By Chris Fraley, Chief Investment Officer
With the advent of crowdfunding commercial real estate investments, individual investors have gained access to a diverse group of offerings. How does an investor sift through all of the different opportunities to find the investment that is right for them? I want to share one of the tools that I use when evaluating a market and specific opportunity. It involves an understanding of the relationship between replacement costs, demand, and the likelihood of new supply, and how they potentially impact a landlord’s ability to raise rents. It is fairly complicated to explain and illustrate how they might be applied to an investment strategy, so I have broken this down into a series of articles. This first article focuses on the economics of how new supply is created.
How does New Supply Occur?
Private sector real estate development simply does not occur unless the project is deemed feasible by an investor and can generate an attractive risk-adjusted return. In many parts of the country and infrequent periods of a real estate cycle, the supply/demand characteristics are not adequate to justify building new product.
Very few developers finance projects completely with their own capital. They typically secure debt from a bank or other lender for up to 70% of the project cost, and will usually set up a joint venture with an equity investor for most of the remaining capital. One of the metrics that lenders and investors look for when determining the project feasibility is “Return on Cost” which is based upon the following equation:
Return on Cost = Expected Stabilized Net Operating Income / Total Development Cost
If a project does not have an adequate Return on Cost, it usually will not get financed. On a more macro level, if the overall market rents cannot justify new supply, developers will generally not build in the market.
Understanding Return on Cost
The required Return on Cost that investors look for to determine feasibility varies over time, but it is highly correlated to projected capitalization rates. For example, if an investor is comfortable underwriting an exit at a 4.5% capitalization rate for a Class A apartment community, they will usually require a 6% Return on Cost for the Development. This is the quick test:
$100MM total development Cost * 6% Return on Cost = $6,000,000 Stabilized Net Operating Income
$6,000,000 Stabilized Net Operating Income / 4.5% Capitalization Rate = $133.3MM Residual Value
This would result in $33.3M of profit ($133.3MM - $100MM of cost) or roughly a 2X equity multiple on a project that was 65% levered.¹
How it Works: Determining Project Feasibility
First, one would need to project Development Costs. Let’s assume that this is a 250 unit, 200,000 square foot apartment building with an average unit size of 800 square feet and total development cost of $500 per square foot including land acquisition. The Total Development Costs would, therefore, be $100,000,000:
Now, let’s figure out the Stabilized Net Operating Income. We will assume for sake of simplicity, that the building has an expense ratio of 35%.
In the above scenario, the project would generate a 6% Return on Cost ($6,000,000 / $100,000,000 = 6%). If the project was in a market where a developer and investor feels comfortable underwriting an exit at a 4.5% Capitalization Rate, the project should be considered feasible and would likely move forward.
What is Replacement Cost Rent?
Replacement Cost Rent is the rent that a Real Estate Developer would need to project in a financial pro forma in order to create a feasible project. In the scenario above, the Replacement Cost Rent for the project was $3,076. In other words, given the costs of the project and the market’s desire to receive a 6% Return on Cost, the project would need to be able to charge an average of $3,076 per unit for a property where the average square footage of the units is 800 square feet.
If any of the above assumptions prove to be incorrect (i.e. market rent was only $2,500, or the hard costs experienced escalations, or the investment market shifted and demanded a 6.5% Return on Cost), the project would likely not get financed.
In my next article in this series, I will explain how understanding Replacement Cost Rent can, in some markets, give investors an indication of how much rents could grow. For example, in a high barrier to entry market like the example above, if Class A apartment rents are currently $2,000 per month for an 800 square foot two-bedroom unit with little vacancy and strong demand for new product, there is a very good chance that the market may experience rent growth. Conversely, if the market for that same unit is $4,000, there is some risk that new supply will enter the market and pressure existing rents. My next article will contain more examples and explain how to apply these principles in different markets.
Disclaimer: All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Readers are recommended to consult with a financial advisor, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors.
- For illustrative purposes only and do not necessarily reflect fees or taxes. Actual performance may vary.