The Elegance and Importance of ‘Return on Cost’

I’ve been joking for a few years now that every deal brought to market is a “value-add”. Even properties that perform well – with high occupancy and no deferred maintenance – are advertised as “value-add” opportunities: of course, you can always renovate and raise rents. Most deals are bought, renovated and sold to a new “value-add” buyer who renovates again, raises rents again, and then sells again to yet another “value-add” buyer.

I now have an even more precise template for most deals brought to market:

• Bought in the last three years
• Mid-to-high 90% occupancy
• No deferred maintenance
• Upgraded exterior/amenities – “Current ownership has spent over $2MM in recent capital expenditures” is seen in most OMs. 
• Some renovated interiors to prove out potential rent increases (a few units don’t automatically prove property-wide rent lift). 
• My favorite part – “current ownership spent money curing deferred maintenance and upgrading the amenities but has left the interiors untouched, leaving all of the value-add for the next buyer” or, “the future buyer has the luxury to only spend capital on income-producing renovations”.

These are not the characteristics of a value-add deal. To me, this is a core-plus asset with some operational and/or capex upside. Even if a deal is truly a value-add, the mere potential to implement a business plan where rents are raised by $200 does not guarantee true value-add level returns: pricing is all-important. The point of value-add is to achieve higher returns than core-plus; the point of core-plus is to achieve higher returns than core. This only works if value-add assets are cheaper than core-plus, and core-plus are cheaper than core. By now, market cycle and tremendous investor demand have warped the risk spectrum, giving investors poor risk-adjusted returns in a typical value-add deal. 

Value-add returns depend on creating stabilized cash flows for less than the cost of simply buying the same cash flows already fully realized. For example, with a 6% market cap rate on stabilized cashflows, a value-add business plan would seek to grow the investment’s operating cap rate (NOI divided by purchase price plus capital expenditures) to at least 7% (preferably 8%). If successful, you have “built” cash flows for an 8% cap and can sell those cash flows at a 6% cap, realizing substantial capital appreciation.

However, in today’s competitive market, many operators are buying that same value-add deal at a 4–4.5% cap rate and only raising their operating cap to 6–6.5%. This means the buyer could put in serious effort to renovate, raise rents, and lower vacancy – taking on substantial risk – and still not achieve much increase in equity or current yield. Worse still, the buyer sustained low cash flows during the stabilization period to achieve the only-slightly-higher stabilized yield on cost. Truthfully, this buyer would have been better off buying a core/core-plus asset and clipping a coupon from the start. This mathematical realization is why I urge investors not to be dazzled by business plans that boast $200 rent bumps and eye-catching “before and after” interior renovation pictures. At high enough entry prices, such large rent increases may be needed just to bring return on cost above the cost of debt. 

A similar metric to the operating cap rate just discussed is one that I call unlevered, stabilized, untrended return on cost (or just return on cost). I often speak with investors who have grown weary of easily-manipulated IRR projections; return on cost is an elegant metric that cuts out the noise of growth projections, exit cap rates, and financing assumptions. This return on cost metric is calculated using pro forma NOI (without growth assumptions), divided by purchase price plus capital expenditures, and is independent of capital structure. This calculation gives the clearest picture of whether or not an investment has true value-add potential. The only thing it misses is the stabilization time factored in to achieve the pro forma NOI. Of course, the combination of time to stabilize and execution risk are why investors have historically demanded a higher return on cost for a value-add deal over a core-plus or core investment. I believe a strong risk-adjusted return for a value-add investment is anywhere from 100 to 200 basis points over market cap rates for stabilized, comparable product. However, since we typically use market cap rate plus 50 bps to calculate our exit cap, we are often aiming for 150 to 250 bps over prevailing market cap rates for our return on cost. For the most part, we are currently buying in areas that warrant 6.5% exit cap projections, calling for an 8%+ stabilized return on cost target. Before even looking at project-level IRR, we look at this figure. Next, we consider unlevered IRR (targeting 9–12%), which factors in growth and sales assumptions, but not financing. These are true value-add returns and are more than commensurate with the execution risk of the business plan. 

Even if a deal fails to meet these hurdles (few do, especially in primary or growth markets), we may still consider the investment if it exhibits true positive leverage. A well-priced deal has a higher return on cost than the amortized debt constant (principal and interest payments as a percentage of principal). While quality property can still be bought for cap rates above interest rates, creating nominal positive leverage, trouble can arise if and when amortization begins. Even 30-year amortization has a major impact on total debt service, which is exacerbated in a low-interest rate environment. A loan with a 3% interest rate would turn into a 5.06% debt constant when amortization kicks in! Here are some amortized debt constants for given loan interest rates that show the increasing severity of this reality with lower interest rates. 

• 3% interest rate = 5.06% amortized debt constant
• 4% interest rate = 5.73% amortized debt constant
• 5% interest rate = 6.44% amortized debt constant
• 6% interest rate = 7.19% amortized debt constant
• 7% interest rate = 7.98% amortized debt constant 

At a 6% interest rate amortization increases debt service by 20%. At 4% interest rates, amortization increases debt service by over 43% – more than doubling the marginal impact. Many investors are banking on rent growth to bail them out of this massive jump in debt service when their interest only period expires. When evaluating the merits of investments, we look for a comfortable spread between our yield and our amortized debt constant, as well as a spread over our projected exit cap rate. While paying down principal via amortization isn’t our idea of an optimal investment strategy, it always makes sense to evaluate fully-amortized debt payments to confirm that our anticipated cash flows are sufficient and have the ability to ride out a loan’s principal and interest payments, even through a downturn.