Trying to wrap my head around YoC as a metric (dev & value-add)...
My understanding of YoC is that it's calculated as Stabilized Year NOI / Total Project Costs. It's often said that you need your market cap rate for the project you're building/renovating to be above YoC by a certain percentage (often called a "development spread"). Is this essentially the developer's profit margin? Would you call that spread the "value creation"?
Also, I've seen it quoted that you want a 150-200+ bps spread in order for it to be worth your while on ground up dev, and then that spread requirement decreases as you move towards less risky investments. For ex, 100-125 bps for heavy value add and 50 bps for light value-add/mark to market; presumably all Core acquisition deals are at par value, i.e. your costs approximately equal the market cap rate because there's minimal risk - you're just clipping a pre-determined (market cap rate) coupon. Is that about right?
In regards to the rule of thumb dev spread people often quote, wouldn't this be contingent on the product type you're dealing with? A 200 bps spread on a 6-cap multifamily deal yields a 33% profit margin, whereas that same 200 bps spread on a 10-cap office deal yields only a 20% profit margin. Assuming we want to speak asset class-agnostically, would it better to discuss percentage change in profit margins rather than spreads?
Also, I'm curious to hear what some of the spreads you're requiring for the asset class you're working on in this current economic climate. Would be helpful to list asset class, spread, and either market cap rate or targeted YoC.
Finally, seeing as profit margin can also be looked at as margin of safety, what do you typically suggest a new developer target in terms of a profit margin in order not to get totally burned on his/her first deal? 35%? 50%? 70%?
You want your ROC to be higher than the market cap rate of the product you’re selling. ROC and cap rate are just inverse multiples of the same NOI. You want to be building at a lower multiple (higher %) and selling at a higher multiple (lower %). That is the value spread of developing a new building, and for taking the risk, etc. you have control over more components than just a flat out purchase price. Spread demand between investment strats should expand as the execution is riskier (risk premium).
OK, then I had it backward. You want YoC to be higher than market cap rate. It's like trying to achieve cap rate compression for an acquisition then?
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