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To be successful in the commercial real estate sector, developers need foresight. An in-depth understanding of the variables that could impact a project's development is crucial to its execution. And knowing a real estate property's return on cost is essential to secure investor funding. The long-term financial viability of a project has always been a part of the development process, but it’s become more prominent due to mounting macroeconomic uncertainty.
Under these conditions, developers can’t come into the conference room with anecdotes and gut instincts. Speaking confidently about a property’s earnings potential in the current marketplace requires a data-driven strategy. And creating those forecasts requires a comprehensive understanding of what return on cost means, how it's assessed, and its associated risks.
But before you do that, you need to have a firm grasp on capitalization rates (cap rates).
What is a Cap Rate?
Cap rate refers to the annual rate of income an owner can expect from a property. To calculate a project’s cap rate, you divide its net operating income by its total cost. Net operating income is determined by taking a project’s anticipated yearly revenue and subtracting its operating expenses. So, if a property costs $15 million and has a net operating income of $825,000, it has a cap rate of 5.5%. Investors can analyze a property’s trailing cap rate, the revenue generated in the last year, to better gauge its potential. They can also use its initial cap rate, the income it could produce in its first year, to inform their decision-making.
For investors, cap rates are a hugely important metric because it helps them approximate a property’s value project and its ROI. The metric is primarily helpful in calculating the value of a stabilized property, one that doesn’t require ground-up development and has a high occupancy rate. An example of a relatively low-risk stabilized property would be a life sciences center housing several doctors’ offices and a medical laboratory.
That said, it’s important to remember that cap rates are theoretical because of the real estate sector’s volatility.
For example, the actual net operating income for a New York City office building in 2020 would be significantly lower than predicted because of COVID-19. Municipal shelter-in-place orders and the widespread adoption of remote work significantly reduced occupancy rates and continue to affect demand two years later. Accordingly, investors consider multiple metrics, including return on cost, before going all in on a project.
What is Return on Cost?
Return on cost, also called yield on cost, is the formula used to assess a project’s long-term value. To calculate it, you add a project’s total price to its value-add expenses and divide that amount by its net operating income. Value-added expenses are costs associated with property renovation, like upgrading a building’s interior or exterior. Return on cost is an important ratio in determining the effectiveness of a strategy intended to maximize the value creation of real estate acquisition.
An aging retail center comes on the market with a total cost of $15 million and an anticipated net operating income of $675,000. An investor might find that 4.5% cap rate appealing to add the property to their portfolio. But a developer might believe it has a greater potential yield with a plan that prioritizes return on cost. In this scenario, the project's total cost would be $18 million, $15 million for the purchase, and $3 million for a 12-month renovation. Once the retail complex is fully renovated, its net operating income would rise to 8 percent or $1.2 million per year.
In practical terms, the difference between cap rate and return on cost can be viewed as risk tolerance. Some investors prefer to put their money into a stabilized property that can generate consistent income over several decades. There are no guarantees that property renovations will translate into greater revenue. Others might feel putting up more money upfront would be worth a higher net operating income over time.
Even so, developers need in-depth knowledge of a project’s return on cost risks to earn and maintain the trust of their stakeholders.
Major Return on Cost Risks
You should consider three significant risks when considering whether a return on cost focused strategy is worthwhile.
First, project teams should know as much about a property’s leasing risk as possible. Events like COVID-19 can’t be anticipated, but analyzing historical data on geography, asset type, and tenant can provide important predictive insights.
For instance, Walmart’s unparalleled financial performance makes it an ideal retail center anchor across the United States. Acquiring a property for one of its stores is a good idea because the brand’s robust and long-standing connection with consumers ensures the security of its rental payments. Moreover, its enduring nationwide appeal makes it a good strong anchor to attract other tenants.
In addition, when implementing a value-creation strategy for a project, you should always know a property’s execution risk. For a tenant like Walmart, the execution risk is relatively low. But the financial commitment required to repurpose a former mall as an industrial facility or residential space is a dicier proposition. In an economic environment that has prompted banks to scale back on investments in commercial real estate, some capital-intensive projects aren’t worth the exposure or effort.
Lastly, there’s construction risk. Estimating a project’s construction hard costs is a complex process with many unpredictable elements, such as raw materials expenses. Then there's the issue of cost overruns caused by many change orders. If a project is rushed into the construction phase before schematics are complete, confusion regarding vendor responsibility becomes inevitable. Once that happens, contingencies get depleted, last-minute reallocations occur, and the budget goes into the red.
However, developers should know they can mitigate the impact of real estate return on cost risk by using proactive intelligence platforms. Real estate development software uses data storage and analytics to leverage historical data to anticipate costs from project inception to closeout. Download our Complete Guide to Commercial Real Estate Data Analytics to better understand the data all real estate developers need to be tracking to ensure projects are successful.
Tag(s): Real Estate Development
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