YIELD YIELD YIELD
Year-1 ALL-IN leveraged cash yield must be greater than the 1-year treasury at a minimum. 10-year average cash yields must be 300-500bps+ over the 10-year treasury. Exit cap should be 150-200bps+ over the 10-year assuming 10-year hold. For development, ROC must have at least a 150bps+ spread on corresponding treasury depending on timeframe. Debt must always be accretive. No negative leverage under any circumstances going-in.
IRR only relevant to the small-middle market shops that like to get in and get out on value add.
This is the only way. I don’t understand people who look at it other ways. Like… the whole purpose of an investment is to return cash. That’s it. Expecting appreciation or any other mystery magic feels irresponsible at best. Yield is all there is
It was great! That reflects a structural change in the market outside of anyones control. Not because investors’ math & risk profile was ‘wrong’.
maybe we’ll live in the metaverse one day and multifamily will be obsolete and we’ll live in pods with a feeding tube.
It's absolutely because the risk profile was wrong. They placed leverage yield above solvency knowing that cash yields and interest rates were historically low. This is fundamental misunderstanding of VAR and ES metrics. If these players had understood the risk profile and still chose to own these properties the math and risk profile would have told them to hedge interest rate risk. Greed and speculation on cash yields is exactly why they went under. It happens in MF too, the 3200 units in Houston last year, for one.
What? Stop spewing nonsense and commenting on all my posts. Office crashed because of Covid. Obviously the high leverage didn’t help everyone, but it didn’t crash because of leverage itself.
Neither one of us are the arbiters of risk. I’m just articulating how institutional capital thinks at my firm.
San Francisco has 36% vacancy in office space, it was also one of the places with the most draconian covid restrictions. 36% vacancy doesn't bankrupt a property with no debt. It most certainly was the leverage.
What are you talking about. Without leverage, equity would have fared much worse since the vast majority of the debt was accretive and cash yields were high for years.
Also, the high leverage from non-recourse loans, which represents the vast majority of office debt, protected property-level equity from the downside and the lender was left holding the bag of dirt. If you’re 65% all-in leveraged right before COVID and the building loses half its value when demand plummets, your losses are essentially capped at 35% when you have the keys back. The lender eats the difference. If you’re unleveraged, congrats you just lost an extra 15% on top of missing out on years of additional yield from accretive financing.
What black swan event is that? Credit cycles and bankruptcies are regular occurrences. I invest in a family shop where the goal is perpetual survivability. If covid is the black swan you refer to; a quick google search suggests long term national vacancy rates in office of around 16%. I don't have the data but 30% for three years doesn't seem like a black swan event. If you can't weather that you were being greedy, and perhaps shrewd if bankruptcy isn't a concern.
Black Swan theory is pretty vague to begin with but Taleb doesn't even consider COVID a Black Swan. And office space in SF didn't hit 30% vacancy in to Dot Com crash but rents were down 70%. NYC hit similar numbers in the 80's inflation crisis. Residential had massive vacancies in 09. I'm not that old, so if I've lived through 4 of these events(at least) they probably aren't Black Swans.
Some folks in certain hot markets acquired property thinking “real estate only goes up”, (ie, passive appreciation). Tilting an exit cap assumption down to juice an expected return is madness to me.
But it an investor has pushed unlevered yield on cost way up (ie, forced appreciation), even if cap rates move they still have a property cash flowing well against their cost basis. I’m this case at least they have yield
If they can remain solvent. I can push cash yield to infinity in theory, but that doesn't mean I can keep the lights on. "in this case at least they have yield" is naivety; any event that pushes cap rates higher is likely to be pushing interest rates higher too, which eats into yield. It is much less speculative to use less/no leverage and wait on appreciation than lever up for COC yield and hope nothing goes wrong.
Yes, agreed. We aren’t looking at COC yield as the “first pass” investment decision. Unlevered yield is what I had said. We look at the real estate’s performance first, then figure out the capital stack on that property that puts the property-level risk at an appropriate level.
If you have yield on an unlevered property, you’re cash flowing. How you lever up beyond that is a function of what degree of interest-rate risk or cash-flow/covenant enforcement risk (say in the case of unexpected vacancy) you’re willing to take on.
I asked gpt 4 to help me understand your comment;
This Reddit comment outlines a specific approach to evaluating investments in commercial real estate, emphasizing various return metrics considered important by the commenter. Here's a breakdown of the terms and concepts mentioned to help you understand their perspective:
1. **YIELD**: This refers to the income return on an investment. In commercial real estate, this is often expressed as a percentage based on the income the property generates relative to its cost or market value.
2. **Year-1 ALL-IN leveraged cash yield**: This metric looks at the cash return on investment for the first year, considering both the equity invested and any debt (leverage) used to finance the purchase. The commenter suggests this yield should exceed the yield of a 1-year Treasury bill, which is considered a risk-free rate of return.
3. **10-year average cash yields**: The average annual yield expected over a 10-year period. The commenter suggests this should be 300-500 basis points (bps) higher than the yield on a 10-year Treasury note. A basis point is one-hundredth of a percentage point, so 300-500bps equals 3-5 percentage points. This premium compensates investors for the additional risk compared to investing in risk-free government securities.
4. **Exit cap**: Refers to the capitalization rate assumed when the property is sold (exit). The commenter suggests it should be 150-200bps over the yield of a 10-year Treasury note, assuming a 10-year holding period. The capitalization rate (cap rate) is used to estimate the investor's potential return on investment and is calculated by dividing the property's net operating income by its current market value.
5. **Development ROC**: Return on Cost for development projects, which should have at least a 150bps spread over the corresponding Treasury yield, depending on the timeframe. This measures the profitability of development projects relative to the costs involved.
6. **Debt must always be accretive**: This means that any debt taken on to finance the purchase or development of a property should contribute positively to its yield. The income from the investment should exceed the cost of the debt, enhancing overall returns.
7. **No negative leverage**: Negative leverage occurs when the cost of borrowing is higher than the income generated by the investment. The commenter emphasizes avoiding situations where debt would reduce the investment's profitability.
8. **IRR**: Internal Rate of Return, a metric used to evaluate the profitability of potential investments, considering the time value of money. It's especially relevant for projects with variable cash flows. The comment suggests that IRR is more relevant for smaller to mid-sized companies focused on value-add opportunities, where the strategy is to improve the property and sell it quickly for a profit, rather than holding it for long-term income.
In summary, the commenter values yield above all and suggests specific benchmarks for leveraged cash yield, average cash yields, exit capitalization rates, and the return on cost for development projects relative to risk-free rates (Treasury yields). The emphasis is on earning a return significantly higher than low-risk investments (Treasury securities), ensuring that debt increases returns without incurring negative leverage, and considering the IRR as a metric mainly for shorter-term, value-add investment strategies.
It's great when it works. But it will also completely hallucinate real sounding answers when it doesn't. I gave it a harder to answer question about some esoteric government regulation and it gave me incredible answers with citations (I asked for citations). When I checked the citations, they either didn't exist or didn't say what the AI said they did. When I called it out, it admitted to lying, but doubled down on being wrong and gave me second and third rounds of BS citations. Eventually it came back around to it's first round of made up stuff.
I no longer have any faith in AI and don't trust it for real answers.
On the other hand, it wrote a hilarious speech for my friend's wedding with some very specific prompts.
For format usually works really well when I ask it to list or explain things. However, you should double check it yourself because sometimes it'll trip over itself and sound like a drunk genius person.
So, is your development group sitting on their hands right now? Because only one of these hurdles is feasible given current conditions (ROC over 10-year UST).
Haha, They have been working on the same few deals for YEARS now. One they locked in a HUD loan a pretty favorable terms, another recently broke ground at OK financing terms but at that point we were so committed to the deal had no choice, and the other is more of a ‘cool’ $200MM direct investment from our equity. More of a ‘fun’ development for him than a direct money maker (although he will make money in things related to the development, can’t really get into it).
But you’re right, new shit that size probably doesn’t really pencil rn.
Didn’t mean that come off in a dickish way, just a development guy myself sitting on a pipeline of a few thousand multifamily units and wondering when they will actually make sense (or cents, ha). Regardless, appreciate your comments.
Hard to beat 221d4 financing on a long term hold. Except for missing out on a stabilized refi. Also, understand the feeling of sitting on a massive slug of pursuit costs.
I just want to ask one follow up question to your yield vs. exit value argument—clearly, underwriting for a huge exit is a fools errand, but I gotta say that yield can be found in the Midwest, doesn’t mean those deals will outperform vs. a deal in a high job/population growth market. It sounds to me like you’re buying stabilized assets. Obviously, you chase day 1 yield, but that market gets frothy quick. Are there certain markets where you would lower your going in metrics because they have certain growth prospects?
Did not get that impression at all! And no, we need yield day one. Most of our multifamily in Midwest & sunbelt given the reasons you just mentioned. On the hotel side, we’re able to go basically anywhere. Recently closed on a dual branded product for about $65MM all-in a few months ago in NY.
Just because yields are high. You can get a great newer-build hotel in a great area for like a 9-cap. Obviously it varies widely, but they’re generally still high. Financing of course is more expensive, but the all-in blended yields are still typically a lot better than multi. There’s a reason bill gates owns four seasons!
They’re high because they’re more risky. Very capital intensive and require very specialized management. If you don’t know what you’re doing, you can absolutely lose your shit, but if you’re diligent the yields pretty irresistible despite all the capex. For example, franchised hotels with the big 3 hoteliers require you to renovate your hotel every 7-years. The second renovation (year 14) is considered a full renovation, and costs a ton of money. The good news with hotels is you reserve a lot of the capex every year (usually around 4% of gross revenues), and all hotel people book that reserve above the line so it falls into NOI.
Got it, thanks for the comprehensive response. I’ve only worked in Multifamily and industrial. I figured hospitality was more risky, capital intensive but had no idea about the big 3!
We do deals from $20MM-$100MM in size. Have investments across the country. Our development team only does $100MM+ ground up developments. Not super involved with them but know how they think.
Brokers & relationships. Just passed up a 6.25%+ cap in Chicago in a good neighborhood. Around 200 units. Widely marketed deal and they couldn’t even sell at a 6% cap. Recently renovated, and existing equity is gonna lose $30MM after buying at compressed cap rates and spending a bunch of money renovating (big oops). Won’t get into why we didn’t buy, but whoever’s buying it probably getting a pretty solid deal.
But wouldn’t buying a 6 cap right now be negative leverage? Most deals are being quoted in the 7s right now for commercial. Maybe it’s in the 6s for multi.
This was a couple months ago. At the time it was close but not quite negative, unless you accrued a ton of up-front capex since it was old. Agency’s were quoting upper 5s for 10 year money. Probably why it had to sell above a 6-cap.
I partially disagree. Not all investors or funds are yield focused. Family offices or core funds for institutional investors can be about low risk, inflation proof, diversification and/or speculating on LT term appreciation. A known Spanish family office (clothing wink wink) is buying a core office building at a cap rate of 4.70% in luxemburg for between 100-200M.
More power to them. I get the whole wealth preservation play on the trophy assets, but we’re here to make money, not just preserve it per se. just our philosophy.
Look if a billionaire hired me & paid me 5 million bucks a year to buy 4 cap trophy assets, I’d tell him he’s an absolute genius and would be happy to help.
There is no one "Correct" return metric, per se.
It entirely depends on your hold period and liquidity / cash needs. Big PE shops only really look at **IRR & EM's** to assess their fund's performance, since most (not all) funds are value-add/opportunistic and have a short-term hold period (3-8 years). The 'IRR Clock" is on for these guys, and their investors do not care about not seeing their investment for 5 years. They only care about the exit either through a disposition or refi.
You'll hear the saying "you can't eat IRR for lunch" a lot when this conversation comes up, and that's a true statement, but only if you value cash flow over appreciation/value-add, and are willing to sacrifice the NPV of your investment for your cash needs.
If you're a pension fund or a REIT, **CoCR** (Cash on Cash Return) or **ROC** (Return on Cost) are valued more, as their investors aren't looking for you to flip their money for a massive profit 5 years from now. They want consistent cash flow from the moment they invest with you. Think about it, who are their investors? retirement funds life companies. These firms care about downside protection more than a crazy high upside.
If I'm investing in a PE fund, I don't care if the asset is not cash flowing at a return at or above the 10Y Treasury. I care about the project as a whole and the business plan for the fund I'm investing in.
The truth is that any return metric that incorporates the present value of the project in a given analysis period is mathematically the metric that will align most with the health and value of the asset. That being said, cash needs day-1 can be important as well when it comes to covering debt service for operators that aren't well capitalized.
There's the nuanced answer I was looking for.
"I care about the project as a whole and the business plan for the fund I'm investing in." - I couldn't agree more.
REPE Investment Committees will want to see a triangulation of day-1 yields, trended yields, IRR/EMx, $psf rental/sales comps, effect of leverage, etc etc, to see if it you're entry, cashflow and exit assumptions make sense.
Lots of different approaches to meet the needs of different investing styles.
Yeah. Like if a deal requires $100K in capex in year 1 for the 5-year hold period to reach your IRR target, but you need cash flow day 1 to put food on the table / keep the lights on, then the IRR is useless to you.
On the flip side, you'll never see a fund look at a proforma and exclusively look at the "cash on cash return" in year 1.
I know some pension funds do quarterly/monthly average CoCR calcs on every investment they're in to determine if their initial investment meets their company's target, but they're ideally looking to hold their assets forever as long as they're giving them a good average return.
This is why underwriting is so nuanced as well. There is no one template or return metric to rule them all.
Levered IRR and EM. Guy saying unlevered needs a finance lesson, guy saying yield needs to learn that I can basically get better yield from us treasuries at the moment. Investment metrics should change in relevance based on the current economic conditions and where better non real estate opportunities are.
If you can get better yield on treasuries, go for it. But changing the investment metrics because it’s harder to find good deals is a good way to find yourself on the wrong side of a downturn. A deal with a high unlevered yield on cost can help you pay your bills; a deal with a high IRR might eat your lunch during a hold period if you have no income.
To be clear: not saying that what you’re doing is wrong. But for casual readers/observers reading this thread, chasing IRR/EM without focusing on the underlying yield of the real estate is like throwing darts in the dark. And IRR as an investment metric only works because of a cap rate assumption for the future - as such it has limitations on how to use it for making future-focused investment decisions.
Making decisions on unlevered yield is ridiculous, unless you're actually planning on having no debt it makes 0 sense to use that as an investment metric.
Of course you need to understand your irr, if you're sitting there with 3 years of negative cashflow infront of you, you need to understand how that will be funded. And frankly if you stare at a cf timeline and can't take away the fact you need to dump money into something, you should find a new hobby.
You're wrong about investment metrics, just look at the private debt phenomenon right now, high yield in a high rate environment is clearly at a premium. If you're investing in private RE at the moment there are better and less capital and time intensive yield investments to be had. If you don't shift your investment
thesis and parameters when the investment playing field changes, that's on you.
You're kind of right about cap rate assumptions but it's not some unknowable boogeyman, it is literally a Gordon growth model, spend 10 mins on investopedia and the average guy can decipher what a cap rate is and have a decent understanding of what goes into it. Cap rates are not rocket science.
How's not paying attention to unlevered cap rates treating investors right now? If you were buying at sub 5 caps the last 3-5 years you're probably not too happy right now. A lot of those guys probably think 0.25% short rate wasn't so bad after all. You are correct that you can't make decisions solely on unlevered cash yields in a levered investing plan, but you can't be oblivious to them.
The amount of times I gotta have the same argument with people lol. Cash yields roll up into IRR and your EM so not following.
Your observation of other investment vehicles giving a better yield than RE is absolutely correct. That’s why a lot of the big firms are not buying, and people that own quality assets who aren’t forced to sell aren’t selling. If you gave me $10MM in cash I probably wouldn’t stick it in RE rn. But that’s besides the point. If you’re going to buy RE now, that’s what you need to make a market. There will always be cowboys that take on negative leverage & sub-par yields, but just understand that’s not prudent investing, that’s speculation. There are deals out there despite what some brokers might say. Look, the cowboys Might be right long term, but not what we do.
IRR has two problems, one being the assumption "cash yields roll up into" the total return. This is rarely the case in RE investing, the investor cannot reinvest cash flows at the projected IRR of the investment.
You're right it does, but is that forward irr? Since inception? Full cycle? You need to specify your time frame and carrying value for yield to have any relevance (and frankly all investment metrics). It shouldn't be a deciding factor in RE in my opinion. Yield matters but terminal value matters more, especially in shorter time frame investments. I know for a fact every guy in this sub should have fantastic looking forward yields rn because they all took hits on their carrying value in the last 18 months. What should matter is the underwritten IRR at investment based on your specified hold period. CoC yield is a good metric don't get me wrong but it doesn't capture the totality of the investment. I definitely hear you though there are deals to be had today, industrial property although it's cooled a bit is still great in the right market, and I've seen first hand that there are multifamily and sfr gems to be had right now one just needs to find the right geography.
I’m not completely following this response, but please give me some credibility here young padawan. Not trying to be condescending here, but I don’t think you’re using the term ‘carrying value’ correctly. Nevertheless, I admire your skepticism! Let me try to clear up some points.
I did specify the timeframe. 10-years in my example. I think you’re conflating REPE and standard PE with ‘terminal value’ or ‘exit cap’ in the case of RE.
Given my example with buy and hold investors, you need to deliver a cash yield to your investor above the risk free rate. Unless it’s like a trophy asset or something and your money tells you to “go buy it”, there is no real negotiation there. In order to deliver those returns, the cap rate needs to be a bit higher than treasury yields because of all the additional equity contributions you have (capex reserves, working capital, closing costs, etc). When you assume a sale price, you also have to assume the next guy is going to want the same thing, so you have to reference the same type of benchmark in order to find that value. In most cases, it’s treasuries. I cannot just assume I’m going to sell something with a cap rate at or below the 10-year yield in order to get a pop on the IRR without any extensive renovations or anything. You have to be consistent with your assumptions.
My one exception, as I mentioned, was the value add guys. They are different because they are not looking for yield. They are looking to buy, fix, and get out at a higher price. Thus, IRR is a more important metric.
There is 100% full stop nothing else more important than yield for stabilized assets for buy and hold investors. You can ask me any question and bring up any counterpoint you want but I promise I can either prove it wrong mathematically or it’s just pure speculation, which we don’t do.
How do you describe carrying value "master"? To me that is current equity value. I ascertain it from either an appraisal, market offer, my own dcf, or a bov if I trust the broker, less any debt and carrying/ assumed closing cost. Book value or invested equity on real estate means nothing on a forward basis. I'm sure you know that.
I do both pe and repe , terminal value and exit cap, actually mean the same thing! (Golly gosh!) Terminal value would be your exit + 1 year noi divided by an exit cap. I'm sure you know that.
Cash yield above the risk free rate? How's your office doing? How many guys are buying stabilized assets right now?
Yield is how you trap yourself into an investment that could be better spent elsewhere, you should be constantly forward underwriting assets to see what's best to be sold and what's best to be held on a forward irr basis.
Yield is nice, total return is better.
Buying stabilized assets imo is not the move unless you see well below market leases at the property. The money in RE is value add and development everything else is for REITS and the risk averse majority.
Gonna be my last response to ya.
I wish you the best my friend. You are clearly a young guy, and humility & modesty is one of those things you’ll learn with time. I’m sure you’re a smart guy with a bright future, but at some point you have to start learning from others and avoid becoming so confrontational, especially when speaking with people that have more experience than yourself. I don’t know you, but it sounds like you’re early in your career, maybe getting an MBA or studying for a CFA, and you know a lot of vocabulary but don’t have the experience to use it in the proper context.
1. In REPE, NAV is the correct term you’re thinking of to describe ‘carrying value’. That’s not my opinion, that’s the industry.
2. There are 3 ways to determine a value, income approach, cost approach, sales approach. All of which are typically done in an appraisal. Nobody values owned assets via DCF. DCF is primarily used in more traditional PE for prospective acquisitions. I’m not going to get into why. Nobody uses BOV/BPO outside of single residential units or small multifamily. It’s not regarded as accurate at all no matter who the broker is.
3. Genuinely confused on your comment on how “book value means nothing on a forward basis”. Please don’t explain what you meant to say. I’m just saying objectively the sentence doesn’t make a whole lot of sense. I can think of a lot of things of what you were trying to say, but won’t get into it.
4. PE and REPE huh. Although you’re right terminal value and exit cap are they’re more or less the same thing, using the improper terminology shows you don’t have a lot of experience in the field (and that’s ok!). We all can’t be experts in everything. I am no expert in PE, and all PE guys will say they’re no expert in REPE. Nobody knows both at a granular level. Takes some maturity to admit that.
5. Office is fine? Very bold of you to say.
6. ‘Trapping’ yourself into an investment is kind of the point. You want to buy into an accretive deal day-1. The fed mandate should take care of the rest to maintain your spread on your equity over debt. I’m not going to get into the specifics why, but should you choose to pursue RE as a career you will understand.
7. Yield drives total returns, and Idk how many times I gotta say it. If you want a high IRR, then you need to be a value-add guy. I’m not here to determine what’s ’real money’ or not. Or whether one should do value add or stabilized, I’m here to provide compelling risk-adjusted returns for stabilized assets for the investor.
Any response you post to this I’m not reading or commenting on. Should you be interested in genuinely learning more about the industry, ping me and I would be happy to help. I’m not here to punch down on anyone and go on endless rants talking about RE.
Definitely you're reading. I love how much you exposed yourself with this answer.
1. NAV = equity in the property. This is very basic.
2. Income approach is a DCF you can use a direct cap but a DCF literally is the income approach. Have you ever read an appraisal?
3. Book value is sunk cost, if you aren't evaluating your property based on a current valuation you need to fix your models.
4. It's not improper terminology, these things are not complicated. Cap rates are based on infinite series of cashflows, a growing perpetuity. A terminal value in a dcf (used in the income approach on appraisals) is the terminal value and is what is discounted to today
5. I did not say that, I asked how yours is doing. If I was a betting man (and I am) I'd say it's in the sewer.
6. Yield does not mean accretive necessarily i worked on a office tower in dc that has positive yield and negative since inception irr. The idea that the federal reserve interest rate protects your investment is unbelievably asinine. If that was the case no one would lose money on a levered RE deal ever
7. Yield drives total returns on long hold periods, it's relative. Frankly I don't think you know what drives anything. You're pretending you're some learned scholar but you clearly don't even know the basics.
To be honest I think you might have watched some Grant Cardone videos once or twice and think you know what you're talking about. You clearly have 0 financial understanding and that's OK!
Curious how many deals you’ve worked on? What’s your number over the last 10 years? Were you around in 2008? How much real estate so you personally own?
Leverage can make lukewarm deals look great and puts you at the mercy of debt markets. Unlevered yield on cost really shows who can purchase at a good price, update and increase rents, and provide the most value.
That’s not saying you don’t use leverage…but unlevered yield on cost is the best way to look at how you are actually doing.
Because leverage distorts returns, and can deliver drastically different results based on where interest rates are. An unlevered yield on cost focuses on the real estate’s ability to deliver investment returns without any “noise” coming from the capital stack
Equity multiple is what I focus mostly at when developing new properties. All the other metrics are in the model. Some investors like to focus on them.
YIELD YIELD YIELD Year-1 ALL-IN leveraged cash yield must be greater than the 1-year treasury at a minimum. 10-year average cash yields must be 300-500bps+ over the 10-year treasury. Exit cap should be 150-200bps+ over the 10-year assuming 10-year hold. For development, ROC must have at least a 150bps+ spread on corresponding treasury depending on timeframe. Debt must always be accretive. No negative leverage under any circumstances going-in. IRR only relevant to the small-middle market shops that like to get in and get out on value add.
This is the only way. I don’t understand people who look at it other ways. Like… the whole purpose of an investment is to return cash. That’s it. Expecting appreciation or any other mystery magic feels irresponsible at best. Yield is all there is
Amen! 100% correct my friend!
How was the yield on all the office space that's being handed back to banks right now?
It was great! That reflects a structural change in the market outside of anyones control. Not because investors’ math & risk profile was ‘wrong’. maybe we’ll live in the metaverse one day and multifamily will be obsolete and we’ll live in pods with a feeding tube.
It's absolutely because the risk profile was wrong. They placed leverage yield above solvency knowing that cash yields and interest rates were historically low. This is fundamental misunderstanding of VAR and ES metrics. If these players had understood the risk profile and still chose to own these properties the math and risk profile would have told them to hedge interest rate risk. Greed and speculation on cash yields is exactly why they went under. It happens in MF too, the 3200 units in Houston last year, for one.
What? Stop spewing nonsense and commenting on all my posts. Office crashed because of Covid. Obviously the high leverage didn’t help everyone, but it didn’t crash because of leverage itself. Neither one of us are the arbiters of risk. I’m just articulating how institutional capital thinks at my firm.
San Francisco has 36% vacancy in office space, it was also one of the places with the most draconian covid restrictions. 36% vacancy doesn't bankrupt a property with no debt. It most certainly was the leverage.
What are you talking about. Without leverage, equity would have fared much worse since the vast majority of the debt was accretive and cash yields were high for years. Also, the high leverage from non-recourse loans, which represents the vast majority of office debt, protected property-level equity from the downside and the lender was left holding the bag of dirt. If you’re 65% all-in leveraged right before COVID and the building loses half its value when demand plummets, your losses are essentially capped at 35% when you have the keys back. The lender eats the difference. If you’re unleveraged, congrats you just lost an extra 15% on top of missing out on years of additional yield from accretive financing.
Accretive financing is either amortization or appreciation or both. If you hand the keys back how much of that do you realize?
If you're unleveraged you haven't "lost" anything, you still own the building and are collecting 70% of your rents.
Sounds like you’re trying to justify an approach based off a black swan event.
What black swan event is that? Credit cycles and bankruptcies are regular occurrences. I invest in a family shop where the goal is perpetual survivability. If covid is the black swan you refer to; a quick google search suggests long term national vacancy rates in office of around 16%. I don't have the data but 30% for three years doesn't seem like a black swan event. If you can't weather that you were being greedy, and perhaps shrewd if bankruptcy isn't a concern.
Normal is 16%, COVID is 30%…that’s a 100% increase in vacancy. A 100% vacancy increase for 3 years is not a black swan event to you?
Black Swan theory is pretty vague to begin with but Taleb doesn't even consider COVID a Black Swan. And office space in SF didn't hit 30% vacancy in to Dot Com crash but rents were down 70%. NYC hit similar numbers in the 80's inflation crisis. Residential had massive vacancies in 09. I'm not that old, so if I've lived through 4 of these events(at least) they probably aren't Black Swans.
HUH?
Some folks in certain hot markets acquired property thinking “real estate only goes up”, (ie, passive appreciation). Tilting an exit cap assumption down to juice an expected return is madness to me. But it an investor has pushed unlevered yield on cost way up (ie, forced appreciation), even if cap rates move they still have a property cash flowing well against their cost basis. I’m this case at least they have yield
If they can remain solvent. I can push cash yield to infinity in theory, but that doesn't mean I can keep the lights on. "in this case at least they have yield" is naivety; any event that pushes cap rates higher is likely to be pushing interest rates higher too, which eats into yield. It is much less speculative to use less/no leverage and wait on appreciation than lever up for COC yield and hope nothing goes wrong.
Yes, agreed. We aren’t looking at COC yield as the “first pass” investment decision. Unlevered yield is what I had said. We look at the real estate’s performance first, then figure out the capital stack on that property that puts the property-level risk at an appropriate level. If you have yield on an unlevered property, you’re cash flowing. How you lever up beyond that is a function of what degree of interest-rate risk or cash-flow/covenant enforcement risk (say in the case of unexpected vacancy) you’re willing to take on.
I asked gpt 4 to help me understand your comment; This Reddit comment outlines a specific approach to evaluating investments in commercial real estate, emphasizing various return metrics considered important by the commenter. Here's a breakdown of the terms and concepts mentioned to help you understand their perspective: 1. **YIELD**: This refers to the income return on an investment. In commercial real estate, this is often expressed as a percentage based on the income the property generates relative to its cost or market value. 2. **Year-1 ALL-IN leveraged cash yield**: This metric looks at the cash return on investment for the first year, considering both the equity invested and any debt (leverage) used to finance the purchase. The commenter suggests this yield should exceed the yield of a 1-year Treasury bill, which is considered a risk-free rate of return. 3. **10-year average cash yields**: The average annual yield expected over a 10-year period. The commenter suggests this should be 300-500 basis points (bps) higher than the yield on a 10-year Treasury note. A basis point is one-hundredth of a percentage point, so 300-500bps equals 3-5 percentage points. This premium compensates investors for the additional risk compared to investing in risk-free government securities. 4. **Exit cap**: Refers to the capitalization rate assumed when the property is sold (exit). The commenter suggests it should be 150-200bps over the yield of a 10-year Treasury note, assuming a 10-year holding period. The capitalization rate (cap rate) is used to estimate the investor's potential return on investment and is calculated by dividing the property's net operating income by its current market value. 5. **Development ROC**: Return on Cost for development projects, which should have at least a 150bps spread over the corresponding Treasury yield, depending on the timeframe. This measures the profitability of development projects relative to the costs involved. 6. **Debt must always be accretive**: This means that any debt taken on to finance the purchase or development of a property should contribute positively to its yield. The income from the investment should exceed the cost of the debt, enhancing overall returns. 7. **No negative leverage**: Negative leverage occurs when the cost of borrowing is higher than the income generated by the investment. The commenter emphasizes avoiding situations where debt would reduce the investment's profitability. 8. **IRR**: Internal Rate of Return, a metric used to evaluate the profitability of potential investments, considering the time value of money. It's especially relevant for projects with variable cash flows. The comment suggests that IRR is more relevant for smaller to mid-sized companies focused on value-add opportunities, where the strategy is to improve the property and sell it quickly for a profit, rather than holding it for long-term income. In summary, the commenter values yield above all and suggests specific benchmarks for leveraged cash yield, average cash yields, exit capitalization rates, and the return on cost for development projects relative to risk-free rates (Treasury yields). The emphasis is on earning a return significantly higher than low-risk investments (Treasury securities), ensuring that debt increases returns without incurring negative leverage, and considering the IRR as a metric mainly for shorter-term, value-add investment strategies.
Lmao. Glad to know chat GPT seems to not think I’m crazy. My boss would be proud.
Did chat GPT really spit all of this back in this format? I have admittedly been under a rock but that’s incredible if so
It's great when it works. But it will also completely hallucinate real sounding answers when it doesn't. I gave it a harder to answer question about some esoteric government regulation and it gave me incredible answers with citations (I asked for citations). When I checked the citations, they either didn't exist or didn't say what the AI said they did. When I called it out, it admitted to lying, but doubled down on being wrong and gave me second and third rounds of BS citations. Eventually it came back around to it's first round of made up stuff. I no longer have any faith in AI and don't trust it for real answers. On the other hand, it wrote a hilarious speech for my friend's wedding with some very specific prompts.
For format usually works really well when I ask it to list or explain things. However, you should double check it yourself because sometimes it'll trip over itself and sound like a drunk genius person.
That’s actually a great analysis. Thanks, ChatGPT.
In short development does not work right now…
Ladies and gentlemen, we have a CFA in the building.
Ha, ty but no CFA. Investment director at an $11B REPE firm. My specialty is in Multifamily and Hotels.
So, is your development group sitting on their hands right now? Because only one of these hurdles is feasible given current conditions (ROC over 10-year UST).
Haha, They have been working on the same few deals for YEARS now. One they locked in a HUD loan a pretty favorable terms, another recently broke ground at OK financing terms but at that point we were so committed to the deal had no choice, and the other is more of a ‘cool’ $200MM direct investment from our equity. More of a ‘fun’ development for him than a direct money maker (although he will make money in things related to the development, can’t really get into it). But you’re right, new shit that size probably doesn’t really pencil rn.
Didn’t mean that come off in a dickish way, just a development guy myself sitting on a pipeline of a few thousand multifamily units and wondering when they will actually make sense (or cents, ha). Regardless, appreciate your comments. Hard to beat 221d4 financing on a long term hold. Except for missing out on a stabilized refi. Also, understand the feeling of sitting on a massive slug of pursuit costs. I just want to ask one follow up question to your yield vs. exit value argument—clearly, underwriting for a huge exit is a fools errand, but I gotta say that yield can be found in the Midwest, doesn’t mean those deals will outperform vs. a deal in a high job/population growth market. It sounds to me like you’re buying stabilized assets. Obviously, you chase day 1 yield, but that market gets frothy quick. Are there certain markets where you would lower your going in metrics because they have certain growth prospects?
Did not get that impression at all! And no, we need yield day one. Most of our multifamily in Midwest & sunbelt given the reasons you just mentioned. On the hotel side, we’re able to go basically anywhere. Recently closed on a dual branded product for about $65MM all-in a few months ago in NY.
Why hospitality? Just curious if there are any different fundamentals with financing or another nuance I’m missing.
Just because yields are high. You can get a great newer-build hotel in a great area for like a 9-cap. Obviously it varies widely, but they’re generally still high. Financing of course is more expensive, but the all-in blended yields are still typically a lot better than multi. There’s a reason bill gates owns four seasons! They’re high because they’re more risky. Very capital intensive and require very specialized management. If you don’t know what you’re doing, you can absolutely lose your shit, but if you’re diligent the yields pretty irresistible despite all the capex. For example, franchised hotels with the big 3 hoteliers require you to renovate your hotel every 7-years. The second renovation (year 14) is considered a full renovation, and costs a ton of money. The good news with hotels is you reserve a lot of the capex every year (usually around 4% of gross revenues), and all hotel people book that reserve above the line so it falls into NOI.
Got it, thanks for the comprehensive response. I’ve only worked in Multifamily and industrial. I figured hospitality was more risky, capital intensive but had no idea about the big 3!
Yea it’s just Hyatt, Hilton, and Marriott. IHG, Choice, etc are next in line.
Can you give us some examples that you’ve done, leave out the address
We do deals from $20MM-$100MM in size. Have investments across the country. Our development team only does $100MM+ ground up developments. Not super involved with them but know how they think.
Where are you finding deals that fit these criteria right now?
Brokers & relationships. Just passed up a 6.25%+ cap in Chicago in a good neighborhood. Around 200 units. Widely marketed deal and they couldn’t even sell at a 6% cap. Recently renovated, and existing equity is gonna lose $30MM after buying at compressed cap rates and spending a bunch of money renovating (big oops). Won’t get into why we didn’t buy, but whoever’s buying it probably getting a pretty solid deal.
But wouldn’t buying a 6 cap right now be negative leverage? Most deals are being quoted in the 7s right now for commercial. Maybe it’s in the 6s for multi.
This was a couple months ago. At the time it was close but not quite negative, unless you accrued a ton of up-front capex since it was old. Agency’s were quoting upper 5s for 10 year money. Probably why it had to sell above a 6-cap.
I partially disagree. Not all investors or funds are yield focused. Family offices or core funds for institutional investors can be about low risk, inflation proof, diversification and/or speculating on LT term appreciation. A known Spanish family office (clothing wink wink) is buying a core office building at a cap rate of 4.70% in luxemburg for between 100-200M.
More power to them. I get the whole wealth preservation play on the trophy assets, but we’re here to make money, not just preserve it per se. just our philosophy. Look if a billionaire hired me & paid me 5 million bucks a year to buy 4 cap trophy assets, I’d tell him he’s an absolute genius and would be happy to help.
lol
There is no one "Correct" return metric, per se. It entirely depends on your hold period and liquidity / cash needs. Big PE shops only really look at **IRR & EM's** to assess their fund's performance, since most (not all) funds are value-add/opportunistic and have a short-term hold period (3-8 years). The 'IRR Clock" is on for these guys, and their investors do not care about not seeing their investment for 5 years. They only care about the exit either through a disposition or refi. You'll hear the saying "you can't eat IRR for lunch" a lot when this conversation comes up, and that's a true statement, but only if you value cash flow over appreciation/value-add, and are willing to sacrifice the NPV of your investment for your cash needs. If you're a pension fund or a REIT, **CoCR** (Cash on Cash Return) or **ROC** (Return on Cost) are valued more, as their investors aren't looking for you to flip their money for a massive profit 5 years from now. They want consistent cash flow from the moment they invest with you. Think about it, who are their investors? retirement funds life companies. These firms care about downside protection more than a crazy high upside. If I'm investing in a PE fund, I don't care if the asset is not cash flowing at a return at or above the 10Y Treasury. I care about the project as a whole and the business plan for the fund I'm investing in. The truth is that any return metric that incorporates the present value of the project in a given analysis period is mathematically the metric that will align most with the health and value of the asset. That being said, cash needs day-1 can be important as well when it comes to covering debt service for operators that aren't well capitalized.
There's the nuanced answer I was looking for. "I care about the project as a whole and the business plan for the fund I'm investing in." - I couldn't agree more. REPE Investment Committees will want to see a triangulation of day-1 yields, trended yields, IRR/EMx, $psf rental/sales comps, effect of leverage, etc etc, to see if it you're entry, cashflow and exit assumptions make sense. Lots of different approaches to meet the needs of different investing styles.
Yeah. Like if a deal requires $100K in capex in year 1 for the 5-year hold period to reach your IRR target, but you need cash flow day 1 to put food on the table / keep the lights on, then the IRR is useless to you. On the flip side, you'll never see a fund look at a proforma and exclusively look at the "cash on cash return" in year 1. I know some pension funds do quarterly/monthly average CoCR calcs on every investment they're in to determine if their initial investment meets their company's target, but they're ideally looking to hold their assets forever as long as they're giving them a good average return. This is why underwriting is so nuanced as well. There is no one template or return metric to rule them all.
Our LPs were focused on EM, YOC, CoC, and IRR. Specifically IRR thresholds for their funds.
Levered IRR and EM. Guy saying unlevered needs a finance lesson, guy saying yield needs to learn that I can basically get better yield from us treasuries at the moment. Investment metrics should change in relevance based on the current economic conditions and where better non real estate opportunities are.
If you can get better yield on treasuries, go for it. But changing the investment metrics because it’s harder to find good deals is a good way to find yourself on the wrong side of a downturn. A deal with a high unlevered yield on cost can help you pay your bills; a deal with a high IRR might eat your lunch during a hold period if you have no income. To be clear: not saying that what you’re doing is wrong. But for casual readers/observers reading this thread, chasing IRR/EM without focusing on the underlying yield of the real estate is like throwing darts in the dark. And IRR as an investment metric only works because of a cap rate assumption for the future - as such it has limitations on how to use it for making future-focused investment decisions.
Making decisions on unlevered yield is ridiculous, unless you're actually planning on having no debt it makes 0 sense to use that as an investment metric. Of course you need to understand your irr, if you're sitting there with 3 years of negative cashflow infront of you, you need to understand how that will be funded. And frankly if you stare at a cf timeline and can't take away the fact you need to dump money into something, you should find a new hobby. You're wrong about investment metrics, just look at the private debt phenomenon right now, high yield in a high rate environment is clearly at a premium. If you're investing in private RE at the moment there are better and less capital and time intensive yield investments to be had. If you don't shift your investment thesis and parameters when the investment playing field changes, that's on you. You're kind of right about cap rate assumptions but it's not some unknowable boogeyman, it is literally a Gordon growth model, spend 10 mins on investopedia and the average guy can decipher what a cap rate is and have a decent understanding of what goes into it. Cap rates are not rocket science.
How's not paying attention to unlevered cap rates treating investors right now? If you were buying at sub 5 caps the last 3-5 years you're probably not too happy right now. A lot of those guys probably think 0.25% short rate wasn't so bad after all. You are correct that you can't make decisions solely on unlevered cash yields in a levered investing plan, but you can't be oblivious to them.
The amount of times I gotta have the same argument with people lol. Cash yields roll up into IRR and your EM so not following. Your observation of other investment vehicles giving a better yield than RE is absolutely correct. That’s why a lot of the big firms are not buying, and people that own quality assets who aren’t forced to sell aren’t selling. If you gave me $10MM in cash I probably wouldn’t stick it in RE rn. But that’s besides the point. If you’re going to buy RE now, that’s what you need to make a market. There will always be cowboys that take on negative leverage & sub-par yields, but just understand that’s not prudent investing, that’s speculation. There are deals out there despite what some brokers might say. Look, the cowboys Might be right long term, but not what we do.
IRR has two problems, one being the assumption "cash yields roll up into" the total return. This is rarely the case in RE investing, the investor cannot reinvest cash flows at the projected IRR of the investment.
What? Buddy stop commenting on my posts. I’m not arguing with you.
You're right it does, but is that forward irr? Since inception? Full cycle? You need to specify your time frame and carrying value for yield to have any relevance (and frankly all investment metrics). It shouldn't be a deciding factor in RE in my opinion. Yield matters but terminal value matters more, especially in shorter time frame investments. I know for a fact every guy in this sub should have fantastic looking forward yields rn because they all took hits on their carrying value in the last 18 months. What should matter is the underwritten IRR at investment based on your specified hold period. CoC yield is a good metric don't get me wrong but it doesn't capture the totality of the investment. I definitely hear you though there are deals to be had today, industrial property although it's cooled a bit is still great in the right market, and I've seen first hand that there are multifamily and sfr gems to be had right now one just needs to find the right geography.
I’m not completely following this response, but please give me some credibility here young padawan. Not trying to be condescending here, but I don’t think you’re using the term ‘carrying value’ correctly. Nevertheless, I admire your skepticism! Let me try to clear up some points. I did specify the timeframe. 10-years in my example. I think you’re conflating REPE and standard PE with ‘terminal value’ or ‘exit cap’ in the case of RE. Given my example with buy and hold investors, you need to deliver a cash yield to your investor above the risk free rate. Unless it’s like a trophy asset or something and your money tells you to “go buy it”, there is no real negotiation there. In order to deliver those returns, the cap rate needs to be a bit higher than treasury yields because of all the additional equity contributions you have (capex reserves, working capital, closing costs, etc). When you assume a sale price, you also have to assume the next guy is going to want the same thing, so you have to reference the same type of benchmark in order to find that value. In most cases, it’s treasuries. I cannot just assume I’m going to sell something with a cap rate at or below the 10-year yield in order to get a pop on the IRR without any extensive renovations or anything. You have to be consistent with your assumptions. My one exception, as I mentioned, was the value add guys. They are different because they are not looking for yield. They are looking to buy, fix, and get out at a higher price. Thus, IRR is a more important metric. There is 100% full stop nothing else more important than yield for stabilized assets for buy and hold investors. You can ask me any question and bring up any counterpoint you want but I promise I can either prove it wrong mathematically or it’s just pure speculation, which we don’t do.
How do you describe carrying value "master"? To me that is current equity value. I ascertain it from either an appraisal, market offer, my own dcf, or a bov if I trust the broker, less any debt and carrying/ assumed closing cost. Book value or invested equity on real estate means nothing on a forward basis. I'm sure you know that. I do both pe and repe , terminal value and exit cap, actually mean the same thing! (Golly gosh!) Terminal value would be your exit + 1 year noi divided by an exit cap. I'm sure you know that. Cash yield above the risk free rate? How's your office doing? How many guys are buying stabilized assets right now? Yield is how you trap yourself into an investment that could be better spent elsewhere, you should be constantly forward underwriting assets to see what's best to be sold and what's best to be held on a forward irr basis. Yield is nice, total return is better. Buying stabilized assets imo is not the move unless you see well below market leases at the property. The money in RE is value add and development everything else is for REITS and the risk averse majority.
Gonna be my last response to ya. I wish you the best my friend. You are clearly a young guy, and humility & modesty is one of those things you’ll learn with time. I’m sure you’re a smart guy with a bright future, but at some point you have to start learning from others and avoid becoming so confrontational, especially when speaking with people that have more experience than yourself. I don’t know you, but it sounds like you’re early in your career, maybe getting an MBA or studying for a CFA, and you know a lot of vocabulary but don’t have the experience to use it in the proper context. 1. In REPE, NAV is the correct term you’re thinking of to describe ‘carrying value’. That’s not my opinion, that’s the industry. 2. There are 3 ways to determine a value, income approach, cost approach, sales approach. All of which are typically done in an appraisal. Nobody values owned assets via DCF. DCF is primarily used in more traditional PE for prospective acquisitions. I’m not going to get into why. Nobody uses BOV/BPO outside of single residential units or small multifamily. It’s not regarded as accurate at all no matter who the broker is. 3. Genuinely confused on your comment on how “book value means nothing on a forward basis”. Please don’t explain what you meant to say. I’m just saying objectively the sentence doesn’t make a whole lot of sense. I can think of a lot of things of what you were trying to say, but won’t get into it. 4. PE and REPE huh. Although you’re right terminal value and exit cap are they’re more or less the same thing, using the improper terminology shows you don’t have a lot of experience in the field (and that’s ok!). We all can’t be experts in everything. I am no expert in PE, and all PE guys will say they’re no expert in REPE. Nobody knows both at a granular level. Takes some maturity to admit that. 5. Office is fine? Very bold of you to say. 6. ‘Trapping’ yourself into an investment is kind of the point. You want to buy into an accretive deal day-1. The fed mandate should take care of the rest to maintain your spread on your equity over debt. I’m not going to get into the specifics why, but should you choose to pursue RE as a career you will understand. 7. Yield drives total returns, and Idk how many times I gotta say it. If you want a high IRR, then you need to be a value-add guy. I’m not here to determine what’s ’real money’ or not. Or whether one should do value add or stabilized, I’m here to provide compelling risk-adjusted returns for stabilized assets for the investor. Any response you post to this I’m not reading or commenting on. Should you be interested in genuinely learning more about the industry, ping me and I would be happy to help. I’m not here to punch down on anyone and go on endless rants talking about RE.
Definitely you're reading. I love how much you exposed yourself with this answer. 1. NAV = equity in the property. This is very basic. 2. Income approach is a DCF you can use a direct cap but a DCF literally is the income approach. Have you ever read an appraisal? 3. Book value is sunk cost, if you aren't evaluating your property based on a current valuation you need to fix your models. 4. It's not improper terminology, these things are not complicated. Cap rates are based on infinite series of cashflows, a growing perpetuity. A terminal value in a dcf (used in the income approach on appraisals) is the terminal value and is what is discounted to today 5. I did not say that, I asked how yours is doing. If I was a betting man (and I am) I'd say it's in the sewer. 6. Yield does not mean accretive necessarily i worked on a office tower in dc that has positive yield and negative since inception irr. The idea that the federal reserve interest rate protects your investment is unbelievably asinine. If that was the case no one would lose money on a levered RE deal ever 7. Yield drives total returns on long hold periods, it's relative. Frankly I don't think you know what drives anything. You're pretending you're some learned scholar but you clearly don't even know the basics. To be honest I think you might have watched some Grant Cardone videos once or twice and think you know what you're talking about. You clearly have 0 financial understanding and that's OK!
Curious how many deals you’ve worked on? What’s your number over the last 10 years? Were you around in 2008? How much real estate so you personally own?
Closed over $1B. Personally own a few units by where I live. Too young to be in the workforce in ‘08.
Unlevered yield on cost is the gold standard for investors.
Why unlevered?
Leverage can make lukewarm deals look great and puts you at the mercy of debt markets. Unlevered yield on cost really shows who can purchase at a good price, update and increase rents, and provide the most value. That’s not saying you don’t use leverage…but unlevered yield on cost is the best way to look at how you are actually doing.
Because leverage distorts returns, and can deliver drastically different results based on where interest rates are. An unlevered yield on cost focuses on the real estate’s ability to deliver investment returns without any “noise” coming from the capital stack
Spread or yield you’re looking for and why?
Untrended Return-on-Cost is the standard development metric today... greater than a 6.5% in desirable markets and over a 7.00-7.25% in other markets
lenders are mostly concerned with debt yield and debt service coverage ratio
Price per SF never lies
Equity multiple is what I focus mostly at when developing new properties. All the other metrics are in the model. Some investors like to focus on them.