumptions one can make here?

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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.

Sorry to be annoying here, but just wanting to confirm - when you say "If you have a spread that gets you to your return threshold then you do it", could you elaborate?

How would you calculate the spread in this example? Having looked online, it seems I would need an exit cap rate that the interviewer did not provide.

Thanks for your help

Most Helpful

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.

Yeah but with financing wouldn't your returns typically exceed the cap rate? Isn't the levered IRR a better metric

Development yield/return on cost/return on investment looks at the return on an NOI basis, so financing has no impact. It's a simple unlevered return metric that can be used to figure out profitability.

You should never look at any metric on it's own. Development yield is a great back of napkin metric to figure out if something is worth taking a deeper dive into. You should consider it alongside levered IRR, cash-on-cash (if the plan is to refinance and hold the cash flowing asset), etc.

For what it's worth, I think your answer is a good one in the context of an interview

The complication here is how those improvements get funded, and what your investors care about (multiple?  IRR, and levered/unlevered?).  Keeping things simple, if you have 70% leverage on this asset and you're paying 3% interest on it, then your effective levered return is 6.33%, which is substantially more attractive.  Under this hypothetical, you probably have to fund the improvements with equity, and those costs bring your cash on cash returns to 6.60%, so still a plus, just much less so of one than the assumed 300 bps spread you have.  And I know that in a hypothetical, you take the assumptions as gospel, but in real life I'd argue that getting those rent bumps isn't a sure thing, that the possibility of cost overruns pops up, that there is a cost to the additional billion in capital, etc etc etc, so the question becomes do you want to take on substantially more risk for (essentially) 30 bps of returns?

Thanks for raising this. May I ask when you're referring to a returns here with figures of 6.33% and 6.60%, what is it you're referring to? The post interest-service annual return?

EnglishQuant

Thanks for raising this. May I ask when you're referring to a returns here with figures of 6.33% and 6.60%, what is it you're referring to? The post interest-service annual return?

Just the difference between a leveraged return and an unleveraged return.  Your hypothetical 4% cap is an unlevered number; assuming your debt is cheaper than your going in cap rate, the leverage will be accretive to your returns.  So of that five billion price, you're financing 70% of it.  3.5b x 3% (interest rate) = 105mm of debt service.  So your 200m cash flow is 95mm after debt service, but that return is on 1.5b of equity.  95/1500 = 6.33%.

Some funds/investors/etc have different metrics for how they gauge whether a project is worthwhile.  If you have a 18 month hold period in mind, IRR may be a bad way to calculate returns because your in and out of an asset so quickly that the returns look really good, even if it's not great from a multiple standpoint.  Some funds cap the amount of leverage they take - for those guys, unlevered return is probably a better metric than levered return.  I'm in the affordable housing space - part of what makes the deals pencil for us is that we can take a lot of leverage at relatively cheap rates, so for us, levering up to 75-80% is part of the business plan, and our levered returns will look far more attractive than our unlevered returns.

Again, your answer was a good one given the info given, not nitpicking that, just saying that when thinking about this from an investment committee standpoint or whatever, there are a couple different ways to evaluate a deal like that beyond your (very sound) reasoning.

I agree with you here. I'll add, I would put one interim step: the property is generating 4% NOI yield in its current state, but what is the market cap rate? If the market cap rate is 8%, but you are investing \$1BB to make \$70MM, (7%), I wouldn't make the additional capital investment. However, if the market cap rate is 5%, or 6%, than I would make it, as I could buy a deal and get a 5% yield, or invest my money into this capital project and make a 7% yield.

This speaks to the idea mentioned above about development spreads doesn't it? If the market cap rate is 8% and ours is 4%, then we are at a -4% spread which is unfavourable correct?

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