This Best Ever blog article is brought to you by BAM Capital, the private equity arm of The BAM Companies, an institutional real estate owner/operator.
Investors often ask about in-place cap rates on acquisitions relative to current interest rates. This relationship tells investors if real estate operators are creating positive or negative leverage on these investments. While this question is fair, it doesn’t tell the whole story.
Real estate is a cash flow business. The trick is to underwrite a property not on in-place cash flow, but on stabilized cash flow. This calculation gives us a stabilized cap/yield, which is the most important metric when evaluating real estate. Not only is this metric important relative to current interest rates, but it gives us the intrinsic value of the property.
Below are two scenarios that display the difference between an in-place cap rate and a stabilized cap/yield with the corresponding cash-on-cash yield.
Let’s look at the in-place pro forma. The operator purchases a property for a 5% cap rate and borrows money from a lender for 5.5%.
This relationship represents negative leverage (in-place cap rate < interest rate) as it yields an initial levered cash-on-cash return of 4.25%. Does this initial below-average return make the deal bad? The answer is, unequivocally, no.
Now let’s fast forward to the stabilized pro forma showing the stabilized cap/yield relative to the interest rate. The operator acquires property at a 5% cap rate that is underperforming in the market (rents below market, occupancy struggles, above-market operating expenses, etc.). All other assumptions being equal, the operator executes their business plan and takes net operating income from $5M to $7.5M. This equates to a stabilized cap/yield of 7.5% compared to the interest rate of 5.5%.
This relationship is called positive leverage (stabilized yield > interest rate), as it now yields a levered cash-on-cash return of 10.5%. Not a bad deal after all.
This example clearly illustrates why the stabilized yield is critical to current interest rates. More importantly, the stabilized yield is paramount to the market cap rate, which creates real value for investors. In the above example, the stabilized yield is 7.5%, and the market cap rate is 5.5%. This 200-basis point spread is all profit.
Said another way, the operator acquires a property for $100M with $5M in net operating income (5.0% cap rate). The operator then increases the net operating income to $7.5M (7.5% stabilized yield) and sells for a 5.5% cap rate on $7.5M of net operating income ($136M), which produces a levered equity multiple that is close to 2x. So, while the initial cash-on-cash yield wasn’t appealing, the overall investment delivered healthy returns to the investor.
When evaluating real estate investments, it is important to focus on the stabilized yield metric rather than solely considering the in-place cap rates and current interest rates. The stabilized yield provides a more accurate representation of a property's intrinsic value and the potential returns that can be generated from it.
By using positive leverage, investors can maximize their real estate investments and create significant value for their portfolios. While the initial cash-on-cash yield may not be appealing, as demonstrated in the example above, executing a solid business plan and increasing net operating income can lead to healthy returns for investors.
About BAM Capital:
BAM Capital is the private equity arm of The BAM Companies, an institutional real estate owner/operator. BAM Capital offers its family of investors access to premier real estate investment opportunities, transparent stewardship of capital, a means to achieve portfolio diversification, and tax-advantaged, long-term wealth creation. Learn more.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.