In Chapter 2, we covered the first step of underwriting a real estate transaction: building a P&L and calculating an Unlevered Yield-On-Cost (UYOC). This chapter will cover the second part, which introduces the project’s capitalization stack and allows us to calculate Internal Rate of Return (IRR).  

While UYOC is useful, it is incomplete in a few ways: it does not take into account the time required to generate a given yield, nor does it contemplate exit scenarios or a project’s capitalization.

These factors are critical, as most developers don’t have millions of dollars of cash lying around to fund the development of new projects. Instead, they’ll have to raise capital from debt providers and equity investors. Like most real estate developers, Elevated Properties–the fictional developer we follow in Thesis Driven’s Fundamentals of Commercial Real Estate course–must raise outside capital to fund the development of Harbor Yards, their project. To do this, they’ll need to pitch investors on the return they’ll receive on their investment.

Calculating a return requires understanding how projects are capitalized. Typically, a developer like Elevated will raise different types of capital with different risk and return preferences. Debt, at the bottom of the capital stack, requires a lower return but also less risk, so it gets paid out before any other capital. Equity, on the other hand, will take more risk but also expect a higher return.

The size of debt on a real estate project is typically measured by “Loan to Cost” (for construction projects) or “Loan to Value” (for stabilized assets). This is simply the ratio of the size of the loan to either the cost of the project or the value of the asset. Typically, lenders are willing to lend more on stabilized, cash flowing assets as they are seen as less risky.

While lenders generally have limited upside–they can earn interest and their principal back at best–equity investors in a real estate project take a significant share of the upside. In most cases, developers such as Elevated Properties will offer their investors a preferred return (a “pref”), with Elevated taking a share of the profit (a “promote”) on any return generated above the investors’ pref.

While the lender will get his or her cash back before anyone, equity investors typically get their money back and a compounding pref before developers see a dollar of profit. While pref and promote numbers vary, it’s typical to see an LP earn an 8% pref (compounding annually), after which the GP (the developer) can take a 20% promote. So the LP earns 80% of the profit above a 8% pref hurdle while the GP earns 20%.

This “flow” of payments through a real estate deal–first lender, then LP, then GP taking their due–is called a waterfall.

Once we understand the waterfall it’s possible to calculate our investor’s return, or IRR. IRR is calculated as follows:

This calculation can get quite hairy–particularly for projects with multiple separate investments or distributions–so most analysts simply use the “IRR” function in Excel to calculate it. But it’s important to note that it takes into account the timing of the initial investment(s) as well as payout(s) to the investors to calculate the return.

In many projects, developers plan to sell their assets upon stabilization and return capital to their investors. As a metric, IRR is very sensitive to the assumptions that analysts make about the project’s eventual sale price–that is, its cap rate.

A cap rate is the ratio of an asset’s NOI to its sale price. While much can be said about what cap rates mean, they are best understood in the context of stabilized, cash flowing assets. In general, the higher the cap rate, the lower the asset price (per dollar of NOI produced) and vice versa. Since we are assuming a specific NOI, analysts underwriting a new development deal will assume a lower future cap rate if they want to be more aggressive and show a higher return. Since nobody really knows what the future cap rate will be–particularly if the project’s completion is years away–assuming a lower cap rate can make the IRR look much better without any change in underwritten performance.

As the chart above shows, predicting cap rates isn’t easy. They vary significantly across time and asset classes as well as across geographic markets.

One other note: while lenders and LPs get their cash out first, developers aren’t completely the last in line to get paid. Along the way, most developers take various fees, such as asset management fees, development management fees, and even acquisition fees. These fees help developers keep the lights on while they wait for their promote to materialize. Some developers with in-house operating teams also take leasing commissions and property management fees, while other developers outsource those functions to third parties.

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