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Page 26 — Property Management Quarterly — April 2017
such as supply, demand and interest
rates.
The second important financial con-
cept is return on cost. Return on cost is
simply the ratio of income to cost and
is most relevant when discussing new
construction projects or capital invest-
ments.
For example, let’s assume that Prop-
ertyY described above requires a
capital investment of $750,000 and, as
a result of this capital investment, we
project the NOI will increase by $75,000
– then the return on cost is 10 percent
($75,000 divided by $750,000). This capi-
tal investment would be viewed as pos-
itive for the owner because he would
be receiving a higher return on this
investment as compared to the original
purchase (10 percent vs. 8 percent). The
return on cost gives you a view of the
financial feasibility of a particular proj-
ect or development and is a key metric
when evaluating the cost-benefit anal-
ysis of different projects.
The third important financial concept
is leverage, or debt financing, which
can improve the yield an investor
generates from an asset. For Property
X, the investor expects a 5.95 percent
return, or yield (assuming the property
was purchased all-cash).
Now, let’s assume the investor can
finance a portion of the purchase price
with a bank loan at a 4.5 percent inter-
est rate. This will result in a higher
cash-on-cash yield for the investor
because the interest rate is lower than
the cap rate – 4.5 percent interest rate
vs. 5.95 percent cap rate.
However, there is some additional
risk to this strategy because the real
estate asset is held as collateral by the
bank. If the cash flow from the real
estate asset declines significantly and
the owner is unable to pay the debt
service, the bank can foreclose.
Property managers should under-
stand the risks associated with debt
and be proficient in calculating key
ratios that banks monitor when track-
ing their borrowers’ loan covenant
compliance – key ratios include loan-
to-value and debt service coverage
ratio.
In order to be more effective as a
property manager, you need to have
a fundamental understanding of
these three concepts. By understand-
ing these key concepts, you will be an
asset to your clients and you will be
able to answer everyday questions,
such as:
• My owner is planning to put the
property on the market next year. The
owner wants to sell the property for
$20 million – what NOI will achieve
this sale price based on today’s cap
rates, and how do I achieve that NOI?
• How does this capital expenditure
that I am recommending ultimately
impact the value of this asset? Is the
return on cost for this capital expendi-
ture sufficient?
• The loan agreement for my proper-
ty requires a 1.25 debt service coverage
ratio.Will the property be in compli-
ance if my operating expenses increase
by $25,000 through the remainder of
this year?
By regularly considering and answer-
ing these types of questions, managers
truly can say they treat the property as
if they own it. s
Finance
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Property Management
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Historical Cap Rates
INVESTMENT ANALYSIS & FINANCIAL MODELING 101 1
The spread between cap rates and
treasuries is a proxy for the additional
returns CRE is expected to yield
relative to low-risk government bonds
The return on cost gives you a view of
the financial feasibility of a particular
project or development and is a key
metric when evaluating the cost-benefit
analysis of different projects.
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